• Lateral Market Perspective – May 2016

    At our last market update call, we took time away from a more general look at the private markets to address four specific questions that came up at the recent EPIC RETURNS conference sponsored by Pension & Investments and Minard Capital. See below for a summary of our responses, along with supporting illustrations and data.

     

    QUESTION #1: What is the difference between sponsored debt funds (e.g. Golub, BDCs) and a non-sponsored fund like yours? How are you generating higher returns than other credit funds?

    • There has been a lot of activity around the private credit market as investors search for yield in a low-yield environment. The reality is that most of this lending is going to PE-backed companies, not filling the void left by local banks which pulled back from corporate lending after the 2007 financial crisis.
    • Golub, Ares and most BDC funds provide commoditized mezzanine and unitranche solutions to the PE market.
    • This sponsor-backed lending market has thrived along with the PE market and post-2007 economic recovery.
    • Just as private equity is highly correlated to the equity market, sponsored credit is correlated.
    • Lateral’s non-sponsored credit model works directly with owner-operated businesses and is defensively structured and collateral-based to maximize recovery outcomes.
    • Lateral generates higher returns through higher cash coupons and significant equity stakes, but our financing offers a lower cost and is less dilutive to company owners than private equity.

    private-public-equity-debt

    At every step of the investment process, Lateral takes an active role which allows us to play a greater value-added role to borrowers while reducing our risk exposure and increasing our recovery position.

    • Origination: Lateral develops direct relationships with its borrowers. Sponsor-focused lenders try to be on the short list for PE firms looking for leverage.
    • Underwriting: Lateral does fundamental analysis and hires its own 3rd accounting, background checks and legal. Sponsor-focused lenders rely on the PE firms.
    • Pricing: Lateral prices risk. Sponsor-focused lenders are chosen by PE firms based on low price and loose terms.
    • Structure: Lateral has tight covenants that are customized for growth and grounded in collateral values. Sponsor-focused lenders compete on loose covenants and rely on docs provided by the PE firm.
    • Portfolio management: Hands-on, value-added and engaged with the management team.
    • Recovery: Lateral has options for recovery- ranging from asset sales, M&A, company takeover and foreclosure. Sponsor-focused lenders count on the sponsor and want to preserve the PE relationship.

    lateral-vs.lender

    The market for non-sponsored credit investments in the lower middle market has fewer competitiors and less capital earmarked than the market for lending to sponsor-backed companies.

    • Most of the $500B raised for private debt is to support private equity financing.
    • <$115B is in more non-PE related financing, according to analyst firm Prequin.
    • Only $59B in dry powder for direct lending funds.
    • For sponsor-focused private credit, which is correlated to private equity, the future may not be so bright, given high market multiples and leverage levels.
    • There is an unprecedented amount of PE money and correlated private credit money ‘chasing returns.’

    private-debt

    • As discussed last month (see PE blog post), the PE market cycle is mature and likely to decline.
    • Currently, it’s a good time to exit PE investments from 2010 and a bad time to make new investments at historically high entry multiples.
    • There is a lot of dry powder and PE activity remains high, although it has slowed down.
    • Debt levels are still high — though lenders have pulled back a little.
    • If you’re an investor in Golub or another BDC fund, you are providing high leverage to PE firms, which are paying high entry prices for new deals.
    • Even worse, there is hidden leverage for private credit firms at the portfolio level, which are often 1x levered themselves – that is, fund leverage on top of the company’s leverage, which magnifies the risk to fund investors.

     

    QUESTION #2: How do you source and originate new deals if you are working directly with companies ? Why would a “good” company accept Lateral’s terms?

