With 80 employees spread across eight offices in North America, and approximately $4.1 billion in assets under management, Chicago-based Monroe Capital has established a deep reach in the senior and junior secured, unitranche and second lien direct lending markets in the US. Since it was formed in 2004, the firm has offered its limited partners commingled investment funds, separately managed accounts, a publicly traded BDC, as well as collateralised loan obligation fund structures. President and CEO Ted Koenig joined managing directors Tom Aronson, head of originations; Zia Uddin, portfolio manager, private credit; and Carey Davidson, head of capital markets, and spoke to PDI about the company’s take on the mid-market and its future.
Q What kind of opportunities are managers targeting amid growing competition in the mid-market today?
Ted Koenig: With the rush of newly minted players coming into the market – exemplified by the fact that 20 new direct lending platforms have entered the market in the last 18 months – there’s been an increased focus on fundraising for the private debt asset class. Most of this fundraising is direct lending opportunities to borrowers with $50 million in EBIDTA and above. That is an easier business model to execute on as opposed to focusing on the lower part of the market with company EBITDA sizes ranging between $5 million and $30 million. It’s much less work to buy into club and syndicated deals at the higher end of the market as most of those lending transactions are distributed by arrangers among several and sometimes, many participants.
However, there is more pricing power and better structures (ie, lower leverage) and more lender covenant protections in the lower part of the mid-market because it’s far more fragmented and less efficient. The downside is that market segment is much more challenging and costly to access as personal relationships really do matter there.
Tom Aronson: First and foremost, dealflow remains strong in Monroe’s preferred space, companies with $5 million to $30 million in EBITDA. The market is competitive but what differentiates Monroe is that our people have deep and longstanding relationships which enables us to maintain consistent dealflow. We are industry generalists but we also have specialised vertical lending groups in technology, healthcare, media, specialty finance, and retail and consumer goods asset-based lending. Our knowledge and expertise in these areas helps distinguish us when evaluating financing opportunities and winning mandates.
Zia Uddin: According to the National Center of the Middle Market, there are approximately 200,000 companies with revenue between $10 million and $1 billion, which is generally referred to as the US middle market. Most of the private credit funds being raised over the last several years are focused on companies north of $50 million in EBITDA. We see less competition in the sub-$30 million space. There are roughly 100,000 companies in our target market.
Q How do you seek to differentiate yourself in this market when there are so many players entering the space?
TA: Monroe Capital has a unique operating platform consisting of approximately 20 origination professionals spread across eight offices, and a large pool of very flexible and long-term, locked-up capital that is not subject to business cycles or to any third-party or regulatory control. Lastly, we have been doing the same business now with the same people for over 15 years.
TK: We discussed earlier that we’re a generalist provider of capital and lend to companies in most industries. That being said, we’ve been successful in staying out of harm’s way the last 15 years because we look at the credit fundamentals of individual companies. More specifically, we use a bottom up analysis and we focus on earnings and liquidity. We stayed away from lending to fibre-optic companies in the early 2000s, we stayed out of ethanol deals in the mid-2000s, and finally, we stayed away from the oil and gas exploration industries in 2013-15, when many of our competitors were active in those areas. That’s not because we don’t like to take risk, but because we take educated risks in industries that we know with companies that generate consistent cashflow. We tend to stay away from commodity-based businesses which is one of the reasons that our funds have performed so well over a long period of time.
We have been delivering consistent returns for over 15 years in the direct lending space irrespective of the business cycles and all the macroeconomic events that have occurred during that time period.
Q Do you think that the non-sponsored space will continue to be less competitive?
TA: I think so. As far as sponsored and non-sponsored deals, we historically have been a 65-35 split. Currently we are closer to 80 percent sponsored, however, that will ebb and flow with the market and M&A activity. We’ve been financing non-sponsored companies since the inception of our firm. Underwriting non-sponsored transactions is very different than a private equity sponsored deal, and takes the expertise of a seasoned underwriting and credit team. It is critical to understand the nuances of the businesses, conduct the appropriate level of due diligence and have the right post-closing monitoring systems in place. It is very difficult to be a firm with a limited staff of experienced lending professionals and consistently underwrite and manage non-sponsored transactions.
Q Is it fair to say that LPs generally have lowered their return expectations in today’s low-rate environment?
ZU: All LPs are looking for yield to fund their obligations. Today, the traditional fixed income market is not addressing that need. While Monroe has been doing the same private credit investing since its formation, the market understanding of private credit has changed. For example, 10 years ago, LPs were trying to figure out where to fit private credit into their portfolios because it looked like private equity in some respects but the current income features also looked like fixed income. Over time, that has changed and LPs have become more savvy regarding the product.
Our LP base has changed as well. Our base of investors have historically been US focused (public and private pension funds, endowments, foundations, hospitals and insurance companies) but it has grown dramatically with the addition of LPs in Europe. For example, investors from Switzerland, Germany and Japan deal with negative interest rates in the current environment, so their return expectations are lower than investors in the US. Also, pension funds in the US have higher actuarial needs they must earn on their portfolios due to funding status, so they’re targeting higher returns.
But you have to keep in mind that LPs take a portfolio approach to private credit now, which is something they used for private equity. Now you see sophisticated LPs selecting a real estate manager, an infrastructure manager, an opportunistic/distressed private credit manager, a large market credit manager and someone like us, as a lower middle market credit manager. They build a portfolio of managers that are focused on different segments of the market in order to achieve their overall return expectations. The common theme however, is that all limited partners are looking for current return.
Q There is a lot of capital being raised for mezzanine while some observe a need for senior debt, are you seeing a senior versus junior capital supply-demand imbalance?
