“People say the world has changed, but the reality is, the world has caught up with us.”
Theodore (Ted) Koenig is reflecting on the huge growth in the private credit market over the last five years as investors have migrated away from other, low-yielding investment options in their search for safe returns. After all, he points out, he has been operating in this same market with the same management team for some 15 years “and nothing has really changed.”
Koenig is president and chief executive officer of Monroe Capital, the Chicago-based mid-market investment firm that covers a wide spectrum of private credit opportunities in the US including senior loans, unitranche loans, junior capital, club and syndicated investments.
He points out that, despite what many people perceive to be a significant opportunity in providing financing to mid-market companies, there are very few independent asset managers such as Monroe Capital operating in the space. “A lot of managers have been formed by the likes of pension funds, insurance companies and hedge funds but we've grown our business independently and as such, our interests are completely aligned with our LPs. We can't raise another investment fund unless the last one was successful,” explains Koenig.
With good reason, Monroe is just finishing raising its tenth investment vehicle at around $800 million of LP commitments before accounting for fund leverage.
Koenig speaks about the subject of private credit warmly and it's no real surprise that he is by now a veteran of the conference circuit. “It's been a lot of fun,” he reflects, as he ponders his 25 years in middle-market finance. “I like what I do and I enjoy talking about it. I see us as a unique firm and as having an entrepreneurial value-added approach. It's been fascinating to be here and watch the market grow and mature into a rock-solid asset class now.”
SEEING THE DIFFERENCE
Part of that maturity is being seen in the investor community, as limited partners (LPs) make the journey from seeing private credit as a good thing per se to seeking to recognise the differences between asset managers. “Over the years, private credit has been a market based on historic data. Investors have concluded that the market simply is what it is and that's ok because it's been performing better than many other asset classes,” says Koenig.
However, he continues: “Over the last few years, because of the increase in the number of asset managers and the sheer amount of capital that has been raised, LPs have started to look for consistent yield and 'alpha' rather than 'beta'.
“So who creates the alpha? If you're the largest foundation in the UK, one of the largest Finnish pension funds or the largest insurance company in Germany [all examples of real-life investors in Monroe funds], you're looking at around 40 asset managers in private credit and it's hard to differentiate one from another.”
Those LPs, Koenig adds, have increasingly gone down the road of employing consultants to help them with their choices. By way of extensive benchmarking, deep diving into strategies and track records, as well as spending time with the managers in question, those consultants are finding ways to understand the differences in various platforms and reward those managers who actually do create alpha.
One distinction is by market size. In the US mid-market, there are broadly speaking three categories: those focusing on businesses with $75 million EBITDA and upwards; those with $25 million and upwards, and, those (like Monroe) targeting businesses with between $5 million and $25 million.
“We've generated a lot of alpha over a long period of time at the smaller end of the market. We like this niche and believe that LPs have come to appreciate the differentiated returns we generate,” Koenig insists.
Beyond size of business targeted, there is another important differentiator – the ability to do so-called sponsorless transactions, i.e., providing financing for companies that are not backed by a private equity firm.
“Historically, we've always done sponsorless deals,” relates Koenig. “There is tremendous alpha on sponsorless deals of around 100 to 150 basis points in terms of the price differential and another 50 basis points or so of fee differential. If you leverage that at one to one-and-a-half turns over a three-year return period, then that's 300 basis points of net annual alpha return for LPs.”
Of course, this would appear very appetising for LPs, which Koenig is quick to confirm – but he is also keen to add a note of caution. “LPs love the prospect of that premium, but from a fund manager perspective, sponsorless transactions are very hard, time-consuming and expensive to access.”
In Koenig's eyes, one of the keys to being able to tap the opportunity effectively is to have multiple boots on the ground across numerous locations.
To this end, Monroe has 18 dedicated origination professionals raking over the space in the US from the firm's nine offices. In addition to Chicago, these offices are located in New York, Los Angeles, San Francisco, Atlanta, Boston, Charlotte, Dallas and a Canadian base in Toronto.
Koenig highlights two major sources for sponsorless transactions: generational change within family businesses; and a demand for financing among businesses that want to grow but not be sold. But although the potential universe for such deals is large, he baulks at the suggestion that it's a massive opportunity in reality.
“The market is only so big,” he states. “People look at the success we've had and think 'that must be easy and we can do that'. And then they try it but it doesn't work and it's proved to be really expensive and hard to break into. Part of the reason is that it's very relationship-oriented and business owners will focus on the longevity of the investor and their reputation for fairness allied with commercial acuity. These borrowers want to deal with people and not firms. We have been doing this for over 15 years now, often financing the same company buy-out for multiple PE firms or purchasers.”
TAKE NOTHING FOR GRANTED
On the unpredictability of such deals, he says: “A lot of non-sponsor deals fall apart before you get to the finish line. With private equity deals, there is a need for finance as the deal is imminent, so there likely will be a closing. In the non-sponsor world, there may not be a pressing need for the finance and people often change their minds as to a closing. They may initially seem keen, and then they decide they don't like your suit or your personality or your business terms.”