    • Lateral looks at 1,000 deals annually through its network of professional relationships and intermediaries.
    • We generally have 10 qualified deals in our pipeline, which changes over monthly.
    • There are usually 3-4 opportunities at any one time under LOI, which our underwriting team goes deep on.
    • Lateral takes a proactive approach to developing high- potential opportunities, for which the firm possesses a unique edge and expertise on.
    • Four specific areas of focus are:
      • Manufacturing: heavy assets with contracts and/or recurring revenue.
      • Healthcare services: facilities-based service delivery, we avoid regulatory risk and reimbursement risk.
      • Infrastructure: telecom, alternative energy and agriculture.
      • Specialty finance (business-to business, rather than consumer finance): leasing, insurance, royalty securitizations

    Investment themes

     

    QUESTION #3: What happens if the economy weakens? If there’s a downturn, how do you get money back? Have you done this before?

    • Lateral has multiple options for recovery and risk adjustment. Not just looking at a foreclosure. Lateral can modulate recovery methods based on changes in risk.
    • As a team, we have extensive experience in workouts and recovering capital successfully in tough circumstances, particularly from 2006 to 2012, which spanned the entire credit crisis. Not many non-bank lenders can speak favorably about their performance through this last downturn.
    • We plan to discuss recovery methods and workouts in more detail in the June market perspective.

     

    QUESTION #4: European credit funds: Many investors have invested with European credit funds. Why should investors strongly consider a US-focused fund now versus continuing to invest in European private credit?

    • Lateral sees extraordinary dislocations in the US credit market – especially in Lateral’s target market of smaller to mid-sized firms (defined as $10-$100mm in revenues).
    • Significant macroeconomic factors create a more risky European environment relative to the U.S.:
      • Negative interest rates, low GDP growth and aging demographics.
    • Tougher to be a lender in European markets, which have pro-labor laws that make it difficult to foreclose on assets, reduce headcount quickly, or take over the company in a workout scenario.
    • Besides not having the scale of the US market, private credit in Europe is crowded and the European market still requires local market knowledge and focus.
    • There are better conditions in the US to protect against downside risk: more stability, more growth, better legal environment and more qualified target borrowers.

    bet on the us economy

    • The US economy presents a far better investment opportunity than economies in Europe, especially in terms of long-term growth.
    • According to OECD projections, the US will continue to grow while Europe will experience anemic growth.
    • In particular, the UK and Germany economies are likely to experience limited growth, according to the OECD, along with the rest of Europe.
    • Combined with the US’s projected long-term growth, Lateral’s strategy for addressing US middle market credit dislocation offers investors attractive investment opportunities. Lateral is able to secure these opportunities in the much larger and more established U.S. market without fundamental political, legal and systemic risk.

    us growth story

    QUESTION #5: How should we think about the trade-off for illiquidity in your fund (versus say BDC’s)?

    • BDCs provide the appearance of liquidity against leveraged and illiquid-underlying portfolios. Most BDCs (including established firms such as Golub) provide leverage to PE-backed transactions, so they are in a weak recovery position, as discussed in Questions 1 and 2 above.
    • BDCs are trading at significant discounts to NAV (82% median, according to KBW) and returns have been negative.
      • -6.5% unweighted average LTM total return across the KBW BDC universe.
      • -0.9% weighted average LTM total return across the KBW BDC universe.
    • The reward for BDC investors has been terrible and the embedded risk in the portfolios remains high with inconsistent portfolio marks.

    ltm total return

    • The trade-off for the illiquidity of Lateral’s 5-year fund versus “liquid’ BDC investments is favorable in a base case of slow economic growth.
    • The trade-off is even more compelling in a downside case where BDCs face dual challenges:
      • Inability to regularly access capital per “40 Act” requirements.
      • Portfolio workout challenges due to their covenant-light, subordinated position.
    • 50% of BDC portfolios’ NAV is in junior debt or equity, according to Wells Fargo’s BDC analyst.
    • 100% of Lateral’s loan portfolio is in senior secured, first- lien debt.

    bdc portfolios

  • Is Private Equity a Panacea or ‘Hail Mary’ for Institutional Investors in the Current Low Return Environment?

