This article was sponsored by Madison Capital Funding.
The demise of banks providing capital to mid-market businesses spelled the rise of private credit managers, but it also had another consequence: the increased importance of hold sizes in transactions.
As a result, upper mid-market lenders have displaced the syndicated market and fewer lower mid-market lenders are needed to participate in a transaction. Senior debt fundraising figures speak to this – in 2012, managers raising vehicles for the strategy collected $16.89 billion, while in 2017 it hit a high of $64.58 billion, according to PDI data. The total for 2018 was $47.28 billion.
“The industry’s move to greater hold size is the most meaningful structural shift in the market post financial crisis,” says Ashish Shah, Madison Capital Funding’s head of capital markets. “Platform hold size has gone up meaningfully for scaled middle-market managers. Pre-financial crisis, a Madison $100 million deal would have four, five, six lenders, and now that can easily be done by one lender.”
While a positive upshot for credit managers that have locked down a capital base to write bigger cheques, it also benefits sponsors: private equity firms have the benefit of relying more on alternative lenders as their portfolio companies mature. “We think it is a fundamental shift in our market,” says Christopher Taylor, Madison’s chief executive officer. “I think hold size, in terms of being able to take down the whole deal and grow with the portfolio company, is a fundamental requirement for playing in the space going forward.”
Sponsors can rely on direct lenders to help them execute their investment plans, particularly on buy-and-build strategies when add-on acquisitions are key and being able to tap idle capital, often in the form of delayed-draw term loans, makes for efficient execution.
“There’s a significant amount of delayed-draw term loans going into the capital structure, mostly to facilitate the investment thesis,” says Jennifer Cotton, chief underwriting officer. “For us, having the dialogue up front, understanding what the sponsor is trying to do, understanding the thesis is really important.”
Product offering has also become key, with many managers offering a suite of loan strategies. This has also worked to the private equity sponsor’s benefit.
“Now, along with the hold size, you have firms that have taken a multi-strategy approach, so they can offer senior, senior-stretch, unitranche, subordinated debt, if needed, on any particular transaction,” says Sunil Mehta, a managing director and head of general industries.
“We’re going to sponsors saying, ‘Where do you want us to play in the capital structure? Here are four term sheets, depending on what direction you want to go.’”
Funds focused on unitranche have been raised, and managers have turned to these one-stop loans as direct lending returns have stagnated and the market has become flush with capital. In 2018, some $27 billion of unitranche loans were completed, a 13 percent increase from 2017, according to data from LPC. “I don’t see the lower middle-market private credit space going back to a true syndication-type execution,” Taylor says. “Which lenders survive the next cycle will determine what the competitive landscape looks like and what deal executions look like.” Sponsors have also become sensitive to how credit managers are funded – is the lender’s capital coming from say, a joint venture, a drawdown fund or some other type of investment vehicle?
“Private equity firms are very sensitive, as they should be, in making sure the partners that they’re picking to finance their deals are able to control that capital,” Taylor says. “I think if you asked them five to seven years ago, it was a less sensitive topic.”
One source of capital that has expanded quite rapidly has been mid-market collateralised loan obligations. The amount of active mid-market CLOs reached at least a six-year high in February, when the figure totalled $48.5 billion, according to LPC.
Madison raised three such vehicles in 2017. The first was a $303 million deal that closed in March. The second and third were, respectively, a $325 million transaction in July and a $302 million deal in September. An additional CLO was issued last year, a $326 million deal.
“The base architecture of the private debt landscape has changed very meaningfully and resulted in more of a winner-take-all environment,” Shah says.
That’s not to say that all is well and good for private equity right now. Sponsors have been under pressure to grow their portfolio companies, given the lofty valuations.
Citing data from PitchBook, consulting firm Bain & Company notes private equity managers cited high purchase-price multiples as their biggest challenge in closing deals. “The heavy competition for assets and the flood of capital – both debt and equity – into the market since 2014 has had the inevitable effect of raising asset prices to all-time highs,” the report reads.
Robert Douglass, Madison’s chief credit officer, says: “With the elevated purchase multiples, we are focused on the pressure that our private equity clients are under to deliver accelerated growth through their platform companies. What we’ve seen in some instances is there has been significant investment in infrastructure, sales and marketing, facility expansion, and then the revenue growth has not met expectations.”
What’s more, private equity firms are relying on manufactured earnings – and not the type that come from makers of goods. EBITDA addbacks have become increasingly concerning for lenders; definitions of EBITDA affect all parts of the credit agreement, as many covenants incorporate EBITDA as a key metric.
“We were more focused on covenant flexibility, and now it’s moved more to EBITDA flexibility and ability to recognise growth,” Cotton says. “The starting point for adjustments can be pretty egregious.
