Stellus Capital Management is bullish on the US lower mid-market.Josh Davis and Dean D’Angelo, partners at the Houston-based firm, maintain secular forces are exerting pressure on banks and collaterized loan obligation issuers, causing them to pull back from this segment of the market. Not only are private credit providers gaining a stronger foothold in the lower mid-market, the two industry veterans add that the types of deals they see are much more attractive than those in the upper mid-market or in the broadly syndicated loan market.
Can you start by telling me a little bit about the history of Stellus and some of its team members?
Josh Davis: Stellus was formed by a spin-out of the direct lending group at DE Shaw in January 2012. The firm is owned by its five partners, who have deep experience in mid-market lending. Four of the five partners have worked together for over 21 years, and the fifth joined us about 16 years ago. We have been primarily investing in the US lower mid-market since the early 2000s and have invested a little over $4.5 billion across multiple market and credit cycles. Currently, we are managing about $1.3 billion of assets.
Why does Stellus like the lower mid-market, and what do you find attractive about that space?
Dean D’Angelo: One aspect that is particularly attractive in the US lower mid-market is our ability to perform extensive independent due diligence by leading the majority of our investments. We directly interact with management teams and the private equity sponsors at multiple points throughout our process. Our team works with the sponsors to tailor our specific due diligence, for example, on market intelligence studies or focused quality of earning reports, to ensure we understand any issues. Our deals are highly negotiated and have full financial covenant packages. Loans in this segment of the market are structured to ensure a company delivers over time. Based on our loan agreements, we are given ample forewarning and protection, as well as the ability to play an active role in decision making, when a company is experiencing unexpected challenges.
This is in contrast to the upper mid-market where the vast majority of the deals are distributed through a syndication process. In this segment of the market, lenders typically have limited ability to perform due diligence or interact with the management teams in advance of investing. The loans are structured as covenant lite. This eliminates the ability for a lender to have a voice when a company is beginning to underperform. Additionally, these larger transactions typically have higher total leverage multiples, often up to 6x EBITDA, over a turn higher than in our target market.
What is the typical profile of a company that Stellus lends to in the lower mid-market?
JD: Typically, the company is private equity-backed by a sponsor that has extensive experience in the industry in which the portfolio company operates. Typically, we have previously worked with the sponsor and formed a long-term relationship.
Other characteristics generally include high free cash flow conversion, so strong EBITDA margins, low maintenance capex and a very strong, defensible market position. The companies we invest in typically are based in the US and have between $5 million to $50 million in EBITDA with strong management teams or a sponsor that has the appropriate network to address any potential management gaps.
Are there any specific deals that you think might be representative of Stellus’ investment philosophy?
JD: We have completed well over 200 deals over the last decade-plus. We currently have over 45 loans in our portfolio, all of which would be representative of the types of loans we provide. So it is difficult to select just one specific deal. We are extremely active, closing a dozen or more deals a year.
You said in the lower mid-market you can avoid covenant lite deals. Are there certain metrics you look for in covenants, whether it is EBITDA, free cash flow, or other relevant things?
DD: I think most of the time we try to have covenants that focus on the appropriate financial metrics for that specific company. For example, we consider the financial structure, the industry, and reinvestment trends. We often have a total leverage covenant and a fixed-charge coverage ratio as well as covenants on capex or reinvestment in the business. However, it really depends on the company and the situation. The covenant package ensures that, if the business is not performing, we are able to proactively get ahead of any problems. If the business is hitting its targets, the covenants typically make sure it is deleveraging over time. So, we look at our covenant packages as being flexible over time with the goal of alerting us when issues begin to arise.
What are some key issues investors are looking for when they invest in the lower mid-market space?
