Founded in 2007, ArrowMark Partners – which changed its name from Arrowpoint Partners this year – is a Denver, Colorado-based investment manager with $11 billion in assets under management. The firm focuses on alternative credit strategies and equity strategies in less efficient markets. ArrowMark began its direct lending activities in 2012 and hired managing directors Michael Novoseller and Vipul Shah to formalise the efforts and spearhead the company’s specialty finance strategy. The pair sat down with PDI to offer insight into this growing market and their own origination and evaluation process.
Why is the lower mid-market an attractive opportunity now?
Michael Novoseller: The lower middle market is attractive because of the substantial number of smaller businesses in the country, and relatively fewer capital providers chasing those opportunities. For private equity firms, that means opportunities to buy quality businesses at attractive valuation multiples. For lending firms, it means opportunities to finance quality businesses at modest leverage multiples and attractive yields.
While requiring a specialised mix of capabilities to source, diligence, manage and add-value for small businesses, there are opportunities to generate attractive risk-return characteristics for investors in the lower middle market.
Which economic or regulatory trends are having the most impact on non-sponsored businesses in the lower mid-market?
Vipul Shah: We define “non-sponsored” businesses as companies that are not majority owned by private equity funds. The non-sponsored companies we invest in tend to be growing, established, and well capitalised. They are often backed by sophisticated families, independent sponsors with domain expertise, public shareholders or a corporate parent.
From a structural standpoint, banks are generally pulling back from cash flow lending, which has created a favourable supply and demand dynamic for active value-add lenders. Additionally, most of the institutional debt financing sources that have come online in response to this trend are focused on companies owned by private equity funds, and are consequently not meaningfully impacting the supply/demand imbalance for debt financing within the non-sponsored market.
In terms of economic trends, lower middle market companies in our sweet spot tend to be US-focused niche businesses, and are usually less susceptible to global events. We have found success focusing on non-cyclical industries where we have domain expertise or operating experience.
How have the needs of LPs informed the way you structure deals?
MN: One of the things our clients continue to emphasise is downside protection. In the non-sponsored lower middle market, you can achieve attractive returns from senior secured loans without applying significant leverage at either the fund or portfolio company-level. When the same business is acquired by a private equity firm, there tends to be higher leverage. For example, we recently lost a financing mandate when the founders of the business decided to sell to a private equity firm and it came back to us as a sponsor-led financing opportunity. The proposed leverage increased meaningfully while the yield parameters tightened meaningfully despite the higher leverage level. Additionally, with the founders cashing out, the alignment with the team that built the business was also less favourable. These dynamics are all part of what we need to pay attention to in measuring the risk of our investments and creating alignment with our investors.
What do you consider an attractive leverage rate?
VS: To enhance downside protection, we look at a combination of total leverage and loan-to-value. We prefer to be below 4x leverage and maintain less than 50 percent leverage relative to the overall enterprise value of the businesses we invest in. The businesses we are looking to invest in are growing and tend have an enterprise value multiple of at least 6-7x EBITDA and often above 10x EBITDA, providing for a meaningful equity cushion.
What do your target companies look for from a debt investor, and how well-served are their financing needs?
VS: The main thing our target companies are looking for is flexible capital to grow and a long-term partner that understands the dynamics of a growing business. Bank capital is an alternative at a lower cost, though it can be restrictive for growing companies and doesn’t offer the business owner a meaningful level of consultative attention or partnership. Another alternative is accepting an investment from a private equity fund, but that capital comes at a higher cost and requires that the business owner relinquishes some form of control. As a former co-founder of a family-owned business, I can confirm there is a dearth of available capital solutions capable of addressing the unique needs of different businesses and we continue to hear the same from our network of entrepreneurs.
We believe there is a significant long-term opportunity to provide a flexible, hybrid capital solution tailored to help lower middle market US businesses continue to grow.
Are these deals getting easier to source?