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    At a recent conference for high net worth investors, TPG Co-Founder David Bonderman repeated a cliche which private equity guys bandy about when the markets get hot.

    “We are selling everything that isn’t nailed down,” he said, remarking on high market multiples and strong private equity (PE) returns in recent years. Probably not the first time he said it, nor is he alone in making the comment (Apollo CEO Leon Black made the same comment in 2013). But ironically, TPG in February was finishing up fundraising on its 7th mega-fund with $10 billion in commitments, presumably to buy new companies. Is this logically consistent behavior, another example for Bernie supporters of Wall Street greed or a market paradox?

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    The answer is all of the above. Let’s call it the Bonderman paradox. It’s difficult to raise money when it’s a good time to invest, i.e. prices are low. It’s easier to raise money when it’s a bad time to Invest, i.e. prices are high. In private equity as in other markets, investors make lagging decisions based on historical results which often don’t reflect changing circumstances and crowd each other out.

    That’s why the private equity market is highly cyclical. Between 2010 and 2014, the combination of cheap debt, low, expanding multiples and recovering GDP resulted in strong PE returns. Now those elements have reversed: leverage is harder, entry multiples are high and growth is sluggish. Recent data from Cambridge Associates shows that the PE market cycle peaked in 2014. Returns are coming down. So why are investors still piling in?

    For institutional investors: “4 is the new 8,” but is PE the panacea?

    At institutional investor conferences this year, consultants have been proclaiming somberly that “4 is the new 8” referring to anemic returns recently relative to typical 8% hurdle rates for pension funds. McKinsey published a report this month questioning whether returns are really coming down to a new normal or just returning to their historical norm; instead, McKinsey argues in “Why Investors May Need to Lower Their Expectations” that the last 30 years were the anomaly. (My brief counter: McKinsey underestimates opportunities for productivity gains in the U.S. economy – not only in technology, but in major sectors undergoing change like healthcare and infrastructure). You don’t need a consultant to tell you that it’s a tough market to generate sustainable returns. But increasingly private equity has become the panacea of choice to offset low public equity and fixed income returns, because of recent relative outperformance, illiquidity and long timeframes. It’s become another way for institutional investors to kick the can down the road. As a result, pension funds and endowments are relying more heavily on private equity allocations than ever before to make up for lost ground in other asset classes. Hedge funds are choking on volatility. Fixed income returns are anemic, distorted for 8 years by zero-rate central bank policy. Public equity markets have diverged from fundamentals, with slow growth and sluggish returns.

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    The conventional wisdom for institutional investors has become to increase their private equity allocation, especially to mega funds like Blackstone and KKR. These firms provide scalable vehicles to write big checks on long-term bets that are difficult to evaluate on a short-term time frame. Recent vintages have comfortably beat the public markets. But the outlook is uncertain.

    For investors, illiquidity masks the volatility and cyclicality of the private equity asset class. There has always been high variability in PE vintage performance based on where entry and exit multiples are in the market cycle. The typically long J curves are getting longer. The statutory life of a PE fund is 10 years but the true average is almost 14 years and many extend to 15-17 years. Long term returns in PE are down due to overcrowding – the highs are lower and the lows are lower.

    For U.S. companies: PE “Sponsors” Are Crowding Out Owner-Operators

    Cyclical downturns get solved in time, but private equity (and limited partners) now face a more serious secular problem due to the sheer size of the industry which has ballooned relative to the opportunity from $500 billion in 2000 to $4 trillion in 2015, according to analyst firm Prequin. Historically, PE has played a positive role in improving the productivity of the U.S. economy, by fostering growth and increasing the scale of companies. Periodically, the industry binges and blows itself up – most famously, RJR Nabisco in 1988 and TXU in 2007 – but the buyout model is not just about bloated megadeals.