DD: For the last few years, most of the institutional capital raised has focused on senior debt-only strategies, often in the upper mid-market. These are generally more conservative and geared for investors who are starting to understand a new market. I think we are beginning to see more differentiation among debt strategies that investors find attractive as their experience enables them to better diligence some of the key attributes of success: strong, cohesive teams; durable track records through cycles; and effective portfolio management and compliance practices. Whether it is a lower mid-market lender with more flexibility to invest from senior to junior debt, or a specific sector or geographic strategy, investors appear more comfortable assessing and investing in strategies beyond the typical senior only universe.
JD: I would add investors are trying to find managers that are not just buying paper or participating in other club deals. They want to invest in teams that have developed strong origination capabilities with a proven history of structuring their own deals and controlling the tranches of loans they are investing in.
How do lower mid-market loans compare to the loans in the broader mid-market – how is it competitive, and what sort of returns are targeted?
JD: A key differentiator is structure for one. Loans in the lower mid-market typically include a full suite of covenants versus the covenant lite loans that are common in the broadly syndicated loan market. I think the pricing in our segment of the market is also better. The loans generally have higher coupons, more upfront fees, and better prepayment fees. We often have the opportunity to co-invest in the equity alongside the private equity firms. And as Dean mentioned earlier, leverage is also typically a turn lower, if not a turn and a half.
In terms of returns and how they vary between segments, at the end of the day, in the upper end of the market, managers are really relying on leverage to generate their return versus the actual coupon and fees that you might earn on the underlying assets. In the lower mid-market, the coupon and fees, upfront fees or prepayment penalties, account for the majority of the return.
What returns are targeted in the lower mid-market versus the broadly syndicated market and mid-market?
JD: I think we are hesitant to comment on returns, mostly because there are so many different flavors. For example, it’s hard to compare a pure senior secured vehicle which is levered at 2:1 or 3:1 to a mezzanine one which is unlevered, or, in between, a more flexible strategy like ours. It is really comparing apples to oranges in some way.
DD: When you start talking about returns, it is very difficult because of the points Josh just mentioned. It is very specific on what type of leverage a fund is looking for and the risk profile of the underlying investments, particularly whether it is junior capital, senior capital or a mix. In terms of the underlying asset, a material difference in the yield exists when you move into the larger end of the mid-market or to the broadly syndicated loan market where yields are much lower.
Does Stellus have any specific areas in the capital structure that you prefer at this moment in time?
JD: We provide flexible debt capital solutions to US lower mid-market business. Typically for us, about 80 percent or more of the loans that we provide are secured. They could be senior secured, first lien, unitranche or may even be last-out or second lien. We focus predominantly on secured transactions with floating rate structures.
DD: As we continue to focus on secured transactions, the wind is really at our backs based on the competitive landscape, particularly in the US lower mid-market where regulated banks and CLOs have been less active. This opportunity allows us to invest more in secured debt and is unlikely to change in the near future.
Can you discuss how the regulatory pressure on banks and CLOs has impacted your market and how you see it developing in the years ahead?
DD: The lender universe has significantly decreased post financial crisis. Historically, the main competitors in our industry were banks, CLOs focused on the mid-market, and business development companies. These traditional participants have had a really difficult time over the past few years, so many have reduced their activity or exited the market altogether. We do not expect either of them to return to their historic levels of activity for several reasons.
First, for regulated banks, every asset in our world is referred to as illiquid, so it is classified as a type 3 asset that garners a high capital charge. Additionally, the majority of the deals we look at or invest in are categorized as Highly Leveraged Loans by banking regulators which, once again, increases the capital charge to the bank. We do not see this changing over time. Secondly, CLO issuance has declined significantly because of the upcoming risk retention rules. We think the impact of these rules and the obligations they put on CLO managers will cause this source of capital to continue to recede in the more illiquid lower mid-market deals.
So when you look at our landscape in the US lower mid-market, we are seeing great opportunities to continue to move into what had traditionally been the purview of banks. We are providing a lot more secured loans where we think we are seeing a better risk-return profile on our investments than what we were experiencing four, five, or six years ago.
This article is sponsored by Stellus Capital Management. It appeared in the Mid-Market Special supplement published with the December 2016 issue of Private Debt Investor.