“EBITDA – through creativity and addbacks and lookbacks, drives a lot of the ability for dividends and debt repayments of mezzanine loans, to add debt and provide greater flexibility. If you are higher in the capital stack, you’re going to have a lot of concerns around those adjustments.”
Taylor adds: “It’s become more prevalent in our market in the last 18 months. But it spans the spectrum, all the way to the largest public companies when they’re doing M&A.”
GP style drift
The growth of senior debt has resulted in some firms stretching on credit quality to generate dealflow, and that also means some firms are deploying capital outside of what many consider direct lending in the core mid-market.
“Are the funds raised truly being deployed in the asset class? It is something I think investors need to be mindful of,” Shah says. “Or is it just covenant-lite syndicated or covenant-lite upper middle-market loans? I think understanding the manager’s ability to source and deploy capital in the asset class is critical.”
Indeed, more than half of investors are seeing GPs deviate somewhat from their stated strategy. Some 55 percent of investors across multiple alternative asset classes, including private debt, are seeing “occasional examples” of style-drift among their GPs, according to the PDI Perspectives 2019 LP survey.
“If you had asked the same question four years ago, I think there would have been a greater percentage of managers who were focused on deploying assets in the core sponsored middle market versus simply raising assets for the asset class,” Shah says. “The sheer amount of capital raising that’s been going on over the past 36 months has led to an oversupply of dollars in the market, and I think those dollars are getting deployed all over the place.”
Investors routinely inquire about sourcing capabilities and wonder whether the firm has the “appropriate sourcing capabilities” to allow the lender “to construct diverse enough portfolios”, Shah adds.
LPs will also ask about hold size capabilities as well as personnel and infrastructure, he says.
“Where it’s really changed over the last 36 months is the institutional investor base has focused on extracting more value from their capital commitments,” Shah says. “Due to the importance of hold size on a platform’s competitive position, scaled institutional investors have focused on driving greater influence over the dollars they commit to a platform. Investors recognise that if they write a meaningful cheque into a platform, that platform’s value proposition to sponsors increases and the investor wants to get paid for that.”
There are smart ways to pursue growth, though, without compromising an investment thesis.
“It’s growing the number of sponsor relationships we have, so we’re not reliant on the same base of sponsors we’ve always been working with, and growing the actual number of companies in our portfolio,” Taylor says. “It’s not just about more dollars in the same number of portfolio companies to generate more AUM growth. It’s about doing more transactions, building more diversity and granularity in the portfolio at this point in time.”
Growing doesn’t necessarily require a compromise of underwriting standards, though.
“I still think we’re sticking to the same core principles,” Cotton says. “There’s probably more turndowns early on than we’ve seen before. I wouldn’t say the standards have changed. It’s just evolving with the times and being able to move quickly.” Douglass adds: “With Madison’s parent company New York Life being around for over 173 years, it looks at growth in decades and not necessarily one given year. While they want us to grow, there’s not extreme pressure to aggressively grow assets, particularly in the late stages of the cycle.”
The recipe for success(ion)
As private debt has mushroomed at an incredible rate, the growing pains have not been just capital related; they have also been related to leadership and personnel. Among these are succession and ensuring firms can remain competitive for the top-tier talent – or being able to cultivate first-rate front- and back-office personnel.
“From an originations perspective, a lot of our folks are homegrown,” says William Kindorf, a managing director and head of specialty industries. “So, they’ve come up through the underwriting ranks, and we kind of prefer that because they know how we view credit. It’s competitive if you try to go out and make a lateral hire. We try to grow those folks internally and provide career opportunities.”
Succession has become a prominent issue in recent years. The founding generations of many alternative asset managers across private credit and private equity have reached, or are reaching, retirement age – or at least a point in the founders’ and chief executives’ lives where they step back from overseeing their firm’s day-to-day operations.
Debt managers face unique challenges that private equity firms, namely those without credit operations, do not need to contend with. Largely, this springs from the vast array of products credit firms can offer: mid-market lending, CLO management, syndicated loan desks and more.
Another integral factor is remaining in the good graces of those banks or institutional investors that provide leverage facilities, a phenomenon much more common in credit investing than in buyout strategies or other equity-based products.
Madison executed its succession plan in 2018. In January of that year, the firm announced Taylor would succeed then-CEO Hugh Wade at the end of June. Wade became chairman until he formally retired in December.
“Communication of that both internally and externally across functions, across constituents made all the difference. There were no surprises,” Taylor says. “I think one of the downfalls of succession is if it happens in an accelerated, unplanned fashion where the appropriate parties – whether they be employees, investors, or clients – don’t have time to digest, understand and react to the change.”
Of course, that gives rise to a unique challenge among asset managers: the senior leadership team must not only be good investors and stewards of third-party capital but also adept leaders.