    The middle market ($20MM to $1 BB in revenues) used to be a growth milestone between small and large, instead of an endpoint. For middle market companies, the predominant model for private equity financing is control buyout transactions. The pervasiveness of this “middle market buyout” model is bad for the U.S. economy. It has caused harm to one of the key engines of U.S. innovation and may have undermined the economy recovery since the Great Recession. Buyout firms create perverse incentives for founder and family-owned businesses to exit earlier than they might have otherwise. Middle market private equity- backed companies are developed to scale and exit to enrich their private equity owners versus owner-operated businesses that have created some of the world’s most durable, long-term companies (Ford, Microsoft, Comcast, Bechtel). The big exception to this rule is Silicon Valley’s venture capital industry where the founder-owned model still dominates amid generous equity valuations. But for less sexy industries like infrastructure, manufacturing and healthcare services, a growing and profitable business often has limited options for growth financing without losing control and being subject to high levels of debt.

    Financial buyers with large funds want control so they can write $50-500MM equity checks and raise cheap debt to lever their returns. As a result, private market transaction multiples rival public multiples — a function of excess leverage capacity, not the potential for corporate efficiency, operating scale or rationalization. The result is a shift in emphasis among growing middle market companies to financial engineering versus innovation and long-term growth. Excessive debt and outside ownership run counter to the ethos of the owner-operated business which has historically built many of the long-term franchises and generational family-owned businesses. PE-owned companies carry 5-7x EBITDA in debt resulting in excess financing costs which detract from investment dollars in product and people. Outside managers might be well-trained and highly rational, but the agency cost of hired guns versus owner-operators is difficult to quantify.

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    Looking Beyond PE: Non-Sponsored Credit and Growth Capital for the Middle Market

    In terms of size, the private credit market is almost as big as the private equity market was in 2000.  In terms of development, it is still an immature industry. Private equity allocations are mostly just spilling over into private credit, but the next step is for private credit to stand on its own as an asset class. Most private credit firms today are adjuncts of the private equity industry, providing leverage services to PE firms and outsourcing origination, structuring and portfolio management to their PE partners.

    At Lateral, we believe there is a $1 trillion opportunity to create a non-sponsored private debt and hybrid debt-minority growth equity market that generates 4-10 percentage points of premium (as historically, private equity has done relative to public equities) by developing proprietary origination, bespoke structuring and high-touch portfolio management capabilities in partnership with great owner-operated private companies. Opportunities abound for growth amid upheaval in the healthcare industry and pressing needs for infrastructure upgrades to name two of our investment themes. For investors, the opportunity is to take uncorrelated idiosyncratic risk in and receive outsized rewards from growing private companies and add some life into their moribund fixed income portfolios. For companies , the opportunity is to retain control, align long-term interests and scale successful companies beyond the middle market – or remain as a successful cashflow generator for owners with no exit in mind.

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    The private equity industry over the next decade is unlikely to be the panacea for the unfunded liability crisis that pension funds and endowments are facing. Eight years of easy monetary policy produced a strong financial recovery with stock market gains and private equity returns, but failed to restore growth. Now too many asset allocators are chasing returns in PE and too many funds are chasing too few deals, resulting in high entry prices and the prospect of low returns. The unprecedented number of businesses owned by financial owners instead of owner-operators is bad for the U.S. economy. This problem is going to get worse, before it gets better. The overhang of nearly $3 trillion in unlevered dry powder in PE funds (theoretically $6-9 trillion in potential buyout values) may take 15 to 20 years to work off.

    Ultimately, only real GDP growth will provide the panacea investors are looking for. Long-term economic growth is rooted in widespread productivity gains and the development of long-term business franchises that enrich a multitude of business owners and their employees, not a concentrated group of financial buyers.

  • Lateral Market Perspective- March 2016: Who Needs Credit Alternative Products and Private Debt? Now Everyone Does

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    Last week, the Fed reaffirmed its low rate policy, now in its 8th year below 1%. The unexpected consequence of the Fed’s extended regime of low rates is that it has shattered the portfolio model of institutional investors and individual investors alike. In the next decade, the combination of a continued low yield environment and the demographic shift of 76 million baby boomers reaching retirement age will lead to a multi-faceted financial crisis of unprecedented proportions.

