Since its inception in 2014, Twin Brook Capital Partners – the lending arm of Angelo Gordon – has been providing cashflow-based financing in the form of senior secured loans to the middle market private equity community. To date, the company has closed over 1,100 transactions with 200 different middle market private equity firms. The firm has offered finance for everything from leveraged buyouts and recapitalizations, to add-on acquisitions and growth capital, among others. The companies that Twin Brook works with typically have an EBITDA between $3 million and $50 million. A larger proportion of these are companies with $25 million of EBITDA and below.
The Chicago-headquartered company is close to reaching a first close on its third fund, Angelo Gordon Direct Lending Fund III. The vehicle, which has a mix of US and international investors, is seeking to raise $2 billion. That is $500 million more than its predecessor, Fund II, which is now more than three-quarters deployed.
What do you consider the primary challenge for a middle market lender in this competitive market?
The primary challenge that any lending firm has in a “hot” credit environment is that there are far more sub-optimal transactions that come to market. When leverage markets are awash with money; private equity firms are eager to deploy capital; and purchase price multiples are at an all-time high. Weaker borrowers stand a much better chance of trading or getting financed.
The outcome of this is that we need to say “no” more often to our sponsors or possibly deploy resources triaging deals that we would not normally spend time on. The flood of weaker deals can put pressure on resources and underwriting bandwidth.
How do you think deal structures have changed in the context of a competitive market?
The answer somewhat depends on what part of the lending market you target, but the obvious changes are around pricing and leverage which clearly have moved in issuers’ favour. In some cases, lender protections such as such financial covenants and various negative covenants have also been weakened in recent years. The absolute acceptance of covenant-lite transactions in the broadly syndicated market – which includes companies with more than $40 million of EBITDA – is more normalised than it was in 2007-08.
The emergence of covenant-wide transactions – with companies that have more than $25 million of EBITDA – in the last 12-18 months is also alarming. The lower middle market – less than $25 million of EBITDA – is somewhat immune from these structures but there is always some level of pressure for sponsors to push larger precedent deal terms throughout the middle market.
What kinds of US companies – in terms of sector, size and needs – are most attractive to private debt lenders right now?
Given where we are in the cycle right now, we believe it’s the companies that showed strong resilience through the Great Recession – or exhibited strong, counter-cyclical attributes – that are the most attractive. Having the right financial sponsor associated with these borrowers is also important, not just for their expertise, but their willingness to support the company with follow-on capital, if necessary.
The size of the company is less clear in its importance because larger borrowers come with very loose credit protections and little or no financial covenants, versus smaller companies who have more traditional protections in place but lack the scale of their larger competitors. Industry verticals – whether its software and technology, healthcare or financial services – are sectors that come to mind that provide lenders comfort, particularly in light of where we are in the cycle.
“Given where we are in the cycle right now, we believe it’s the companies that showed strong resilience through the Great Recession – or exhibited strong, counter-cyclical attributes – that are the most attractive”
Does the amount of dry powder in the market concern you? How can the industry best mitigate the impact of it?
I think it concerns everyone in the market as it creates structuring pressure on lenders, but we believe execution, structure flexibility and long-term relationships are the key decision-making factors for borrowers. The winners and losers in private credit will be determined by the depth of the lending team’s experience, the strength of a lender’s origination function and the role the lender plays in a transaction.
If you have a well-established direct originations function – instead of relying on buying other lenders’ deals – we believe that bodes well for long-term success. If your role in these transactions is to act as an administrative agent, that should also be helpful in the long term for your strategy. This is because you are able to deepen the relationship with a sponsor; build a larger and diverse portfolio of credits; have more control over the credit agreement; and generate more capital market income than your competitors.
Does the competitiveness of the deal market dictate one preferred financing structure over another?
In a market that demands speed from buyers who need to minimise lender processes on their side, unitranches have become a popular alternative to more traditional two-party debt structures. However, sponsors will often opt for senior-subordinated debt structures because they have good relationships across both senior and junior debt providers and are comfortable coordinating multiple tranches in the debt structure. These days, sponsors will typically ask lenders for term sheets highlighting both options. Ultimately, it comes down to certainty, speed, flexibility and price.
What role do the banks play in the current debt market? Are US private debt lenders more likely to see them as competition or as partners?
In the middle market, commercial banks are struggling to maintain relevance in the sponsored lending world. The regulations are a significant time drag on their ability to screen, underwrite and process a transaction. Despite the new administration, the relaxation of Dodd Frank and the overall tone of less regulatory oversight, banks still maintain that getting transactions done is fraught with restrictions. Separately from the regulations, the banks are having a difficult time competing on hold sizes, lack of product offering, unitranches, amortization terms etc.
“The winners and losers in private credit will be determined by the depth of the lending team’s experience, the strength of a lender’s origination function and the role the lender plays in a transaction”
Moreover, it’s the overall lack of conviction that most banks have around the space. Finance companies are set up with the sponsor at the centre of their reason to exist. For banks, middle market sponsored finance is not what gets them excited. Their focus is selling treasury management, foreign exchange and other non-interest-bearing products. Credit is important to them, of course, but their risk tolerance is really geared towards larger double B or investment grade rated companies where they can sell their traditional banking products.
How do you think private debt lenders can best prepare for a turn in the credit cycle?
Without a doubt, we believe it comes down to the size and experience of the professional staff that a lender employs. When the cycle hits it’s all about bandwidth. If an account manager has 15-20 names he, or she, is responsible for, and just one of them goes sideways, that’s an increased time constraint on that individual. During a cycle that portfolio may have two-thirds of those 20 names in triage for an individual account manager. That is not sustainable. However, lenders that have invested heavily in personnel to manage through the downturn should come out with better outcomes. Twin Brook has a professional staff of over 45 people and plans to add another seven by year end. Our preferred ratio of account managers to borrowers is 1:6.
What is you biggest source of optimism in the US private debt market right now?
Despite the fact that the market is somewhat frothy today with price and structure clearly in favour of borrowers, the bright spot for lenders is that we believe there are no indicators that we are near a recession. In the event a cycle occurs, the US economy is likely more insulated from the severity of the shocks that occurred in 2008-2009. Also, dealflow continues to be strong. The first half of 2018 showed a significant increase in M&A volume over previous periods and the number of opportunities in all segments of the market continues to be robust. Despite the amount of liquidity in the market, we believe there are ample opportunities for experienced lenders to deploy capital.
This article was sponsored by Twin Brook Capital Partners. It first appeared in the US Mid-market Report that accompanied the September edition of PDI.