We typically use our monthly commentaries to discuss specific elements of our approach or how macroeconomic trends can impact our business. Recently, however, two of our associates, Chelsea Graves and Peter Faigl, participated in the private debt panel at the SuperReturn conference in Chicago, and they returned with some key observations: private debt might be the strategy-du-jour among alternative managers and investors, but very few people understand the difference between what we do and what a typical corporate cash flow lender does.
At the conference there was a significant emphasis on cash flow lending, as opposed to the asset-backed lending, which is Old Hill’s investment focus. Additionally, many discussions were heavily dominated by huge deals sponsored by private equity firms. The type of private credit transactions we focus on was almost absent from the gathering, which brought 180 private credit professionals together with 40+ local and international LPs to discuss trends in the global private debt space.
Interestingly, it was also clear from the conference that little attention is being paid to the smaller end of the SME segment, despite the need for non-bank capital solutions in this segment. Small balance lending transactions are in OHP’s sweet spot, we operate almost exclusively in the $2-$25 million-per-deal realm, and this is by design. We have found that small balance lending transactions, where properly constructed and thoroughly vetted, have paid major dividends for us over the years.
Accordingly, we’re going to use this month’s commentary to highlight the differences between cash flow lending and asset based lending and to explain why we believe our approach can provide a better outcome for investors.
A typical corporate lender provides loans to companies across many different industries with repayment of such loans dependent on the continuing ability of the company to generate revenue and profits. If revenues/profits decline, the company may not be able to satisfy its obligations and the loan may have to be extended, restructured or worse. While there may be some corporate assets that can be sold to help satisfy the loan, those are frequently encumbered by other lenders (i.e., real estate or equipment), difficult to dispose of (i.e., intellectual property) or generally illiquid. Old Hill on the other hand, focuses its lending efforts on either – a specialty finance company (i.e., originators or aggregators of financial assets like consumer loans or equipment lessors) - or a borrower looking to finance hard assets/inventory for which there is a reasonable secondary market (for example aircraft engines/parts). What makes us different from the corporate cash flow lenders besides having a specific industry focus, is that we lend not against the ability of the company to generate cash flows and stay in business, but against the value of the assets of the company and the assets’ ability to generate those cash flows. For example, a consumer finance company has a portfolio of consumer loans (the “assets”) and payments on the consumer loans is what constitutes the company’s revenue. We are mostly concerned about the value of the loans and the ability of the underlying obligors (the people who took out those loans) to continue to make payments on those loans; not on the ability of the company to originate new loans and stay in business.
Another important distinction is how we exercise control over the assets. A corporate lender makes the loan directly to the company and is subject to a bankruptcy risk and dealing with various other creditors even if the underlying assets continue to have value. We, on the other hand, require the originator to sell the assets into a subsidiary that has its activities restricted to a single activity – owning the assets – which makes it less susceptible to a bankruptcy filing. We then make our loan directly to this subsidiary, file UCC financing statements, take pledge/possession of the subsidiary’s shares/membership interests (which allows us to effectively control that subsidiary and the assets in it in case we have to), and, in some cases, require an independent 3rd party to have a possession of the physical collateral (like titles to vehicles if we are funding auto loans or artwork in case the collateral is artwork). Furthermore, the subsidiary is required to have an independent 3rd party manager whose consent is required for any bankruptcy filing. All these provisions effectively give us a direct control over the assets. In a typical corporate loan, the company retains control over both the assets and the cash.
In addition to the main aspects of our lending approach described above, we make sure our loans are structured with a proper alignment of interest, protection against bad acts and finally having a clear resolution strategy should a problem occur. Proper alignment of interest is usually achieved by advancing less than the value of the assets being pledged and thus tying a portion of the company’s capital on a subordinated basis to us in the subsidiary. Bad acts guaranties are obtained from the firm’s main principals and protect us against various nefarious acts like theft and fraud, but also against softer issues like willful breaches of representations and warranties. If such an event occurs, the principals become personally liable for all the obligations of the subsidiary. Having a clear resolution strategy is also of utmost importance and Old Hill has extensive experience working out troubled credits. That said, it should be kept in mind that even if there is a problem with our loan, the nature of the underlying assets (to the extent they are loans or leases) allows us to just collect out the portfolio and effectively self-liquidate the loan or for hard assets to seize and sell the collateral.
Ultimately, we’re fortunate that so many larger lenders are focused on areas outside of our narrow but lucrative slice of the private debt market, and we are more than content to continue doing what we do best – structuring mutually attractive financing solution for small- and medium-sized businesses using process discipline and an unwavering determination to mitigate as much risk as possible. This approach has been the key to nearly two decades of successful direct lending experience.
Each month, we like to include an example of a transaction we are pursuing or have rejected to illustrate not only our approach, but also our depth of process and risk management. This month, we’re highlighting a potential senior secured credit facility to a company in the healthcare sector that needs support to grow its cross-border medical claim portfolio and expand across the Americas. This transaction was sourced through an industry contact of one of the senior members of the Old Hill team, who was keenly aware of our ability to provide flexible revolving facilities secured by financial assets.
The company focuses on cross-border medical claims, a niche area within the healthcare finance space. The process includes claim services, funding, and collection. If an American outside of the U.S. needs a medical procedure, they visit a local hospital and provide proof of insurance. The hospital will then call the company, which processes the information through a 24/7 call center and forwards it to the appropriate insurance company. Once the claim has been approved, the company remits payment to the hospital, charging a servicing fee, and receives reimbursement from the insurance company via a lock box account. In the proposed transaction, Old Hill would have a senior claim on the receivables of the company.
If pursued, this transaction would be an attractive risk/return proposition for Old Hill, leveraging off our experience in transactions secured by a portfolio of financial assets with minimal credit risk. The proposed structure would carry an interest rate of approximately 12.5% over the term of the loan.
Original article can be seen HERE.