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.
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.
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.’
- 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
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.
- 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.
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.
- 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.