This article is sponsored by Monroe Capital.
It’s been a volatile two years, with highs and lows. How would you assess the opportunity set today?
The past two years have been unprecedented. But our experience for the last 18 years instills a sense of credit discipline that has served us well. We’re going to remain deliberate during heady times, and this positions us to remain active when others may head to the sidelines.
Looking back to last year, though, the pandemic created a backlog of activity. And once the economic picture started to improve, and investors gained confidence that certain sectors could withstand another round of lockdowns if that occurred, M&A activity started to percolate again. You also have record amounts of dry powder in private equity, a private debt market that has also been raising record amounts of capital, and it set the stage for one of the busiest deal environments during the last half of last year.
A lot has changed, though. While at this point last year, nobody could say for certain the pandemic was behind us, this year we don’t see any evidence of an economic slowdown. With the inflationary backdrop and likelihood for future interest rate hikes, a sense of caution still endures.
It’s been a long time since lenders had to plan for an inflationary, rising-rate environment. What are some considerations?
It’s true that as a floating-rate asset class, private debt is going to be attractive in a rising-rate environment. The counter point, though, is that identifying managers that produce differentiated risk-adjusted returns is going to become a bigger factor for investors in this rate cycle. Among lenders, it becomes that much more important to stick to your knitting to produce alpha.
At Monroe, we remain hyper-focused on our underwriting to ensure a margin of safety exists so our borrowers can service their debt when interest rates climb. But the bigger and related threat is inflation. And we’re closely monitoring the extent to which rising raw material, component and labour input prices could begin to erode margins. We’re also attuned to the potential risk that consumer and business spending might be negatively affected in certain segments.
You also have the geopolitical tensions and the war in Ukraine, which has the potential to create secondary impacts that exacerbate supply-chain uncertainty and add further impetus to rising input costs, especially on the energy side.
Given threats, where and how are you finding conviction in this market?
Again, experience is critical. That experience includes managing risk through multiple economic cycles and across multiple industries. We manage these risks several ways.
The depth of our pipeline allows us to be highly selective when constructing our diversified loan portfolio. In the lower middle market, too, there isn’t the same kind of pressure to give up documentation protections or loosen or forgo covenants.
Another factor is maintaining strict investment discipline around acceptable leverage, loan-value and liquidity levels. Inflation, if it starts to impact margins, can affect these metrics over the life of a loan. But we’re not the type of lender to make a loan and leave it in the top drawer. We closely monitor a company’s performance and have protective covenants in the event a borrower deviates from plan. And importantly, we have close relationships with our borrowers.
We also seek to work with companies with defensible market positions and resilient business models, and scrutinise the experience of management teams and their financial sponsors.
Where are you finding companies that fit this description? Is it case by case or do specific sectors lend themselves to this archetype?
Certain sectors, of course, are going to be more sensitive to inflationary pressures or rate hikes. Right now, inflation issues are most acute in certain industrial and durable goods sectors where profits have not been as strong due to margin compression. Interest rates remain relatively low, but we are cognisant of the potential top-line impacts on rate-sensitive industries where consumer or business spending is
Alternatively, we’re continuing to find safety in areas that we have historically focused on and are more protected, such as technology and software, business services and healthcare.
Take technology and software. We have deep relationships and domain expertise that go back years. The importance of tech is also growing. You saw this during the pandemic. Companies prioritised their digital spending because it has become essential to day-to-day operations.
In a period of rising costs, technology also represents a source of efficiencies. From the perspective of a lender, the industry’s ongoing shift to a recurring-revenue model imparts stability and visibility.
Similar themes are playing out in business services, where the labour shortages help to amplify the value proposition of specialist vendors. And, of course, healthcare enjoys the tailwinds of an ageing population and steady demand untethered to the economic or market cycles.
Given the rapid ascension of the private debt market and the amount of capital that has flowed into the asset class, where is growth available for fund managers?
The key, again, is to stick to your knitting and core competencies. Available growth for fund managers exists through expansion into complementary strategies or geographic markets or by focusing on specific industries. Additionally, creating bespoke vehicles for certain investor types, like insurance companies, can further accelerate growth.
At Monroe, that has meant capitalising on our deep private credit expertise we have developed over the years. Our opportunistic strategy, for instance, targets asset-rich segments where our loans have strong downside collateral protection and we have the ability to earn asymmetric returns for our LPs due to transaction complexity, a misunderstood situation or market dislocation.
The common threads are extensive experience through multiple market and economic cycles, deep domain expertise, and a “credit first, zero loss” mindset. This approach guides us during the highs and the lows. It also allows us to put capital to work in many environments, but particularly in a market like this in which underlying growth trends remain in place even as the macro-economic picture becomes a bit more cloudy.