Even the best professional golfers can’t avoid every hazard on the course. Similarly, even the most experienced lenders financing US mid-market companies occasionally need to pull out a ‘rescue club’ when a loan goes off track and potentially defaults.
The question for investors is: How does a manager maximise recoveries and fund returns by preparing for the unexpected?
Just as a golfer’s success depends on spending time on the practice range, having the right equipment on hand and knowing the course, a lender’s preparation for a possible default can make all the difference in maximising recoveries. This process starts early with rigorously selecting and underwriting transactions, followed by a forward-looking approach to structuring and documentation. The final step is managing the loan proactively, including handling a workout if it becomes necessary.
Prepare to be lucky
In golf, winning requires consistency and not just the occasional spectacular shot. The same is true of lending. Senior lenders should focus on building a portfolio that generates predictable outcomes.
This prudent approach to increasing recoveries and corresponding fund returns starts by identifying companies with strong underlying attributes. Structuring loans with appropriate leverage, solid sponsor backing and multiple exit scenarios are also critical.
Gary Player, one of the all-time great golfers, famously said: “The more I practice, the luckier I get.” An origination process that reflects the experience of evaluating countless transactions across multiple credit cycles is equally important in achieving success in lending. But we know that the possibility still exists to ‘miss-hit’ a shot occasionally and contend with an underperforming borrower.
Mitigating this risk can be managed by building highly diversified loan portfolios comprised of companies with characteristics expected to exhibit modest default rates while producing substantial recoveries in distressed situations. Combined, these generate a low-volatility return profile.
Common sense dictates the best way to improve recoveries is to lend to companies less likely to default. To this end, we find companies with a varied customer base, multiple products and/or end markets, a high degree of recurring revenue and historically high customer retention rates most attractive. Avoiding binary risk situations, in which significant value can dissipate overnight, is also something to keep in mind. These hard-to-mitigate risks include high customer concentration, a single product, exposure to sudden regulatory changes, shrinking markets and sectors highly susceptible to technology disruption.
Underwriting also involves identifying exit scenarios. If there’s a problem, and the company defaults, are there viable opportunities to monetise the investment and enhance recoveries?
Loan structuring is key because appropriate leverage is critical to improving recovery rates. This includes recognising historical fluctuations in purchase price multiples and earnings. A 50 percent LTV loan at today’s high multiples can easily become a 75 percent LTV loan if multiples revert to more ‘normal’ levels. Even if valuation metrics remain unchanged, building in an additional cushion is prudent in cashflow lending, where default rates and recovery rates tend to be negatively correlated.
Plan for recovery
A tried and true golfing axiom says: “If one shot gets you in trouble, make sure the next shot gets you out of it.”
The lending corollary is that thinking ahead when structuring and documenting a loan provides many more options if a borrower gets in trouble.
Covenants and appropriate covenant cushions help a senior lender improve recoveries by bringing parties to the table early, while a company’s enterprise value exceeds the lender’s debt levels.
Agreements should detail enforcement rights, as well as delayed draw term loan and acquisition governors specifying controls on cash distributions such as dividends and junior debt repayment. Controls on add-backs and adjustments and a pledge of equity securities are also critical to maximising recoveries.
Intercreditor agreements can affect recoveries, so senior lenders should make sure the agreements are appropriate to the transaction and borrower. Key elements include payment blocks, standstill periods, and lien release, as well as restricting rights to offer competing debtor-in-possession financing.
Lastly, documentation should specify requirements to perfect the collateral and borrower reporting. Providing financial information every month is ideal, and frequent communication with borrowers and sponsors is essential.
Manage to win
A lender’s rigorous underwriting and structuring can be undone if it fails to actively manage the portfolio and pay close attention to borrower performance over time.
Successful portfolio management starts with building a team of experienced risk professionals who have responsibility for a limited number of accounts. For example, at NXT there’s an average eight to 12 accounts per manager. There’s time to focus on each account.
Further, the same team underwriting and closing a transaction typically monitors its performance so they have in-depth knowledge and can quickly spot and respond to any negative trends. Any loans with ongoing issues are reviewed by the organisation’s most senior leaders.
A robust technology platform flagging performance trends is essential in managing a sizeable portfolio. However, numbers and trends tell only part of the story. Staying in close touch with company management and the sponsor paints a complete picture. This intensive, proactive approach can help a lender anticipate when a storm might roll in.
Playing through bad days
There are days when even the best golfers don’t have their ‘A’ game. Such is the case for lenders when loans underperform.
How a lender handles workouts can make a significant difference in how much it recovers. Getting to the table early and enforcing protective rights is the first step. A lender also needs to understand what is driving a borrower’s performance issues. Can the challenges be addressed to ‘fix’ the company or has the underlying value been fundamentally impaired? The answer often depends on whether the problems are a result of operational missteps rather than secular economic forces or industry changes.
In some cases, lenders offer short-term forbearance before executing a long-term amendment. The goal is to keep the restructuring process on track while lenders consider strategic alternatives and gain a better understanding of the company’s outlook and valuation. Forbearance usually includes modified covenants, minimum liquidity thresholds, process milestones and the like. It may also include additional sponsor support.
In other cases, the best strategy is to quickly drive an orderly sale of the company while its value can still provide a complete or high recovery rate to the senior secured lender.
Workouts can be time and labour intensive, but confronting the issues head-on always produces a better outcome than hoping for the best.
When managed properly, senior debt can deliver attractive, consistent returns through all types of business and economic cycles. Analysis shows the ultimate returns from investing in senior secured mid-market loans are quite sensitive to defaults and recoveries.
Selecting a manager which can not only source transactions effectively but has a plan for minimising defaults and maximising recoveries should be a critical component of every investor’s due diligence.
Ultimately, if you want to walk off the 18th green pleased with your ‘score’, choose an asset manager which knows the lending game inside and out.
Neil Rudd is NXT Capital’s chief financial officer and Joseph Lazewski is the senior credit officer for NXT’s Corporate Finance Group.
A leading provider of structured financing to the US middle market, NXT Capital’s asset management platform provides proprietary access to directly sourced, floating-rate senior secured loans. Investment alternatives include separately managed accounts, funds and CLOs. See www.nxtcapital.com.
This article is sponsored by NXT Capital. It was published in the May 2017 issue of Private Debt Investor