Open Range

New York City froze this winter. Ten stories above West 57th Street, where the typical throngs of businessmen and tourists gingerly tiptoe through icy puddles and muddy snow banks, the co-head of Kohlberg Kravis Roberts’ leveraged credit platform is considering brighter days and greener pastures.

“When we look at it, I feel like we’re in Iowa before any farmers got there,” Erik Falk tells Private Debt Investor over lunch. “There’s a huge space.”

An Illinois native, Falk’s choice of metaphor appears apt. There are parallels between the formative years of the American Midwest and those of the non-traditional lending sector. Like the early homesteaders of America’s breadbasket, asset management firms forming private debt and credit strategies are venturing into a wide-open landscape removed from traditional regulatory constraints.

Extending the metaphor, private borrowers’ demand for capital – particularly those in the mid-market – exceeds the amount that has been raised by asset managers, thereby creating a supply / demand imbalance that eases competition for favourable assets. Simply put: when it comes to private debt, there’s more farmland than there are farmers.

As a member of KKR’s leveraged and private credit investment committees, Falk has overseen the development of the firm’s credit and debt platform since joining in 2008. Before KKR, he co-led Deutsche Bank’s securitised credit group and sat on its Global Markets North American Management Committee and Complex Transactions Underwriting Committee. His transition from the world of banking to that of non-traditional lending mirrors the one taking place in the market at large.

As banks continue to scale back their private lending operations – both in the US and in Europe – a growing number of private equity firms and other non-traditional lenders have filled the breach. Even with the addition of new entrants however, the marketplace remains far from crowded.  

“The funniest thing to me is, everyone in the market likes to talk about all these competitors out there,” he says. “But if you aggregate the capital that those people have, it seems to me like it’s a lot less than the Wall Street proprietary trading desks when they were all levered 15x, 20x to 1. And that doesn’t even include other areas of the banks. They all had these businesses, and they all had these businesses in the US.”

Or, they did until the credit crisis hit. The crisis’ effect on the banks, and that of the subsequent tightening of lending regulations, limited the banks’ ability to provide financing, which opened the market to managers operating with institutional capital. Having established a credit practice in 2004 – well before the crisis – KKR responded to the market dislocation by building out its platform across several unique verticals.

Five years removed from the crisis, the opportunity set remains fertile, and anything but frozen.

 

The build-up

In January this year, KKR announced a $2 billion final close on its debut special situations fund – doubling the target the firm had set initially. That highly successful fundraise capped an effort that spanned roughly a half-decade, a period that also included the launch of discrete funds for KKR’s direct lending and mezzanine strategies.

Even before KKR came to market with its special situations vehicle, it pursued those investments and other credit strategies through its separately managed accounts business (launched in 2008) and with balance sheet transactions, says Jamie Weinstein, who oversees the special situations fund from the firm’s San Francisco office. Nat Zilkha, who is based in London, acts as co-lead on the strategy.

“One of the things we learned in launching a separate account platform, and bringing institutional investors in that format, was that they actually wanted to invest in discrete strategies,” says Weinstein.

“And the way they look at their asset allocations, and how they think about breaking down the world of credit, is that they wanted to have a more focused effort. And that led us to analyse how we organised ourselves and how we structured our business.”

As investor demand for credit and debt related strategies grew, the firm used capital raised by its separate accounts business to establish a track record for investing in special situations and other strategies. That track record provided proof of the firm’s capabilities when it launched specialist investment vehicles for several of its credit strategies – i.e. separate pools of capital with commitments from multiple investors for special situations, mezzanine and direct lending, respectively.

“It’s one of the lessons we’ve learned as a firm over time. Seeding new ‘first time’ funds can be challenging,” Weinstein says. “One way to approach them is to go to close relationships of the firm, and raise discrete pools of capital from them. Or in some cases, we’ve actually used the balance sheet of the firm to create a discrete pool of capital and build a track record.

“When we went to market with the global special situations fund, we were able to use a track record that was – at that time – already three years old and now four years old.”

Interestingly, while Weinstein characterises the launch of discrete versions of KKR’s credit strategies as being investor-driven, Falk and Marc Ciancimino – who leads the firm’s mezzanine business – maintain that the decisions to form direct lending and mezzanine vehicles were rooted in the firm’s desire to match the skillsets of its investment professionals with sponsor and borrower demand for alternative financing.

