The ongoing chase for attractive yield opportunities, paired with a growing investor appetite for exposure to U.S. middle-to-lower-middle market direct lending, has led to a dramatic increase in the number of lenders and funds serving this market. This expansion has subsequently sparked investor concerns that the space may become over-crowded, thus causing deal flow to dwindle. This month’s commentary features a recent interview published in the summer issue of Family Office Magazine, in which Old Hill’s Peter Faigl provides a Portfolio Manager’s perspective on the increased competition for promising deals, while also addressing the common questions and concerns he gets from investors in the space.
Recent industry press suggests competition for attractive middle-market deals is getting intense. Do you agree?
First and foremost, it’s important to map out the direct lending universe. There is a lot of talk about how crowded the space has become – first in the $30 million or more range served by the larger regional and national banks and bigger lending funds, and secondly in the $10 million -$30 million range serviced primarily by local and regional banks. However, what tends to go unaddressed are the various submarkets within direct lending, some of which remain less competitive due to the need for specialized knowledge or, in some cases, monitoring capabilities. For example, financing leveraged buyouts and recapitalizations is a very competitive segment, since these are your standard cash flow-based loans where principal is typically a multiple of EBITDA. Many industry players possess the requisite knowledge for this type of transaction. Conversely, lending to specialty finance companies requires specialized knowledge of the assets being originated (for example, consumer leases), since those are the assets from which the loan will be repaid. The universe of investors with this kind of expertise is much narrower, and this generally means less competition.
Note, too, that while the rush of new entrants into the direct lending space in recent years may have led to fears of overcrowding, it hasn’t guaranteed quality. Indeed, some of these new entrants possess very limited expertise in what can be a complex asset class. Like any hot sector, they’re just in direct lending because of the outsized returns available. But they don’t fully understand their risks, and/or they don’t have any workout experience. We’ve seen this firsthand; On three separate occasions recently, we ran into a competitor that has raised hundreds of millions in capital for direct lending; in each case, the company they financed wound up either in bankruptcy or liquidation.
Another factor when looking at deal flow in the direct lending space is that many lenders will not underwrite unprofitable companies or those with limited operating histories. But proper utilization of structural features can protect the lender in case the operating company gets into distress, making this segment of the market also less competitive. For example, part of our business is lending to specialty finance companies, many of which are not profitable due to high fixed costs at inception and economies of scale that are still to come. One approach is to separate the assets backing our loan from the company through a sale to a special purpose LLC, and then utilize a third-party servicer to collect on the leases, loans or whatever receivables we are financing. In this scenario, should the specialty finance company go out of business, we retain control over both the assets underpinning our capital and the manner they’re being collected. The originator’s default is thus relatively inconsequential.
A third factor is deal size. Even if a lender operates in a specialized space, size still constrains certain large lenders. It’s economics – the same amount of time and effort is required to properly put together a $5 million financing as a $50 million one; when you’re managing billions, you’re simply not going to spend a lot of time on smaller deals. This means less competition for smaller deal sizes…in fact, we typically run into competition once a client is looking for $20 million or more.
On the flip side, we rarely have to compete when someone is looking for $5-$10 million, and there are fundamentally more smaller companies out there than larger ones. This gives us a unique opportunity to review a larger number of borrowers and try to pick the ones that we think will grow successfully. Essentially, this allows us to get in early – we’re happy to see competition appear once the client has grown and where we have rights of first refusal for any new financing, prepayment penalties that discourage clients from looking elsewhere, etc.
OHP is known for its high selectivity, but does this approach unduly limit your number of potential deals? Does it ever become an obstacle?
We’re fortunate in that we review a large number of smaller transactions, and we can be picky. If we were solely focused on larger deals, our selectivity could easily become a problem. From our standpoint, we are disciplined and steadfastly refuse to chase markets we find unattractive. We have not extended credits to certain submarkets for a number of years because of competition or because we’re waiting for the market to turn. In the meantime, we continuously look for ways to explore new asset classes and or to acquire further specialized knowledge.
Has your deal screening process changed as interest rates rise?
No, we haven’t changed a thing. We are opportunistic investors and even difficult assets can be financed profitably with the right structures and at the right advance/loan-to-value rates. When we start looking at a new asset class, we start small and at low advance rates. Our coupon rates are, in most cases, indexed to either LIBOR or the prime rate, and thus will ratchet upwards along with benchmark rates.
What do you tell investors who believe lack of good deal flow is a key issue in the private debt space?
We reiterate that while it may be an issue for some, it really isn’t one for us. We have been in this business for more than twenty years, and as a result, our network of contacts for potential transactions is very extensive. In fact, nearly half of our originations come via referrals from past or existing clients, and roughly one-third come via various intermediaries – brokers, advisors, attorneys, accountants, etc. – with whom we have done business in the past. Taken together, these categories represent the majority of our deal flow.
What are some of the common questions/concerns you’re getting from investors these days?
Given the normalization in monetary policy underway, a fairly common question is on our default rate and losses to date. More specifically, investors want to know what we expect to experience once a recession hits. Historically, we have seen about a 10% default rate in terms of number of deals, but we have generally been able to work out those credits without any capital losses. During a recession, I think it is reasonable to expect defaults to rise, but that’s the advantage of bespoke structured finance transactions; given the nature and very careful structuring of our loans, we’re confident the impact on our portfolio will be less than the market and industry averages.