There’s an oft-repeated saying in the lending business – at least among those who have experienced multiple credit cycles – which is that it doesn’t matter how loud the music is playing, you need to think about what happens when the music stops.
Three years ago, most investors assumed we were entering the later innings of the credit cycle. However, a tax cut, an ensuing surge in GDP and robust corporate earnings growth all coalesced to make the past 18 months among the most rewarding periods for investors in recent memory.
As the markets progress past the midyear point, however, many of the same questions that gave investors pause in 2016 and 2017 have again begun to bubble up. The mounting trade war with China has only made global trade more contentious and uncertain (as have the recurring trade skirmishes with Canada, Mexico, the UK, Europe, India, etc.); M&A and private equity valuations continue to hover well above historic norms; and geopolitical risk remains front and center, even if the focus has shifted from the government shutdown in January to escalating tensions between the U.S. and Iran. All of this, of course, is occurring against a backdrop of an inverted yield curve, which reflects the anxiety in the credit markets over the near-term outlook.
Still, company performance is the overriding factor that impacts lender portfolios. As long as cash flows continue to show momentum and the default rate remains below historic norms, a strong case for optimism should keep the credit markets liquid for at least the balance of the year. That being said, given the mounting uncertainty, investors in the credit markets are paying more attention to underwriting, the required skillsets to manage risk, and even the types of debt and coverage required to protect investors if the environment changes.
Underwriting
When marketwatchers inquire about the types of deals that are in demand today, the answer is that all deals are getting financed in this market. Healthier deals – involving good companies that generate consistent cash flow – will get financed in all market cycles. In particular, lenders are gravitating to business services companies, enterprise software or SaaS companies with recurring revenue models, operators in medical and healthcare services, and other areas less exposed to the business cycle. But even deals in cyclical industries, ranging from restaurants and auto parts to advertising and hospitality, are finding no shortage of lender interest.
This is a function of the ravenous appetite among PE and private credit investors. While the crowded market creates challenges for newer players to put capital to work, borrowers have used the competitive environment to push back on fees, creditor protections and even the time to close. In this market, increasingly characterized by aggressiveness on covenants, loan documentation and EBITDA adjustments, lenders have to be more attentive to the risks in their underwriting. Each of these factors will affect recovery rates of defaulted credits, as many lenders learned during the last downturn in 2008 and 2009.
The weakening of covenants, for instance, have already resulted in disagreements around protections. Notably, when J. Crew transferred certain intellectual property to a new subsidiary and then borrowed against the facility, its existing lenders cried foul at having lost a key protection that informed their underwriting. A similar court fight followed PetSmart’s decision to transfer its stake in Chewy.com out of reach of its existing creditors. EBITDA adjustments and add-backs have also become more common and more aggressive, particularly as sellers rush to market in order to unload assets while valuations remain high. It just underscores why the more diligent lenders today are sharpening their pencils and scrutinizing these areas to protect themselves when the cycle turns.
Specialization / Differentiated Skillset
In the middle of a credit cycle, there isn’t necessarily the same kind of incentive for lenders to build out a specialized skillset. Dealflow is readily available – particularly for sponsor-backed transactions – while risk is generally muted as long as the economy and company performance are tracking in the right direction. This explains why there was such a rush over the past few years of new players in the private debt space, because there was a collective perception among new entrants that the barriers to entry were not as high. At the front- and tail-ends of a cycle, however, experience and capabilities really matter.
Amid the extended run, for instance, we have been using this opportunity at Monroe to increase the depth of products we offer, while expanding and augmenting the industry verticals we focus on. We continue to develop and hire more industry experts and bring in “all-star” players so we can continue to differentiate ourselves as a true value-added partner to our borrowers. We want to be the first and last call in a crowded field and in order to do that, we need to be experts in the industries and the markets we serve. This expertise also allows us to gain comfort with credits that may deter our competitors. This is particularly the case coming out of a downturn when the rest of the market is tentative and licking its wounds. It also provides us with insights around unseen risks, which is critical when the market gets heated and protections begin to weaken, as we’re seeing today.
Our deal origination team, located across six offices throughout the U.S., coupled with our broad industry coverage, also provides a distinct advantage by increasing our universe of possible deals. Beyond eliminating the pressure to take on riskier credits, this depth allows us to offer speed and certainty to financial sponsors – a key differentiator in such a competitive market. We also have dedicated capabilities for independent sponsors and non-sponsored acquirers, which accounts for roughly 30 percent of our M&A-driven deals.
Opportunistic Credit
A corollary of the private debt market’s growth, outside the aggressiveness on the part of borrowers, is that more vanilla financing arrangements have become commoditized. A specialized skillset and diligence in underwriting still matter – at least when it comes to fund performance and returns – but for many borrowers, the amount of leverage available, the cost of the debt and the flexibility of terms will trump these capabilities when all else is equal.
To put these resources and our expertise to work, however, we’ve increased our exposure to opportunistic credit over the past few years, which accounted for roughly 20 percent of Monroe’s transactions in 2019. To be clear, this is not a distressed or loan-to-own strategy. It’s about sourcing complex transactions that are too much effort for traditional lenders. And by focusing on asset collateral, which offers protection throughout all market cycles, we can build an “all weather” portfolio that has the potential to amplify returns during downturns. It’s not a departure from direct lending, but it allows us to gain exposure to the corners of the market that still offer a premium for risk and complexity.
We are still quite bullish on the balance of the year, but as other downturns have demonstrated, the credit cycle can be quite fickle when doubts creep into the market. As a result, we are tightening our lending standards and will continue to actively monitor our portfolio companies. We continue to be cautious about EBITDA add-back adjustments that may appear aggressive, and we’re cautious around valuations. We have also increased the surveillance activity in terms of information we’re requesting from borrowers.
Our experience over the last 15 years in this business tells us that when you are at the top of a business cycle – where I believe we currently reside – you simply need to be more attentive to the risks. In fact, this is what often separates the longer-term, relationship-oriented lenders from the visitors in the market who tend to come and go. But in the meantime, it’s our experience that also allows us to stay active in a heated market while accommodating for the risks that do exist.