MN: Since the presidential election, the overhang of uncertainty has lifted and we are seeing more business owners willing to take in new capital. We are also coming off quite a few years of economic growth and there are a lot of businesses that have performed well. There is still the memory of the last recession, though overall a lot of businesses are in a good spot now and business owners are comfortable employing a little bit of leverage to finance growth. We continue to see a strong pipeline of non-sponsored debt financing opportunities. That said, the ability to consistently source quality and actionable non-sponsored transactions remains a critical barrier to entry.
What can private debt investors in general do to source and build relationships with target companies?
VS: This is a hard part of the market to enter if you haven’t previously focused on non-sponsored deals or been an experienced private equity investor. We have found our edge is maintaining a relationship-oriented mindset and focusing on industries we know well. There are tens of thousands of companies in this realm. Having the data, systems and processes to track all of this is crucial. We are maniacal about measuring and tracking metrics – via software, tools and data analytics. We know each month where dealflow has come in from and how it got here, and that helps drive the strategic execution of our sourcing process. Response time and making referrals are important to our sourcing relationships. If an opportunity doesn’t fit our investment mandate, we will go out of our way to immediately make a referral to like-minded investors we know. We believe that thoughtful, timely and consistent referrals enhance our competitive edge in the long run.
What are the traits of companies you target and those you avoid?
MN: We mostly invest in companies focused on business services, software, franchising, health care services, and other niches. We look for top performers within those sectors – businesses that have high quality management teams, strong track records of operating success, and myriad growth opportunities both organically and through acquisitions. We primarily target businesses with $5 to $25 million of EBITDA, and can support our portfolio companies’ growth to over $50 million of EBITDA. Our portfolio companies tend to be growing at a faster rate than GDP growth. Situations we avoid are average or underperforming businesses, industries with regulatory overhang and industries that are cyclical or have limited growth prospects.
Do non-sponsored deals require more diligence and can this be a drain on resources?
MN: Yes, and yes. When a private equity fund owns or is buying a business, the sponsor leads the due diligence and packages information for the lender. The sponsor has the direct relationship with the management team. The effort to source and execute in a non-sponsored strategy versus a sponsored strategy is apples and oranges. We are sourcing and executing with a similar level of depth and focus as private equity firms. It is more research-intensive and there is more primary analysis to be done. We are leading the due diligence and documentation, hiring third party advisors, and managing the entire process.
Non-sponsored investing requires differentiated execution resources from what is typically employed by a sponsor-focused lending strategy. We have a team that is focused on fundamental research and is constructed similarly to what you would find at a private equity firm. For example, rather than due diligence being conducted within a small “execution” deal team, our process demands significant involvement from the most experienced members of our team, every step of the way throughout the diligence process.
How do you structure and underwrite loans to protect capital and manage risk?
VS: We think a core differentiator for us is having the ability to pick the most attractive part of the capital structure on a risk-return basis. Sometimes it’s the first lien or unitranche. Sometimes it’s the second lien or mezzanine. Sometimes there is an attractive equity opportunity. We like having the flexibility and versatility to take advantage of the best risk-adjusted returns in any scenario.
With our direct investment approach and consistent focus on areas where we have domain expertise, we can customise business-specific covenants that serve as leading indicators of how a business is performing, while enabling our companies to continue growing. When it comes to identifying and managing risk, another core vantage point has been our ability to collaborate with industry-focused research analysts across our firm’s various credit and equity strategies.
What is your outlook for this segment of the market, including sponsored and non-sponsored deals?
MN: Lower mid-market cashflow lending will continue to have strong long-term demand from investors looking for consistent yield-driven returns with strong downside protection. We expect that middle market sponsored loans will continue to maintain premium pricing and better deal structures than what is available in the broadly syndicated loan market. Further, we also expect to continue to see favourable opportunities for non-sponsored loans compared to what can be found in sponsored loans. Because sponsors tend to do the heavy lifting as it relates to sourcing and leading execution across a portfolio of companies, it is easier for a lender to scale assets under management by targeting these private equity-owned businesses. We believe this dynamic will preserve the opportunity in non-sponsored finance.
This article is sponsored by ArrowMark Partners. It appeared in the Non-Sponsored Finance Special supplement, published with the May 2017 issue of Private Debt Investor.