Solar Capital weighs up cash flows versus asset values

What should investors look for in a private credit manager?

Michael Gross

Michael Gross: Private credit covers a wide variety of strategies and requires investors to look at the specific focus of each manager.

Private credit funds are typically yield-seeking strategies, but an important difference is whether they lend based on cash flows or based on asset values, each of which carries different levels of credit risk.

Investors need to understand the risk-return profile of the manager’s strategy and performance over the course of a credit cycle, assess if the team has the expertise to originate bespoke portfolios, and judge their ability to monitor and manage risks. Management’s incentives and its co-investment in the fund reflect the degree of their alignment with investors.

The manager’s fund structure, either private and/or public, is also important given investors’ different liquidity, vintage and duration priorities.

Can you explain cash flow versus asset-based lending (ABL), and can investors benefit from having both strategies under the same roof?

Bruce Spohler

Bruce Spohler: When you’re lending on a cash flow basis you’re underwriting the credit based on the sustainability of a borrower’s cash flow. You need to stress test the cash flows to see how a borrower will perform in various economic scenarios. Mid-market loans are illiquid so you need to know that you can recover your principal over the term of the loan, even if market conditions turn difficult.

For asset-based loans, you need to have highly specialised teams who understand the underlying collateral that secures the loan and its value in a liquidation scenario. Collateral may include accounts receivable, inventory, or machinery and equipment, as well as intangible assets such as IP and personal guarantees.

By operating both strategies in tandem you can offer a holistic view of financing solutions to mid-market borrowers. The diversified platform of our core cash flow and ABL businesses gives us the flexibility to allocate capital to the most attractive risk/reward investment opportunities.

Either way, we always make sure we’re investing at the top of the capital structure in first lien senior secured loans.

How do you break down the mid-market?
MG: We define the upper mid-market as companies with EBITDA of $50-100 million, while the lower mid-market encompasses companies with up to $20 million EBITDA.

The best cash flow opportunities exist for deals in the upper mid-market where we have the scale to be a full solutions provider and the larger cash flow base of these companies can better withstand a downturn. When lending against assets, we tend to focus on providing working capital solutions to lower mid-market companies in market niches that fly under the radar screen of commercial banks, and are therefore less competitive.

What are some of the common ABL strategies?
BS: There are several niche markets in ABL, including both traditional and non-traditional asset-based lending, equipment finance, life science lending and lender finance.

Traditional ABL is a relationship–based business where credit specialists serve as the borrower’s local bank and finance their working capital requirements, backed primarily by accounts receivable and inventory. We use one team that specialises in financing smaller healthcare companies exclusively and another team that serves diversified industries.

Non-traditional ABL business provides capital to companies in transition that are cash flow challenged but asset rich and lack access to traditional bank lenders. We also have an equipment finance business that lends against the liquidation value of essential use equipment to mid-market borrowers.

Our life science business lends to privately held or small cap, late-stage drug and medical device development companies where our collateral is a combination of both cash and the value of the intellectual property.

Finally, we lend into the large and growing market of lender finance where debt financing against pools of assets equates to “cost of goods sold” for a typical operating company that needs capital to continue to fund its growth. These loans are structured to provide a collateral value cushion in the event of an unwinding of the portfolio.

Each of these strategies requires dedicated professionals with the experience and skills to value collateral and manage risk. Thematically, we have focused on building businesses in ABL niches that banks retreated from post the credit crisis.

What are the risk return profiles of each strategy and what are the barriers to entry?
MG: Cash flow loans currently generate returns of 6-10 percent with risk mitigated through a time-intensive due diligence and underwriting process which can take several months. Over time, the benefits of better underwriting in the middle market have translated into better risk-adjusted returns compared to liquid leveraged loans. The barriers to entry in the upper middle market segment are speed, certainty and scale of capital, sponsor relationships and the ability to offer customised solutions.

BS: Among non-traditional asset-based strategies returns are closer to 11 percent, as these borrowers cannot go to traditional banks. The main barriers are long-term sourcing relationships and expertise in valuing collateral.

MG: With traditional ABL, all the loans are fully collateralised through a first lien, with consistent returns of 10-11 percent. Both of our businesses are relationship based, which is a significant barrier to entry.

BS: Equipment finance delivers returns of 10-11 percent and life sciences returns about 12 percent (17+ percent when including warrants and success fees). In both segments, there are only a handful of competitors and specialist knowledge is required. Yields in the lender finance segment range from 10–12 percent with the main barrier being the ability to diligence the complexity of the borrower’s underlying portfolios.

How do market conditions differ for cash flow lending and ABL?
BS: They each have different drivers and different participants. In cash flow there’s spread compression due to a very competitive market right now, so it’s less about fundamentals and more about the way transactions are being structured and the lack of covenants. Fundamentals are strong, as PE-owned companies continue to produce single digit revenue and cash flow growth on average in today’s slow growth environment.

In ABL, there’s less spread compression and less competition and not much pressure from the banks so this helps hold returns at much higher levels.

How do you manage the risks of cash flow lending versus ABL?
MG: For cash flow lending, risk management begins with asset selection and it is critical to have the right loan structure and covenants in place. In ABL, risk management is focused on the expertise in tracking and monitoring collateral valuations.
We find the best approach is to always underwrite credit as if we are late in the cycle because you can never tell when markets will turn until after the fact. Capital preservation is our number one priority.

Where do you see the best investment opportunities?
BS: There are pockets of attractive investment opportunities across all of our strategies. In our cash flow business, we stay defensive and focus on stable, free cash flow generating businesses in the upper middle market that have minimal cyclicality. We are very constructive on the long-term supply/demand dynamics of middle market cash flow lending given both the maturing debt that will need to be refinanced as well as new debt required to support the current record amounts of private equity uninvested capital. In addition, opportunities for asset based lending in highly specialised niches where banks have retreated continue to be extremely attractive.

What keeps you awake at night?
MG: Not our portfolios, which are 100 percent performing. We do see risky structures being underwritten with poor covenant structures. This could become a concern for investors when the cycle turns.

BS: We’re also in a rising interest rate environment and expect rates will approach 3 percent next year. This will put stress on highly leveraged borrowers as their debt service requirements increase.

This article is sponsored by Solar Capital