TK: Mezzanine is a tough asset class, which in the best of times generates low double-digit net returns. Over a long period of time, mezzanine has generated high single-digit returns. That’s because it is generally a binary risk asset class – either the loan asset performs and generates a return or the loan does not perform, in which case a loss of principal is a likely probability. Since private senior debt has generated similar type returns over a long cycle with a much lower risk and volatility level, there has been more of a preference for private senior debt among institutional limited partners versus mezzanine debt.
ZU: Also, the mezzanine product has become less attractive for borrowers with the resurgence of unitranche debt, which has become more in vogue and cost effective the last several years.
Carey Davidson: Unitranche continues to be a very attractive solution for sponsors and borrowers and as such, the product continues to take market share. The unitranche provides certainty of execution as it requires only one set of documents with one single credit process and can often be committed to and held by one lender in its entirety, eliminating the flex component of a deal. It is important to note that the unitranche can take on many forms. While the traditional upper mid-market unitranche generally has a first out with leverage as deep as 3.5-4.5x and last out leverage of 6-6.5x plus, the typical Monroe unitranche will have total leverage of around 4.0x, with the first out being capped at 1.5x. We view this distinction as critical in our ability to protect our optionality in a stressed scenario, as we have the right to buy out the first out participant with a relatively small cheque. The bottom line is, regardless of the form it takes, the unitranche provides borrowers today the most efficient path to execution.
Q What trends have you seen on leverage or purchase price multiples?
TA: We have seen the push for higher lending multiples in our market by private equity sponsors. This has been driven by the stronger purchase price multiples and the need for private equity firms to take on more leverage to support their expected returns. For the most part, the M&A transactions are being supported by a greater percentage of equity in the capital structure. We tend to see higher debt multiples in areas such as technology where there is strong free cashflow to support the requested debt levels. Other more traditional businesses that may have high capex and lower free cashflow often cannot support an increased debt load. Overall, our debt levels have remained consistent while the increases in purchase price multiples have been supported by greater equity infusions at close.
Q Have you noticed any changes in covenant levels or collateral protections on deals?
CD: In the upper end of mid-market, we have seen the best companies backed by top-tier sponsors getting very favorable terms, including both leverage and covenant levels (or lack thereof). While these trends can flow down to the lower mid-market, Monroe has experienced our market retaining more discipline, and we are still structuring very reasonable deals, with terms and covenants that are appropriate for companies that are smaller.
TA: As far as covenants, there have been more requests on the sponsored deal side for covenant light structures similar to what may be prevalent in the upper middle market. However, this is not as typical in non-sponsored transactions. But as a firm, we really haven’t gone that way. We don’t tend to compromise our covenant position or our credit standards. With the over 2,100 investment opportunities that we review each year, we continue to be able to select 50-60 or so deals annually with appropriate risk-return structures.
Q Has there been an increase in non-US investors in the mid-market?
ZU: There’s certainly been an increased awareness among non-US based investors of the opportunities that exist for private debt. All over the world, generating current and dependable yield has become important for institutions, pension plans, insurance companies, non-profits, hospitals, religious organisations and high-net-worth families.
Q What has the effect been of the new US administration on the mid-market?
TK: If you look at the stock market or bond market, you’ll see investor sentiment that is more confident than before last November’s election. In our space in the mid-market, the credit cycle may have been extended by a few years with the new administration. But that said, the election has had less of an effect on the mid-market than the larger cap market given the fluctuations and strengthening of the dollar. This has created a very hospitable space for investors in the US middle market.
Q You have a BDC. What is going on with the BDC market, it seems that many firms are struggling to generate returns and cutting dividends?
TK: Whenever lots of new players come into an industry, a shakeout follows. It happened in the private equity industry, the REIT industry and now we are seeing signs of it in the BDC industry which is a close proxy for private debt. If you look at what transpired in the last year with the 50 or so publicly traded middle market BDC lenders, around 12 or almost 25 percent of them cut their dividends because they were not making enough income to cover their expenses and pay their dividends. Almost 90 percent of all publicly traded BDCs lost NAV (Net Asset Value) from where they were two years ago.
Losing NAV or eroding shareholder value is a very simple concept: it comes from one of two sources: the BDC has paid out dividends in excess of its current income, or the BDC has incurred realised and/or unrealised losses. Upon a close examination of many of the publicly traded BDCs, you will see that a surprising number of them have actually destroyed shareholder value; I call them “capital incinerators”. Now that is not the case with everyone. There are a handful of high quality BDC platforms that have generated very solid and consistent returns over a long period of time. For example, our BDC, Monroe Capital Corporation (NASDAQ: MRCC) has generated an over 19 percent cash on cash return for shareholders this past year and an over 47 percent cash on cash return to shareholders since its IPO in 2012, all while paying around a 9 percent per annum dividend fully covered by income.
Q Why the differences in performance given everyone is investing in the same markets?
TK: Same reason that some private equity firms can consistently generate top-quartile returns and others do not. In private debt, it’s all about the platform, the people and the focus on credit. The winners and losers will be determined by which platforms can source their own deals and create truly differentiated and proprietary investment products for their limited partner investors as opposed to which platforms are simply “buying the market” by participating in market led and distributed dealflow. Most new entrants and other asset gatherer firms are forced to do this because of their sheer size and/or the high cost of establishing their own sourcing and underwriting infrastructure.
The institutional LP world investing in the private debt asset class has become much more sophisticated. LPs and consultants have become more discerning. That means that private debt is not a “one size-fits all” asset class. LPs are demanding access to the very best asset managers in the large cap EBITDA borrower space, as well as in the upper middle market and the lower middle market segments in order to create diverse portfolios just like with the private equity asset class.
This article is sponsored by Monroe Capital. It appeared in the Mid-Market Lending Report, published with the June 2017 issue of Private Debt Investor.