Koenig proceeds to outline some of the other challenges: “You have to do a lot of work to dig hard in order to find these deals as they come from many different sources and places. Then you have to conduct extensive due diligence and underwriting. Finally, you have to execute,” he adds.
If all this sounds too much like hard work, Koenig is a firm believer that it offers rewards that make it worth it. He points out that private equity-backed deals account for around 80 percent of the market and, because of this, they are much easier to source. They are also easier to transact, with what Koenig describes as “a due diligence package that comes to the lender very often, all tied up in a nice neat bow.”
The downside of this lies in the fierce competitive environment for such lending deals today, with many seeing auction processes involving multiple lenders that inevitably drive down interest coupons, increase leverage and raise LTVs (loan to values). That is the reason that Monroe maintains a healthy mix of PE-sponsored as well as non-sponsored financing transactions.
With Europe frequently importing trends from the US, it comes as little surprise to discover that non-sponsored deals – while beginning to take root in Europe – are on a much smaller scale than on the other side of the Atlantic. Koenig believes the non-sponsored market in Europe is about 10 years behind the US and says the continuing strength of local banks in lending to the mid-market and the lack of regulatory pressure is a major reason why.
Koenig states: “The banks are not in the same position as in the US, where regulators have done a more thorough enforcing job and leveraged lending has moved out much more into the private credit world. In Europe, the banks find themselves in a more advantageous situation. The corollary to that, however, is that pricing in Europe is not as firm for these financing transactions as in the US.”
Koenig says he is frequently asked whether Monroe will be moving to Europe, and concedes that he has been keeping a close eye on the region over the last few years. However: “The reality for us is that the US market is much deeper. We invested $1.8 billion last year in 64 transactions. The European market is not that deep, and at the lower end of the market where we like to play, there are very few transactions that the banks will let go.”
He also points out that the idiosyncrasies of individual markets in Europe are challenging. Koenig adds: “Each country has different credit challenges. We are very credit-focused, and we don't want to change the way we do business. We would like to participate in Europe but we need consistent and expected alpha for our LPs. We are continuing to look at ways to find it.”
Focusing back on his home market, Koenig sounds a lot more assured: “In the U.S., it will be more of the same,” he asserts. “Non-sponsored deals will continue to be difficult to source and we will continue to seek them out, along with their promise of outsized returns.”
You speak a lot about alpha. Why is that so important right now when your asset class seems to be so hot in terms of fundraising?
TK: That is precisely the time when managers should be considering alpha and what makes their investment platform differentiable and sustainable. LPs are becoming more sophisticated in this asset class and my view is that they are going to be selecting managers that can generate long-term consistent and safe yield. There may be a “trade” opportunity right now in the space, but that will not last. I have seen this business mature now over 15 years and through three down economic cycles. The managers that have built lasting and reliable platforms all generate alpha in some form.
You mention that you have run your business through three down economic cycles over the last 15 years. Why have you and Monroe been able to succeed and prosper when so many other firms in this space have not made it past these cycles?
TK: There are three primary reasons: First we do not and have not raised AUMs for the sake of growth. While maximising fee income is very enticing to the manager (particularly those asset managers that are institutionally owned), it is not always in the best interest for the LPs. We have only grown and raised new capital as our market share has increased and the opportunity to add high-quality originations and new ideas for investment have presented themselves. For us, it’s about quality over quantity and we limit and hard cap our annual investment funds for this reason.
Second, it’s about credit. Many asset managers in this space have raised large funds in the last few years and have not seen a down credit cycle yet. They are mostly focused on originations and not credit, portfolio management and surveillance. The discipline of a credit-focused shop and a “zero loss” tolerance had been crucial for us in getting through numerous down cycles over the years. A lot of these managers who are quoting current returns are going to be very surprised when the cycle turns and loss of principal eviscerates what were once nice current returns. We have seen that occur time and time again with other and newer managers.
Third, it’s about the team. We have an investment team of almost 70 people. While it is more expensive to operate and maintain, it’s crucial to have the talent to originate, underwrite, approve and manage each of these loan investments. Private credit is an active management business and each of those four disciplines involve different talents and skills. It is unwise in my opinion, in our business to shortcut any of these important elements or tasks.
What’s next for Monroe?
TK: You can expect more of the same. It’s good to sometimes be boring and in our business that is a very good thing. Our firm is completely 100 percent owned by management so our foremost interest is in our funds’ performance so that our people can earn their carried interests in our funds.
For example, in our latest 2016 investment fund of around $800 million in LP commitments pre-leverage, we have about 56 of our employees with carried interests in that particular fund. That is unheard of in our industry and I think it creates the proper alignment of interests with our LPs.
Theodore (Ted) Koenig is president and chief executive officer at Monroe Capital, the Chicago-headquartered mid-market and lower mid-market investment firm.
This article is sponsored by Monroe Capital. It appeared in PDI's Sponsorless Finance supplement, published June 2016.