Allocations to private credit strategies have exploded in recent years, and with them, the choices available to investors and lenders alike have mushroomed. A myriad of avenues now exist to provide exposure to high-yield, non-traded, illiquid instruments, including lending transactions based on cash flow or assets, small balances or large, lower middle-market versus upper, and borrowers either sponsored or unsponsored by private equity funds.
As capital has flowed into the segment ($42 billion in the first half of 2017 alone, according to Preqin), funds and alternative investment pools that focus on large-balance, cash flow-based deals with sponsored companies have been the most popular. This is primarily due to the transaction sizes such funds are able to handle and the incredible influx of cash into them that has to be put to work, not because they necessarily offer a better yield or more attractive risk characteristics.
Old Hill Partners, on the other hand, focuses on an entirely different niche within the private debt universe. Our corner of the world is focused on small-balance, asset-backed transactions with primarily unsponsored companies – a niche in which we have found the best of several worlds.
At first glance, having a private equity sponsor involved with a borrower seems like a good idea. Theoretically, the lender has institutional support behind a transaction that will come in with more equity should problems arise. But as was experienced during the financial crisis, this theory works well right up until the day it doesn’t – private equity firms are subject to the same laws of the finance jungle as everyone else, and their support for a particular borrower can evaporate quickly in an environment when everything goes south at the same time.
Ditto with the idea that a PE firm will come in with more equity when the need arises. The theory rests on a couple of assumptions, with the first being that the PE firm has capital to contribute in the first place and the second being they will take steps to defend their equity position. Currently, with PE fundraising at a record and the industry awash in cash, the opposite scenario may seem hard to believe, but note that it wasn’t too long ago when the unpleasant prospect of throwing good money after bad was foremost in the minds of many PE firms staring at books full of underwater portfolio positions.
Finally, a PE sponsor can often dictate, or at least have significant influence on, the characteristics of a debt transaction. Not only can they drive less favorable economic terms for the lender, but also PE sponsors are increasingly insisting on covenant-light transactions that limit, reduce or remove the structural elements that serve to protect lenders. For instance, various business performance metrics, financial ratios and restrictions on asset dispositions can act as crucial early warning indicators for private credit providers. Unsurprisingly, therefore, private equity-sponsored companies typically carry greater leverage on their balance sheets than non-sponsored ones.
Unfortunately, the low interest rate environment of the past several years has created a seller’s market for private credit transactions, which in turn has resulted in a surge in such covenant-lite lending. Indeed, in 2010, with lenders still cautious following the financial crisis, almost 100% of new loans contained traditional covenants. But by 2016, nearly 75% of new U.S. loan issues and 60% of new European issues were covenant-lite. The result? Lenders get diminished clarity over the financial condition of their borrowers, little influence over financial decisions, and less advance warning that problems are on the horizon.
Conversely, in the kinds of small-balance, asset-backed transactions we make with non-sponsored companies, Old Hill Partners is able to negotiate favorable terms that secure both our returns and our principal. They allow us to have significant insight in, and control over, the outcomes represented by the transactions within our portfolio. For us, this creates several advantages – we’re able to earn greater returns on our invested capital, we can ensure the collateral matches or exceeds our exposure, and we can mitigate future defaults through generous visibility into the health of our borrowers.
An added benefit of Old Hill’s approach is the institutionalization of those borrowers. In many cases, Old Hill’s capital (and the due diligence process that precedes it) is the first institutional money our companies have seen. Subsequently to our involvement, they are much more bankable and attractive to private equity companies because they bring a higher degree of professionalism and financial discipline to the table.
It is not our contention that a non-sponsored approach in better in all cases. In fact, for large, cash flow-backed deals, having a private equity sponsor might be better. However, in our world of lower middle-market, small-balance, asset-backed transactions, non-sponsored borrowers are far more apt to generate higher risk-adjusted returns – and at a lower aggregate default rate - for lenders like Old Hill Partners.
Old Hill Partners Inc. (“Old Hill”) is an SEC-registered investment adviser with significant experience in all facets of asset-backed lending and alternative investment management. Our primary investment strategy is asset-backed lending. We offer customized lending products and services to small and middle-market clients and work closely with our borrowers and partners to provide creative funding structures to support their growth initiatives. For more information, please visit www.oldhill.com.