    One of the only potential solutions will be the emerging asset class of credit alternatives in general and private debt in particular.

    The “Agg”, or the Barclays U.S. Aggregate Bond, which measures a mix of government and investment-grade corporate bonds, generated an annualized total return of 7.94% between 1976 and 2013 (source: BlackRock). Most of the return was derived from steady coupon payments, and the index only generated 3 years of negative returns (1994, 1999, 2013) going back to 1976. Also during this period, the baby boomer generation (born between 1946 and 1964) consisting of the largest population cohort ever (75 million people) hit the most productive years of their working careers. Baby boomers fueled consumption and growth in both the stock market and the fixed income markets.Graph 1

    In the last decade, the baby boomer generation has started to reach retirement age. The number of Americans above 60 has grown dramatically and will accelerate through 2025 when the last of the boomers come of age. Between 2010 and 2025, 30MM additional people will hit 60 bringing the total 60+ population almost 90MM. Furthermore, actuarial tables 20 years ago had projected that retirement would generally last 20 years and because of health improvements, experts now believe that average retirement timelines will be closer to 30 years.

    This demographic shift is occurring at exactly the wrong time to coincide with sluggish economic growth and zero rates. Under-funded pension plans are already paying out more than they take in. Individual retirees will have to find a way to generate bigger nest eggs or postpone retirement altogether.

    Graph 2

    From 2011 to 2015, the annualized total return of the Agg dropped to 2.4% – a 550 basis point difference from its historical average. Inflation has remained low and stock market returns have been robust, but since 2014, the stock and bond markets have been flat and highly volatile – the worst of all trade-offs: risk without return.

    Investors need yield from somewhere new to make ends meet. But in the world of alternatives, the private debt industry is still very much in its infancy. Private debt firms have raised only $300 billion in assets under management in the U.S. relative to multi-trillion dollar alternative asset classes like private equity and hedge funds. As the demand for yield becomes more urgent from investors and institutions, private debt will become a more fundamental part of portfolio allocations. Over the next decade, private debt has the potential as an industry to scale to a level comparable with private equity and hedge funds.

     

     

     

  • Lateral Market Perspective - February 2016: Evaluating How Credit Alternatives Will Perform in the Next Phase of the Economic Cycle

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    Evaluating How Credit Alternatives Will Perform in the Next Phase of the Economic Cycle

    When a tweet by Oakland A’s slugger Jose Canseco on negative interest rates in Japan resonates among financial analysts, we must be living in strange times that even academics had never believed possible.

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    The comment speaks to how much the conventional wisdom on the rate environment has changed. In the last month, speculation has moved from how quickly the Fed will raise rates this year to how far below zero monetary policy can go.

    In the EU, Sweden and Switzerland, investors are buying contractually money-losing bonds. In Japan, consumers are paying for banks to hold their savings. This is a new and unprecedented reality –and in theory, a possibility (though not likely) — for the United States.

    Continuation of low rates—then (2007) and now

    What we can expect for the U.S. is the continuation of low rates. The market (as expressed by the 30-day Fed Fund Futures prices) has discounted to less than 30% the possibility of any further rate increases in 2016. Treasury yields have dropped to new lows, more than reversing the December rate increase and taking rates down to new levels. High yield spreads continue to widen, causing some analysts to term the sell-off a “credit bear market.”

     

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    For investors, low rates are likely to continue for the next three years or more, but going forward, the context is different especially for non-bank credit alternative players who have been an important source of yield in a yield-starved market.

    It’s a good time to be more cautious than greedy in evaluating credit alternatives.