“Even though at that time we were quite focused on the liquid markets, we were seeing enough of these originated situations and we felt that given the infrastructure we had for sourcing, [and] also the diligence approach we take, we were pretty well placed to have a proper mandate,” Ciancimino tells Private Debt Investor.“We felt we’d have a good sourcing network. And then, we felt we’d bring a little bit more of a private equity approach to junior credit. Doing our own origination, our own diligence, using the resources that we have across the whole firm.”

Ciancimino joined the firm from the now-defunct GSC Group in 2008. The formal launch of the mezzanine strategy in 2010 ultimately led to senior lending opportunities, says Falk.

“What was really a catalyst for us, when we started our formal mezzanine business, with originators going out, they were calling on sponsors, they were calling companies,” Falk says. “What was coming back a lot of the time: ‘It’s great that you want to provide mezzanine. Do you have any ability to provide senior debt to us?’”

 “We did have some ways to do that, but it was with limited pools of capital. That was really the start of us segmenting direct lending into a business,” he adds. “It was really more of a pull than a push.”

The market “pull”, in Falk’s words, has been greater than KKR anticipated initially. KKR closed its Mezzanine Partners Fund on a little over $1 billion in 2011. The firm announced plans to launch a senior direct lending fund the following year. That vehicle raised just under $500 million with a GP commitment of $100 million.

Those vehicles are almost entirely deployed at this point and the firm invested more than $4 billion through its special situations, mezzanine and direct lending strategies last year, head of global capital and asset management group Scott Nuttall told analysts during a fourth quarter earnings call in February.

“We have seen the origination pace pick up and be much faster than we thought it would. We always thought it would take us three years to invest, it’s taken us basically two,” says Falk, in regards to the direct lending fund.

“The deals that we see, and the velocity of deals, is getting to be more rather than tapering off in the market.”

 

Putting capital to work

The speed with which KKR has put capital to work is indicative of the breadth and scope of the credit platform’s sourcing capabilities. However impressive the firm’s reach may be, its ability to make the most of that reach is also dependent on economic trends market affecting the market at large. The investment theses governing the mezzanine, senior direct lending and special situations platforms’ investment activities are united by a common truth of current financing environment – banks aren’t lending like they used to.

“When I rewind back to when we were raising the first fund, and I think about the presentation that we were doing then, definitely one of the theses we had on how the markets would evolve globally was that private credit would fit most naturally with those set up to take that kind of risk,” says Ciancimino.

“We felt it wasn’t the most natural thing for [commercial banks] to hold and that their expertise and use of their balance sheet was best suited to other types of credit,” he adds. “It has played out like that to some extent.”

The banking sector’s withdrawal from mid-market financing – particularly in Europe – coincided with a period of greater investor demand for yield. Furthermore, as banks pulled back, private companies were forced to seek alternative sources of capital for their M&A, refinancing and recapitalisation needs.

In short, the volume of financing demanded by the market exceeded what KKR had anticipated when it was marketing the direct lending fund, which contributed to the fund’s accelerated investment pace. The source of that activity has come from a few different areas, says Falk.

“When you move over to Europe, some of the activity is picking up when you look at core M&A,” says Falk. “The second thing that’s important is, in Europe there have been a lot of situations where banks have been lenders to companies but there hasn’t been that catalyst to refinance. The banks weren’t going to sell the loan to take a loss, the companies really liked the cheap financing they had – but now you’re coming up on the ultimate refinance need.”

“We’re seeing that converting into more pure refinancings, sometimes it turns into an M&A deal because the sponsor says, ‘Alright, enough of this I’m going to sell’,” he adds. “The other thing is, when you look at the banks, outside of a certain set of companies that we ourselves can’t define – they’re not willing lenders. So the sponsors are reaching out to alternative capital providers.”

That could be one reason why the special situations platform has focused on European transactions through the early stages of its new fund’s investment period (the fund held a first close in late 2012). KKR highlighted five investments made in 2013 in its announcement on the fund close; bed and mattress manufacturer Hilding Anders International, food business TPS Group, abrasion and cutting technologies company Winoa Group, the insulation division of Uralita and Amedisys, a home healthcare company. All but Amedisys and TPS Group are European companies.

“We had been very active in the US, in 2010-2011 in particular. The market opportunity had shifted to look much more like Europe. And we told people that we would end up investing a majority of the capital – not all of it – but a majority of it, in Europe,” says Weinstein. “In 2014, that’s still the case.”

“Thematically, the European banking system remains clogged with a lot of assets that aren’t necessarily resolving themselves,” he adds. “The European approach had been one characterised by a lot of regulatory forbearance by regulators, which means a long slow grind through a credit crunch. And Europe is still in the middle of that.”