How has investing in the private lending space evolved over the decades and, in particular, what role did 2008’s great recession play in shaping the industry as we know it?
Michael Gross: We have been in this industry since its fledgling days. We earned our stripes under Michael Milken at Drexel Burnham Lambert in the 1980s, where we were structuring high yield debt for LBOs. With only a sliver of equity contributed to those leveraged companies, the margin for error was extremely small.
Several years after becoming a founding member of what became Apollo Global Management, I began the firm’s private debt business by creating the first externally managed business development company (BDC). Meanwhile, Bruce was running sponsor finance at CIBC World Markets. In 2006, we partnered to create SLR Capital Partners, an investment firm exclusively focused on private credit.
In those early days, the private debt market was investing in junior capital, including second lien loans and subordinated debt, which carried higher yields but also greater risk. The great recession revealed flaws in this approach. We were fortunate that our portfolio weathered that storm, and our firsthand experience as a firm navigating that environment continues to inform our steadfast commitment to conservative underwriting.
As the markets emerged from the 2008 recession, the private debt market shifted to a greater emphasis on downside protection, with a senior secured claim on assets, covenants, cash rather than PIK interest, and other investor protections. Our current portfolios are predominantly first lien senior secured, supporting our commitment to capital preservation, while our annualised income distributions remain in the 10 percent to 12 percent range.
How have competitive dynamics evolved in the wake of the great recession and how did SLR respond in terms of its strategy?
Bruce Spohler: As a result of US fiscal and monetary policy actions designed to spur economic recovery, the markets were flush with capital, which drove asset prices higher and increased competition for private cashflow loans. In addition to focusing our sponsor finance origination efforts on first lien loans, we expanded our investment strategy.
In 2012, we made the first strategic addition to our platform by acquiring a commercial finance company led by a highly experienced ABL team, which provided us with an ABL underwriting capability. During the subsequent decade, the SLR platform acquired several other speciality finance businesses. Our suite of financing capabilities allows us to offer a full range of debt solutions to our borrowers and a diversified, unique investment offering to our investors.
Indeed, our intention is to continue to expand the SLR platform in order to meet emergent investor needs. As part of our strategic plan, we partnered with Hunter Point Capital and Goldman Sachs’ Petershill Partners in September 2022. This decision was part of our ongoing efforts to increase our scale and ability to create additional financing solutions in response to growing investor demand.
To what extent have you observed enhanced specialisation in the private debt field?
MG: As commercial banks have retreated from mid-market lending to sub-investment grade companies, non-bank lenders have stepped into the niches that require more extensive underwriting and monitoring. The SLR platform has several teams that focus on specific industries, such as life sciences, and are skilled in assessing the value and monitoring the collateral supporting our loans.
Our speciality finance platform gives us access to attractive asset-based loans that carry potentially higher yields and lower risk than cashflow loans. This allows us to be more selective in our cashflow lending strategy, focusing on recession-resilient sectors with low capital requirements.
We invest in upper mid-market companies backed by top-tier financial sponsors with deep industry expertise and strong track records. As a result of our higher yielding speciality finance portfolios, we are able to accept a slightly lower yield for these safer cashflow loans, while still generating attractive risk-adjusted aggregate portfolio returns.
How have you seen investor appetite for private lending change in the years leading up to today’s new macroeconomic environment?
BS: When we marketed our first private debt fund in 2006, institutional investors didn’t have a dedicated portfolio for private credit. The quarterly current income component aligned with liquid credit while the illiquidity and long investment horizon matched the private equity structure. As a result, hedge funds held a larger share of private credit investments.
As the asset class grew, pension funds and other income-orientated investors developed the expertise to evaluate private debt managers. Their allocations to direct lending have enabled them to benefit from the yield premium private loans carry over liquid leveraged loans and high yield securities.