    After the Global Financial Crisis, low base rates and QE fueled a 245% aggregate gain in major stock indices. The energy boom and strong M&A activity resulted in growing Fortune 500 profits. Credit alternatives firms including private debt and market place lenders stepped into the void left by banks–refinancing corporate debt, providing leverage to private equity transactions and pioneering new lending models to consumers and small businesses.

    Eight years into a tepid recovery, equity valuations remain lofty–still only 10% below all-time highs. Global GNP growth is stalling outside the U.S., resulting in shortfalls in Fortune 500 earnings. Collapsing commodity prices have crushed the U.S. energy industry. Corporate credit markets once again look a lot like they did in 2007: increasing leverage, widely syndicated participations, covenant-light documents, more subordinated and second-lien than senior secured loans.

    Instead of sitting on bank balance sheets, these loans are being held by private debt firms, marketplace lenders and with retail investors via mutual funds/ETFs. They carry similar risks to pre-2007-era credits which nearly took down the U.S. banking system, but this time the risk is held in some new and unproven pockets that are both unregulated and uninsured.

     

    Guidelines for evaluating credit alternatives

    Pension funds and family offices alike need alternative low risk, yield products in the absence of attractive risk-reward returns in the corporate bond markets. Private debt firms, business development companies (BDC) and marketplace lenders have emerged as the primary contenders to deliver a diversified source of cash yield via a scalable institutional-quality product. While these firms have done well since 2009 under favorable conditions, it’s an open question how they will perform in a period of extended turbulence.

    Investors should ask the following questions, when evaluating credit alternative funds in the next phase of the economic cycle:

    1. How did your portfolio perform during the last recession? How do your returns vary in best versus worst case scenarios?
    2. How much of your loan portfolio is senior versus second-lien, unitranche or subordinated? Show me a credit agreement – is it covenant light or covenant tight?
    3. Do you use portfolio leverage? (i.e., debt funds that borrow money using the investors’ money as collateral and then lend that money out to borrowers)
    4. What protects investors from losses or reduced returns? What are your recovery rates? (i.e. ability to recover capital after a borrower defaults)
    5. What is your exposure to a single vertical – in particular, the energy or commodity markets?

     

  • Lateral Market Perspective – January 2016: What Do Changes in the High Yield Market Mean for Your Private Investments?

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    The last time that U.S. high yield spreads (the difference in the effective interest rate paid for riskier corporate bonds relative to US Treasury bonds) had widened out to the levels they are at today was August 2011.  The S&P 500 index was still at 1120, below pre-recession levels. The price of oil was $110. And Donald Trump’s role in the political arena was limited to espousing anti-Obama “birther” conspiracy theories.

    How times have changed.

    Default risk is back in the minds of high yield investors. Oil and other commodity prices are down by 80% or more – dragging the energy sector with them. But the U.S. stock index is still in lofty territory after a 7-year bull run, just 9% from all-time highs. Meanwhile, Mr. Trump who incidentally built an empire fueled by high yield bonds – and defaults — is a front-runner to be the next leader of the free world.

    New Trump

    So far, 2016 has left investors wondering where to hide.

    Increasing risk has been compounded by economic slowdowns in China, Brazil and Europe. That means the Fed is unlikely to raise U.S. base rates significantly this year – which will keep U.S. stocks on life support. On a relative basis, the U.S. economy is well positioned: historically low borrowing rates for corporates and a healthy consumer (low unemployment, the beginning of wage growth, and extra dollars from cheap oil). Within the U.S. economy, we believe that lower middle market companies (companies with less than $100MM in revenu
    es which is Lateral’s focus) are the best positioned given they have little or no reliance on exports. Smaller companies in asset-based industries excluding energy aren’t as exposed to the shifting credit/commodity cycles and other externalities. The risks are intrinsic and fundamental (management execution, collateral value, contract veracity), non-correlated and without the volatility costs of mark-to-market pricing.graph 3

    The changes in the high yield market over the past 3 months have wide-ranging implications, as the spread between investment grade and high yield widen.

