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Old Hill's September Commentary: Climbing Walls of Worry

One of the most fascinating aspects of finance is how often multiple people will look at the exact same data point or economic metric, and yet have completely different interpretations of it. It’s good, in a way, since that’s how markets are made because if everyone is on the same side of a trade, there is no one to trade with. Contrarians will often point to a preponderance of like-minded opinions as bearish signals and, conversely, broad differences of opinion a sign of a healthy market. In fact, this is the origin of the old adage that “bull markets climb walls of worry.” If no one is worried, you probably should be (and vice versa)…

The wall of worry concept came to mind during the summer, when we came across an article in Barron’s that discussed Oaktree Capital CIO Bruce Karsh’s thoughts about direct lending. Direct lending, in which non-bank institutions provide debt capital to private companies, has been in the midst of its own wall of worry ever since the Fed began to normalize monetary policy in 2014. Unsurprisingly, handwringing about higher interest rates decimating the private debt space neatly coincided with a truly massive surge in money deployed into the sector – global aggregate capital raised for private debt funds rose from $44 billion in 2011 to more than $107 billion in 2017, according to industry data provider, Preqin. Wall of worry, indeed.

The article highlighted many of the common concerns about direct lending, adding that the explosive rise in interest among hedge funds and PE firms could be construed as fairly uneducated capital chasing the latest shiny ball (made a little shinier by the diversification, low correlation, floating rates and illiquidity premiums inherent in private debt deals). It also helped that, since the financial crisis, there has been a worldwide dearth of instruments able to consistently generate similar risk-adjusted yields. Private equity-sponsored loans in particular are singled out in the Barron’s piece, partially because, as Mr. Karsh rightly notes, too much private equity capital has been sitting on the sidelines looking for a home. He predicts a lot of direct lending “issues” arising over the next few years. 

Historically, high levels of institutional dry powder in the alternative investment space has led to overpriced assets and poor decision-making. In the current case, the tendency has manifested itself through characteristics like low or no-covenant loans, high loan-to-value ratios, inflated purchase prices for private equity deals, and a ready-fire-aim mentality in due diligence. 

While direct lending certainly wouldn’t be the first asset class to go from shiny to shunned inside of one investment cycle, we think is worthwhile to point out that in direct lending, one size does NOT fit all. 

Sponsored loans are just one of the various submarkets within the direct lending universe. In fact, the biggest delineation in the space is between firms that lend against future cash flows and those that lend against assets, like Old Hill Partners. The former is typically collateralized by the ongoing EBITDA of their borrowers, and can have their models heavily impacted if the economy slows. The latter typically secures transactions by way of the assets of the borrower backing the loan. When properly researched and evaluated, these assets can hold their value more consistently through economic cycles than the cash flow-lending approach. Moreover, recovery rates in asset-based lending generally tend to exceed those in cash-flow lending during periods of economic decline.

There are other differences within the direct lending universe. For instance, Old Hill Partners works almost exclusively with small- and medium-sized businesses, where we can become intimately acquainted with both the business model and the management of the firms with which we work. This helps lower risk and ensures early insights into any potential problems on the horizon. Many of the later entrants to the direct lending sector are working with large numbers of more complex organizations and transactions, and lack both this clarity and comfort level. 

What’s more, deal size still constrains certain lenders, regardless of their level of experience in the space. For lenders managing billions, it is simply uneconomical to spend the time and effort necessary to properly structure a $5-$20 million transaction, when the same amount of time and effort can structure a $50 million one. This means less competition for smaller deal sizes. As a lender who specializes in small-balance transactions, Old Hill has the skill to underwrite (and the infrastructure to manage) these smaller deals, and rarely runs into competition for good deals. In fact, we begin to see competition once a borrower is looking for $20 million or more, and are often able to compete successfully based on structure and flexibility.

Another important differentiator is tenure. Late to the party, flush with cash, faced with an environment where too much capital is chasing too few deals, and cyclically inexperienced, many alternative investment funds lack the know-how to navigate a tough environment. On the contrary, many are choosing quantity over quality, and cannot fathom a world with 5%+ 10-year Treasury bond yields. Lenders with some perspective – i.e. those that have seen an entire credit cycle, for instance – can choose the right deals, at the right time and with the right collateral. It will be the experienced lenders, like Old Hill Partners, that are most likely to come out the other side of a downturn in relatively fine fashion.

And while we’re speaking about cycles, it’s important to note that despite the near-constant litany of issues facing the U.S., our economy is doing very well. Buoyed by hugely stimulative tax reform, meager inflation, high employment and historically low interest rates, the environment in which small- and medium sized companies is operating is a strong one. “Issues” may be looming in the broader direct lending universe over the next few years, but at least from where Old Hill is positioned within the private credit landscape, they don’t seem imminent. 

The bottom line: We agree that segments of the direct lending universe have become overextended and are vulnerable in a downturn. In particular, investment firms more focused on cash-flow lending are chasing yields up and down the direct lending landscape, and that may not end well. Thankfully, we – and therefore our investors – don’t play in that pond. We believe the overall conditions still speak in favor of the carefully curated, highly customized asset-based transactions in which Old Hill specializes.