Today, many institutional investors have dedicated private credit portfolios allocated across several managers. Over the past few years, we have been hearing from sophisticated investors that they have reached capacity in general cashflow lending and are seeking to diversify their private credit exposure into niche areas, such as our speciality finance strategies, which include ABL, equipment leasing, asset-based loans to commercial lenders, and life science lending.
Our speciality finance strategies provide a unique addition to the funds that we manage, giving us the ability to choose the best risk-adjusted return strategy throughout an economic cycle, and to be selective with regard to when in the economic cycle we allocate to each asset class. This diversification also enables us to be more concentrated in recession-resilient, defensive sectors within our sponsor finance strategy.
Asset-based loans also typically experience lower default and higher returns relative to traditional cashflow loans, enhancing our risk-adjusted returns. We believe that our barbell portfolio construction approach is compelling, especially in a recessionary environment, where collateralised investments tend to outperform. We expect investors to continue to seek out niche private debt managers to increase both the yield and diversification of their portfolios.
What impact is the withdrawal of banks having on the private lending industry today, and how do you see this evolving?
MG: Since the 2008 recession, banks, which must manage regulatory capital requirements based on their percentage of illiquid holdings, have been retreating from private lending. In mid-2022, banks and brokerages that had been active in syndicated liquid leveraged loans suffered losses as rising interest rates and economic concerns triggered a sell-off, reducing their activity. This created an opportunity for non-traditional lenders to gain further market share.
We saw this dynamic both in cashflow lending as well as our speciality finance strategies. As a result of the decreased supply of capital for private loans, terms have become more attractive for those lenders that do have the available capital. We recently raised $3.8 billion of new capital commitments, inclusive of anticipated leverage, which makes us a valuable financing partner in this market.
Meanwhile, the regional bank failures in 2023 have caused disruptions to the banking system, which may have long-term implications that could benefit non-traditional lenders such as SLR. As was the case after the great recession, banking regulations will likely come under scrutiny. We believe that reduced involvement by banks in the US mid-market will benefit our sponsor finance strategy, but to an even greater extent our ABL and leasing strategies, which typically face more competition from regional banks.
These strategies require significant expertise in evaluating and monitoring collateral by large numbers of originations and back office professionals. Thus, they are businesses with significant barriers, so cannot be entered easily. The established 19-office nationwide presence of the commercial finance companies owned by our funds gives us an advantage in capitalising on this trend.
Another feature of our platform is our scale – with the pullback of traditional bank lending, borrowers are looking for lenders that can hold larger loan sizes. Our total available capital, including anticipated leverage, of approximately $12 billion, and our ability to hold up to $200 million in a single investment, grants us access to larger and safer deals, as many lenders are tapped out.
What do you think it will take to be successful as a private lender in the decade to come?
BS: Through periods of increased liquidity from government stimulus, there is less differentiation in manager performance, as even weaker companies can be refinanced. During challenging times, such as higher interest rates or a recession, the strength of the original underwriting comes to the fore. We believe that managers who showed discipline throughout the recent periods of easy money will receive the bulk of new capital commitments during the next fundraising cycle.
Having the capital to provide a full debt financing solution is valued by borrowers, sponsors and venture capital firms, which provides these lenders with a competitive advantage. Additionally, we believe that our principal investment approach, with members of the SLR team investing more than $100 million alongside our funds, will continue to bolster our investment discipline and result in an enhanced return profile. With this alignment, our platform prioritises the preservation of capital, along with income generation.
We believe that the ability to be innovative in solving borrowers’ capital needs will continue to be a differentiator as well. SLR has the necessary experience to build niche speciality finance strategies, and we intend to continue this approach to increase our importance to our borrowers while expanding the investment opportunity set for our investors.
Finally, from the investor perspective, our ability to offer a variety of solutions, customised for different investor types by asset mix and structure, sets us apart. We have a broad investment product offering and serve a wide range of investors. We believe this differentiated approach will enable us to continue growing our platform over the coming decade.
Michael Gross and Bruce Spohler are co-founders of SLR Capital Partners