When asked what’s more important, being a good investor or leader, Madison’s leadership team agreed they were interlinked. “If you don’t have the right level of talent and the right level of infrastructure inside the business, you can’t invest and lend and deploy capital on behalf of your investors prudently,” Taylor says. “In my mind, they work in concert together.”
Ultimately, they answered in a manner other firms might have dodged: people over dollars; the latter will likely follow the former. “If we don’t have the human capital, the financial capital is not going to be there,” Douglass says. “Sourcing is always a focus of our investors; portfolio management is always a focus of our investors. There’s no question the financial capital is essential for growth, but it starts with the people.”
Q: How important is the usage of data analytics and technology in underwriting and portfolio management?
Jennifer Cotton: In today’s environment, utilising data is really important to get to the core credit fundamentals. Credit analysis, in both underwriting and portfolio management, is much stronger when we can point to empirical data to support the story or investment thesis. Over our history, we’ve looked at over 1,000 transactions per year and collected an abundance of data and knowledge. From the start, when underwriters are reviewing transactions, they are identifying key indicators and using them in the underwriting that can then go into the portfolio management aspect of our business.
Robert Douglass: From a portfolio management perspective, we changed our portfolio management database a little over two years ago. We historically tracked data on a monthly basis. However, we relied heavily on our portfolio review process, which was done on a quarterly basis.
What we quickly learned is the time lag from when we received the reporting to when we actually held the quarterly review discussions was creating a very reactive decision-making process. With the new database, we can track our portfolio accounts as our account managers input the monthly data. The portfolio management system further allows us to generate customised reports that help isolate potential problems within the portfolio across a variety of indicators in real time.
Q: How should a firm approach diversity and inclusion, and what programmes should be in place?
JC: From a diversity and inclusion standpoint, I think looking for different backgrounds makes a lot of sense. It brings a lot into the culture and the fabric of the organisation.
We look for different backgrounds but also different levels of experience. We train and develop our employees to look at transactions and evaluate credit opportunities, and expect them to add a piece of their own backgrounds and experience to the process.
For organisations that collaborate and want different points of view, you get that from having diversity in your employee base.
Q: What does a successful leadership team look like?
Christopher Taylor: I believe there are two components to a successful executive or senior leadership team. The first: being well-rounded. I think every function of the business needs to be represented at the executive level of the firm. We have underwriting, credit, capital markets and originations comprising our executive team.
The broader employee base knows that no matter what part of the business they are in, they have representation in both strategic and managerial decisions.
Then, more importantly, successful executive teams have trust. At the end of the day, each member of the team needs to trust one another. There needs to be a fundamental level of authenticity and comfort among the team to be honest, transparent and communicative with one another. If you have that as the foundation at the top of the organisation, it trickles down to the rest of the firm.
Q: How does a firm ensure its investment committee has vigorous debates and comes up with the best recommendations?
Ashish Shah: The investment committee is comprised of individuals from different functional areas of the organisation. Having individuals with different backgrounds and perspectives helps manage investment bias and positions us to generate the best outcomes for New York Life and third-party investors. An effective investment committee evaluates the business and industry fundamentals along with the transaction considerations including role, ownership, capital structure, management team and hold size. The composition and diversity of the investment committee allows for rigorous and thoughtful debate on the totality of the transaction.
Madison believes it is important that each investment committee member has an equal say and equal influence over the investment decision. All investment committee decisions require a unanimous vote.
Q: Where are private credit managers seeing the most product growth?
Sunil Mehta: We’re seeing the most product growth in senior-stretch and unitranche structures. The ability to offer multiple debt structures combined with a large hold size has resulted in differentiation among private credit managers. We’ve also seen a lot of growth in unfunded commitments, so that would be in large unfunded revolvers or delayed draw term loans. Offering unfunded commitments provides flexibility to allow private equity sponsors to grow their portfolio companies after the initial buyout.
Usually those commitments are ones in which the private equity sponsors have an aggressive add-on acquisition investment thesis. So, having debt capacity readily available in the capital structure is really important for them to execute on their growth thesis.
Q: How should private debt managers think about industry specialisation?
William Kindorf: Early in our history, Madison Capital identified industry specialisation as extremely important. We view it as a significant part of our growth, and we feel like it gives us unique access to sourcing deals.
Today, we have three industry speciality verticals: healthcare, insurance and financial services, and software and technology services. Across all of our industry verticals, we find private equity sponsors value industry knowledge and experience. As a result, our existing verticals and any we form in the future will continue to be a core part of our growth strategy.
Within our industry verticals, we know players outside of just the private equity sponsors. We have contacts at the investment banks, the specialty intermediaries and, to some extent, the actual industry players. It provides additional avenues for sourcing transactions and may allow us earlier access to the transaction or the management team.