How ABL protects value in a frothy cashflow loan market

Identifying asset-based lending niches is the way to avoid the excesses of the leveraged loan market, maintain Bruce Spohler and Michael Gross of Solar Capital

What are your views on middle market leveraged lending and the opportunity set today?

MG: Cashflow lending to middle-market companies remains challenging. The influx of capital in recent years has created a borrower’s market, characterised by high enterprise values, loose structures, and low pricing. As a result, we’ve focused our cashflow origination efforts on upper middle-market traditional first lien loans with covenants and additional structural protections.

We target  companies with total leverage of 3.0-5.0x debt to equity and are willing to forgo incremental yield in exchange for better structural protections. We’re avoiding higher risk second lien and unitranche loans and are focused on investing in defensive, non-cyclical industries such as consumer staples, healthcare and business services.

We also have a preference for lending to new M&A transactions as opposed to refinancings as there’s typically an opportunity to drive better terms when a company comes to the loan market for the first time. We’ve passed on re-investing in some existing loans when terms and structures of refinancings no longer meet our underwriting criteria.

As private credit becomes more competitive, what have been your strategic initiatives?

BS: Coming out of the 2008 Recession, we developed a two-pronged strategic initiative to position our portfolios defensively and to optimise our returns.

First, we focused on rotating our portfolios from unsecured subordinated fixed-rate loans to senior secured floating-rate loans. To protect capital, we gave up yield in exchange for better structural protections in newly originated loans. Today, over 90 percent of cashflow investments are first lien senior secured loans and carry floating rate coupons. As a result, credit performance across our investment vehicles has been meaningfully better than the market average.

Second, we set out to build speciality finance businesses with the goal of evolving the Solar Capital Partners platform to be a diversified commercial finance company, with expertise across cashflow and asset-based lending in market niches that are less competitive and less correlated to the leveraged loan market. In 2009 we launched what has become a very successful lender finance business to mid-market commercial finance companies with assets of $50 million-$300 million. These borrowers often need more flexible capital than banks can provide to fund their working capital requirements. Our team’s deep experience has facilitated the expansion of our speciality finance platform, as we often will lend to a commercial finance company prior to seeking an equity stake.

Currently, we have teams specialised in traditional and non-traditional ABL, healthcare ABL, lender finance, and life science lending. These loans have meaningful covenant protections and carry higher yields, providing a more favourable risk/return profile than much of the current cashflow lending opportunity set. We identified niche ABL strategies that were less competitive, required highly specialised skills and were managed by teams with long track records through multiple market cycles.

How do you protect franchise value and remain disciplined in frothy or borrower-friendly markets?

MG:  Alignment of interests and investing as principals are deeply embedded in SCP’s culture. Our investment teams have over $80 million personally invested across our investment vehicles. We believe that investing our personal capital as partners with our shareholders and LPs and not just investing for them is a powerful discipline that protects franchise value.

With over 30 years each in the business, Bruce and I understand that the key to generating strong performance in private credit across market cycles is to avoid losses and have diversified sourcing capabilities with the flexibility to allocate capital to investments that meet our strict underwriting criteria.

Can corporate cashflow direct lending and asset-based lending fit together, and if so, how?

BS: The diversified platform has worked extremely well. Our broad spectrum of financing solutions increases our relevance to borrowers. Due to the specialised skill sets across our platform, we’re able to underwrite borrowers holistically to determine the best-risk reward opportunity within the capital structure, ranging from an asset-based loan fully collateralised by assets or a cashflow senior secured loan. Our originators cross-sell our complete suite of loan products, which enables us to source more proprietary investment opportunities.

Additionally, our speciality finance platform provides an element of counter-cyclicality and diversified asset duration to our portfolios. For example, our non-traditional ABL platform, which provides capital to companies in transition, has historically experienced its best performance during economic and market downturns.

In ABL, the turnover of collateral and opportunity to re-underwrite risk more frequently than cashflow lending enhances the risk/return profile of our portfolios. During heated credit conditions, as we have today, not only do our asset-based loans carry credit protections and yields superior to those available in the cashflow market, but the higher returns we receive from our speciality finance investments enables us to be even more selective in underwriting cashflow loans. Our barbell approach to portfolio construction has allowed us to maintain weighted average asset-level yields close to 11 percent in the face of continued spread compression in cashflow lending.

How do market conditions differ for cashflow versus asset-based lending?

MG: Due to the relatively low barriers to entry in the cashflow loan market, that segment has seen an influx of capital. The oversupply has resulted in loose underwriting standards. Given the commercial banks’ pullback and the significant private equity capital raised, the long-term supply/demand imbalance remains favourable for direct lenders. However, until the transient money recedes, we’re staying focused on lower leveraged, traditional first lien cashflow loans.

We’ve not seen the same competitive dynamic in speciality finance. Our ABL businesses operate where banks do not compete – under the radar screen – in niche markets that require deep expertise, human capital-intensive collateral monitoring and sophisticated back office operations. The lack of competition is even more pronounced in these niches.

How do you think strategically about capital under management?

BS: We’ve always tried to target a capital base that is sized for the market opportunity with the flexibility to take advantage of market dislocations. Platform scale and diverse sources of funding have become competitive advantages: the ability to speak for up to $200 million tranches of upper middle-market loans while still enabling each investment vehicle to be well-diversified increases the opportunity set and enhances the ability to drive better terms Today, we believe $6 billion-$7 billion is about the right size for Solar. We manage two publicly traded BDCs, several joint ventures, and private credit funds, all with similar investment mandates that facilitate scale and co-investing across our platform.

What is the one thing you think investors may not fully appreciate about risk management in a diversified platform?

MG: Our centralised risk function provides a framework for allocating capital to the strategies having the most attractive risk/return profile on an absolute and relative basis. Further, alignment is supported by incentive compensation tied to overall performance of the platform as well as our ROE’s, with a three-year look-back within each business unit. Our teams have exceptional and long track records through market cycles and they know when to raise their hand for additional capital.

We’ve been investing long enough to know that cashflow lending will become attractive again. When that happens, our team will capitalise on the opportunity. Until then, we can generate attractive returns and protect capital through select first lien cashflow and ABL investments.

Michael Gross and Bruce Spohler are co-founders of Solar Capital Partners, the New York-based investment company