    First, high yield is still expensive relative to embedded risks and liquidity constraints in the market. Funds and ETFs are vulnerable to correlation and liquidity constraints so there’s still more risk that needs to be priced in. Long-feared liquidity traps inthe bond market materialized in December due to a combination of the Fed’s zero interest rate policies and regulatory changes. The corporate bond market increasingly favors early sellers and “runs” on illiquid bonds that beget selling in unrelated but more liquid bonds. As a result, bond prices didn’t then and don’t now adequately reflect risk.

    Since August, high yield spreads have widened by 275 basis points and prices have dropped by 30% but default risk is going up significantly. Mutual and hedge funds are experiencing redemptions and outflows–most notably the gating of the Third Avenue Fund. The result is further illiquidity. High yield issuance this month is on pace to be down 90%, year over year,
    according to Citi analysts. Analysts have been steadily increasing its expectations for defaults, particularly in the energy sector, driven by the plummeting price of oil.graph 2

    Second, the sponsor-backed private debt model is getting less compelling to investors. More than $100 billion was raised for private debt funds and business development companies (BDCs) last year.  The 8-10% target returns from covenant-light loans to private equity-backed companies no longer makes sense in an environment with rising high yield spreads and declining public equity comparables. Steep competition in this market has resulted in highly leveraged transactions with limited covenant protection and generic pricing divorced from the underlying risks. For private debt funds, the illiquidity to investors is much less justifiable given the 5-10 year locked structures with no upside. Furthermore, these funds often employ 1-2 turns of leverage, adding to the risk which investors must consider.

    For BDCs, which are theoretically liquid instruments and publicly traded entities that participate in middle-market private and syndicated loans, the trouble has already started. Or as the Wells Fargo BDC analyst put it: “Winter is coming.” BDC stocks are trading on average at 69% of their portfolios net asset value and portfolio write-downs are just starting. Because of their discounted values, BDCs are unable to raise new capital in the public markets. Every new $1 invested by the BDC is effectively marked down to 69 cents. As a result, the effective yields on some of these discounted portfolios are in the high teens even though their underlying portfolio yields no more than 10%. The market believes that more write-downs are in order for BDC portfolios.

    Third, private equity deal-making is increasingly hamstrung as the cycle turns. Sellers of private companies believe their companies are worth what they were last summer when transactions were being closed at a premium to public market values. Now with the public market in correction territory, private equity investors must justify paying even steeper multiples to close deals. As noted above, private debt investors and high yield issuance are starting to pull back, leaving private equity firms to overpay and reduce debt/equity leverage ratios, a double whammy on target returns, in order to get transactions done. Anecdotally, this has resulted in numerous broken transactions as sellers decide to wait for a better market. PE investment committees are also pulling transactions which no longer make sense and must instead evaluate portfolio write-downs.

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    At Lateral, we are encouraged by the recent changes in the high yield and private equity markets which have improved our position in several live transactions and clarified our differentiation to investors in delivering low volatility, defensively structured portfolios with attractive returns independent of credit, commodity or economic cycles. By focusing on lower middle market U.S. companies we avoid global risk factors and address a structural dislocation in access to capital for a key segment of the healthy domestic U.S. market. By focusing on collateral and event-driven growth catalysts, we underwrite to the fundamental performance elements of our borrowers with an emphasis on capital preservation, consistent baseline returns and uncapped potential upside. By exclusively lending to non-sponsored companies, we maintain direct visibility into company performance, customize and enforce covenants and help highly incentivized owners to grow and build successful companies.

    We are still only at the beginning of a slow end to the Fed’s low rate regime. For investors looking for a compelling risk-reward in today’s volatile m
    arkets, yield opportunities remain scarce. High yield still doesn’t pay enough for the embedded risks. Correspondingly, illiquid sponsor-focused private debt funds need to keep up – and do better than incremental outperformance of comparable risk in the public markets.

    Graph