US Special: It's time to do you homework, says Garrison

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Mitchell Drucker

Established in 2007, Garrison Investment Group is a credit, distressed and asset-based investor focused on the middle market with $3.9 billion of assets under management. Its newest direct lending fund targets lower middle-market companies with revenues in the range of $75 million to $400 million and EBITDA between $5 million and $30 million.

Mitch Drucker, the head of Garrison's corporate lending team, has more than 30 years of experience in the lending business.  He formerly served in various positions at CIT, presiding over a team of 200 professionals.  Given that we are in the eighth year of a bull market credit cycle, Mitch discusses how Garrison approaches opportunities in the lower middle market. 

Q: Are we in a direct lending bubble or heading toward one?   

MD:  A direct lending bubble would be created if too many lenders are chasing deals, which leads to yield compression.  Much of the new capital in the direct lending market comes from groups spun out of leveraged finance units of banks that tend to target larger deal profiles given their prior experience and skillset.  As a result, most of the new funds being raised are focused on the upper-middle and broadly syndicated markets, and we could see a bubble in those segments.  That being said, banks are retrenching from lending as a result of regulation and other factors, leaving a large void to fill.   

I believe the lower middle market, where we focus, remains attractive as it is fragmented and inefficient compared to these larger markets.  We believe our team has the capability to find attractive risk-adjusted returns and the lower middle market continues to offer an opportunity set where yields remain relatively high.

Q: In addition to pension funds, are there other investor types showing increased interest in direct lending? 

MD:  At a time when the United States 10-year treasury yield is approximately 1.5 percent, direct lending is an attractive alternative asset class to fixed income for most investors. There is increased interest from insurance companies and funds of funds, as well as international capital due to low to negative interest rates abroad. Most investors are looking for yield and relatively stable, risk-adjusted net returns of 9-11 percent.  We believe direct lending to lower middle market corporates can achieve this range of yields. 

Q: How strong is deal flow in the current direct lending market?

MD: Deal flow is somewhat predicated on sponsor volume, which has decreased in 2016.  At the same time, we have seen companies struggling to generate organic growth. This is a time where everyone needs to be especially cautious.  Our origination platform continues to generate deal flow due to our long-standing relationships.  New entrants may experience more muted origination activity.

Q: Do you think that capital market dislocations and volatility will re-emerge? 

MD:  We have experienced temporary dislocations in the economy driven by global geopolitical issues as well as general weakness in Asia and Europe. There are also concerns regarding commodities and rate increases, and all of these issues can create dislocations. The bank and the CLO fundraising markets start to tighten up and liquidity dries up.  We can continue to transact in this market environment due to the capabilities and experience of our team, and many times we are able to participate in transactions which actually have enhanced risk / return profiles.

Q: How does Garrison respond to these dislocations?

MD: Once we initially observe late cycle indicators our immediate response is a flight to quality.  Fortunately, our team's history of investing through multiple credit cycles provides us the ability to understand when and where to buy credits from lenders or funds selling credits.  When dislocations occur, we act opportunistically.  We have reviewed some syndicated deals where yields widen out because the high-yield market is temporarily disrupted. We can also participate in rescue financing for companies directly affected by dislocations or reserve-based lending in the energy markets, which is another type of asset-based lending.  

Q: How likely do you think it is that these dislocations will worsen and lead the economy into recession in the next 12 to 18 months? 

MD: We are not here to make a prediction but instead to prepare and lend against credits that would be resilient regardless of macro uncertainty. Our economy's growth has been quite tepid despite a very hot construction lending market.  If construction lenders leave the market that will have an effect on other derivative industries. We are seeing increased delinquencies in consumer credit.  There has been a recent pick-up in corporate default rates and non-accruals as corporations are under margin pressure due to increased lower-income wages that have not been passed onto the customer.  All of these factors only reinforce our commitment to diligent credit underwriting.

Q: How do you seek to protect yourself against the risk of recession?

MD: We look to invest in companies that are recession-resilient. We want to ensure that we have very tight structures, strong interest coverage and larger equity commitments from the sponsors. We want to stay in first-lien positions where we can minimise losses if default rates pick up.  We have found that our deal profiles offer increased transparency and control mechanisms when compared to broadly syndicated plays. We are being more selective with our new investments.  Historically, we would execute one out of every 20 deals but I would say we are currently doing one out of every 30 deals. 

That being said, we actually don't mind the concept of a down market. If we are doing our homework, we expect our returns to improve because we may receive additional default, waiver, amendment, and restructuring fees. If our loan-to-values are conservative, we get incremental fees and have decreased risk of principal loss.  

Q: Is the lower middle market more or less risky and volatile?

MD: Based on our observations, the lower middle market has an incremental 20 to 50 basis points of annualised losses when compared to the upper middle and broadly syndicated markets. However, first lien loans in the lower middle market generally provide a yield premium of between 300 and 500 basis points when compared to these upper markets.  As a result, net yields in the lower middle market tend to be superior.  This is achievable by underwriting credits with discernible downside.

Q: What are some factors that differentiate Garrison?

MD:First and foremost, we have the experience and the track record necessary to participate in the lower middle market.  I have been in the business 33 years and our team has averaged 23 years.  Since inception, Garrison has closed over $1.4 billion of direct loans. 

One of the big differentiators is our sourcing capability.  Lending in our target market is a relationship-oriented business. One of the biggest referral sources for us has been the banks.  They have been regulated, or over-regulated, can't consider criticised credits and are typically only offering revolving loans against current assets. We can do a side-by-side term loan with their revolver.  This ends up blending the interest rate the corporations pay and everyone is happy.  We also receive calls from sponsors and banks at the same time to complete a joint deal. We source opportunities through club partners with like-minded credit philosophies which leads to reciprocal deal flow.  We cover traditional capital market participants and restructuring experts which generates a lot of our pipeline.

Also, there are many examples of synergies between the verticals at Garrison which is really a competitive advantage.  We are working on a deal where we are lending to a company that is exiting bankruptcy and operates gas stations and convenience stores. We are structuring a first-lien on their real estate collateral, which our real estate team helps us underwrite.  Our BDC and CLO businesses also help us broaden the universe of covered credits.  

Q: Are some business segments more attractive now than others, particularly if we are heading into a downturn?

MD: We like to focus on businesses that generate recurring revenue. Software companies and business services companies are attractive, as are companies with hard assets, like transportation companies.  We just closed a deal for a business that performs repossessions for sub-prime auto lenders. Given the rampant increase in sub-prime auto lending we think this is a business that would do well through a downturn.
We have an aversion to certain industries in secular decline, such as the printing, newspaper and periodical sectors.  Also, where government intervention or regulation may lead to a binary outcome for a business we do not feel that opportunity has an optimal, discernible downside scenario.  

Q: Given the concerns about a bubble and/or recession, why is this an opportune time for Garrison to continue its direct lending activity? 

MD:Even if a recession is imminent, we believe in the opportunity set in the lower middle market because it is so inefficient and fragmented.  Given our focus on capital preservation, we believe we can achieve adequate risk-adjusted returns in a healthy environment, a somewhat heated environment, and any environment where there is dislocation. We have managed through the cycles.

This article is sponsored by Garrison Investment Group. It was published in the US Special supplement of PDI's September 2016 issue