US Special: MGG and the importance of covenants

MGG Investment Group is a direct lender assisting companies in the lower mid-market with complex financing challenges including corporate carve-outs, acquisitions and restructurings. 

Since launching in 2014 with $200 million from real estate development firm McCourt Global, the firm has built its reputation by providing capital to a diverse set of businesses caught between the decreasing ranks of community banks and the upward market migration among larger banks navigating post-crisis regulation.

Led by former Highbridge managing director Kevin Griffin and Greg Racz, former president at Hutchin Hill Capital, who worked together through the crisis, MGG seeks to protect its investments by including covenants in its loans that allow MGG to anticipate challenges in its partner businesses and make changes in them when necessary.

Here, they discuss the lower middle-market, their approach, and how they expect the proliferation of cov-lite loans (which they shun) to impact the distressed cycle. 

Q: Why focus on the lower middle-market, and what is MGG's advantage?

First and foremost, you have fewer eyeballs and less competition in our part of the market (under $50 million EBITDA), especially post-financial crisis. We do a lot of non-sponsor-based finance and asset classes and complex situations that deter other lenders. There are very few firms with our two decades of experience focused on that. A lot of the banks and larger players have gone upmarket, servicing the bigger, $50 million EBITDA-plus businesses, and BDCs focus almost exclusively on PE sponsors or more junior, cov-lite loans, which we avoid.  

Q: How does your sourcing process change when looking for niche opportunities in the lower middle market? 

Most people source about 100 percent of their deal flow from PE sponsors and banks; we source about 20 percent of our deals from there. With the other 80 percent, about 25 percent are more CEO/industry relationships we've had over time, and the rest more “mom and pop” investment banks that have good clientele, but no balance sheets. 

It's a network developed over our entire careers, and while we might not be the only ones seeing a deal, we often get last looks on things we like. Our history of successfully closing tough deals and partnering with firms to help them grow while generating attractive returns for investors through market cycles also generates significant repeat business and referrals.

Q: Is there a tension between MGG's focus on extensive due diligence and the 'need for speed' which can sometime define opportunities in the lower mid-market?

We do a lot of deep-dive diligence, including bringing in independent forensic accountants to help vet the data we receive from the company, really scrub the numbers, and do independent background checks. We are detailed and thorough but, when needed, we can move quickly. 

The bigger challenge sometimes is obtaining the information in a timely fashion from the company. We've been working with the same accounting vendors and lawyers for years so we can be targeted, and pretty much meet any timing obligation, if we receive the information from the other side. We've never promised on timing and been unable to get there because it's our fault. We've built up that reputation and that's why people choose us; they know we're going to get there if we get the information we require.

Q: Can you give an example of a deal that you passed on that some of your peers might pursue?

We focus on good downside protection, lender-friendly documents, and a lot of covenants in our deals. We will go into out-of-favour industries, cyclical industries, if we have all of those rights and remedies. 

One deal we didn't do was a cyclical industry in the lumber space. During the diligence process, we concluded that it was highly cyclical, and while we were conservatively levered (sub three times) and our returns were in the low teens, because we always underwrite to a downside case we insisted on a strong covenant package, strong downside protections if there's an economic downturn.

There was a competing lender willing to give a covenant-lite, PIK-toggle loan. We didn't think that was appropriate for this type of business, frankly any type of business, but specifically a cyclical one. We had the opportunity to match that transaction, but passed given we thought the structure too-borrower friendly, too risky. 

Q: Can you describe the covenants you attach to loans and why you structure deals with more covenants?

We try and focus on covenants that provide warning signs of a downturn or problems in the business. If there is that warning sign that trips our covenants, then it becomes about who has control, who has leverage over who. We want to have the power and control, and not have someone else telling us what they are going to do, that's extremely important to us. 

Specifically, it depends on the deal, but we like a minimum EBITDA covenant that is straightforward and easily defined in the document, some sort of fixed-charge coverage ratio covenant, which allows us to understand what the needs of the business are from a free cash flow perspective. We like to box in capital expenditures, control leakage out of the system. 

We could be in a software business where recurring revenue is a key issue for us to watch, so we may covenant around that. We will add some liquidity constraints around the business so we can have cash in the company if we need to take things over. 

Q: What is driving the move towards covenant-lite structures in the market and what impact will it have on the distressed cycle?

First, the game for most institutions is to deploy assets, raise more assets, and build a bigger empire, so people are willing to look the other way, give borrowers more leverage, at a low rate, with a very weak (cov-lite) document. 

Second, some people willing to do cov-lite deals have capital markets or trader-type backgrounds, and fundamentally don't understand the credit documents, or why a loan has protections in it. They take a macro-view of the world and say 'If I have 100 loans and 10 come back as defaults or zeros, I still have 90 that are still working, I'm okay'. You may do that in CLOs, you may do that in the broadly-syndicated market; you don't do that in the lower middle-market.

Third, you have a lot of people investing only since 2010 and the world's been pretty good since 2010. You don't test those issues out until a downturn and these newer entrants have not lived through cycles. What we'll see when the economy is not as good for these businesses is the capital structures that have been put in place are extreme and too aggressive. By the time such lenders have some sort of say, given the covenant-light structure, you're looking at payment defaults. At that point, the company may have eroded in value so we'll see higher default, lower recovery, higher loss rates than historically. 

That said, the distressed cycle may take longer to play out. With so many cov-lite loans (two times recently the pre-crisis highs, which is truly amazing), it will take more time for companies to default just by virtue of the lack of covenants.

Q: Where have the banks gone? What is the impact on you?

Banks have focused more on the upper middle-market, because under the new rules, banks can hold less capital on balance sheet when they lend to bigger companies. Plus, banks can cross-sell, sell various products and services, get fees for different business lines more readily to the bigger companies. 

The opportunity has always been large for those familiar with the lower middle-market but as many community banks have disappeared – nearly 2,000 banks have been eliminated since the financial crisis – and big banks have abandoned the lower middle-market space post-crisis in part due to these stricter capital rules, the opportunity has grown quite significantly for us.

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