Defining the taxonomy of private credit: the strategies and risks

Private credit is a rapidly maturing asset class, but the different strategies involved are still not all that well understood or defined. What does private credit mean? What are the risks involved for different strategies? Where are the best opportunities for investors? Randy Schwimmer shares his thoughts in our exclusive interview.

Private credit is an asset class that’s grown quickly with different strategies emerging. Are the differences among these strategies well understood?

There is absolutely a need for clearer definitions and a better understanding of private credit. One of the biggest misconceptions is that rather than being a single asset class, private credit is a spectrum of different strategies with, in some cases, wildly different risk and return expectations.

Practitioners across private credit encompass a variety of investment practices and work within a range of risk parameters. At one end there are the asset-based lenders. Their loans are fully secured by “hard” assets such as receivables, inventory and PP&E. With conservative advance rates, these loans yield around Libor +2 per cent. At the other end of the spectrum are higher-yield strategies such as mezzanine and opportunistic funds that can yield mid-teens returns, but risk is proportionately higher.

Where are funds being raised for private credit being deployed?

Most of the private credit capital is dedicated to higher yield / higher risk strategies. An investor seeking mid-teens returns should understand the risk involved is significantly greater than lower-yield strategies. All senior secured private credit is not created equal!

Where does Churchill fit into that spectrum?

Churchill has a senior secured cash flow oriented loan strategy. We lend to middle-market companies with ebitda generally of $10-50 million of EBITDA, with exceptions at both ends. These borrowers are all owned by top quality private equity sponsors.

Private equity support gives senior lenders the comfort of a capital cushion below them. It also provides strategic and operational expertise to assist management to both grow and address problems during challenging times. Sponsors can also inject additional capital for growth, acquisitions, and turnarounds. These factors help align the interests of owners and credit providers.

How do you distinguish your risk strategy from others along that spectrum?

We have a checklist of 35 criteria we use to assess credit risk. We scrutinise a potential borrower’s customer concentrations, regulatory risk, barriers to entry, performance during the last downturn, to name just a few items. If the company doesn't meet these basic hurdles we would have to look very carefully before moving ahead. It’s not to say businesses never face challenges down the road, but if you’re starting with a challenge, that makes execution more difficult.

Of course, there are private credit providers who will lend to companies with less than $5 million EBITDA, or with two year operating histories, or that have filed for bankruptcy twice, or have 75% Walmart concentration. But that’s a very different risk profile than what we do.

A recent survey highlighted that investor/regulatory reporting and the limitations of loan-tracking systems were the two most common challenges facing private credit investment managers. What’s your view of that?

With private credit maturing as an asset class, managers are forced to become more sophisticated on all aspects of finance and operations. Particularly as firms such as ours raise more diversified funding sources, it’s critical to institutionalise risk and reporting systems. This requires a dedicated commitment from senior management. Having been owned by top-tier private equity and asset management firms has been extremely helpful in giving us the experience to develop the kind of sophisticated back-office that institutional investors now demand.

A strong operations team is not just a nice-to-have. Our core principle is that timely and accurate reporting is fundamental to sound risk management and a top priority.

Has the asset class grown too quickly for adequate risk standards to be maintained? How do you, as a top private credit manager, address this?

We just published a piece in our weekly newsletter, The Lead Left, reviewing the loan market run-up since the recession. No question terms have deteriorated of late. But much of this has come to the higher end of the middle market by way of the broadly syndicated market.

The most cited example is the increase in covenant-lite structures. Pre-crisis, cov-lite was generally restricted to issuers in the $100 million EBITDA range. That’s changed over the past 4-5 years. Intense competition for deal flow has pushed some direct lenders to extend cov-lite to companies at (and below) $50 million in EBITDA.

That’s challenging enough. But combine it with the blurring of how EBITDA is defined. Pro forma add-backs and adjustments are being used by sponsors to show higher EBITDA to lower reported purchase price multiples and leverage.

Closing debt amounts – the leverage numerator – is also misleading. It fails to include incremental debt capacity available to the borrower, which can be substantial. Combined with overstated EBITDA definitions, and you end up with leverage that’s significantly higher than what’s reported.

Our response to loosening market discipline is to tighten our own. We turn down the vast majority of deals that come our way. On average, we complete roughly 10-15% of deals we review.

The next downturn should prompt a return to credit sanity. But that timing could still be years away. In the meantime, experienced managers like Churchill will do what we can to protect themselves against things they can’t control. And use their skills and experience to protect themselves (and their investors) against the things they can.

So how would you describe the current environment for sourcing deals? How has that changed in the last 2-3 years and what has affected that? Have you altered your approach in response?

The recent headlines highlighting deal origination often question whether it’s too late to get into private credit. The reality is very different. For a variety of reasons, the deal-sourcing environment, for firms equipped to handle it, is as good as it's ever been.

For one thing, private equity sponsors have raised over $500 billion in dry powder to invest in new properties. We’ve simultaneously been actively ramping our own relationships with the top-tier sponsors we've been doing business with for almost 15 years. Those include many LP relationships with our parent company Nuveen/TIAA we’ve nurtured over the past four years.

We’ve also grown our capacity to provide larger one-stop financings by raising multiple funding vehicles. The ability to comfortably hold $150 million and more per deal as well as providing a seamless credit structure, has been instrumental to generating increased deal-flow. Over the last few years sponsors have looked to shrink the number of lending relationships they have to only their top providers. That allows them to avoid the challenges of the loan syndication market, which has benefitted us.

Which strategies/approaches do you see as presenting the best investment opportunities in private credit at the moment?

We truly believe that the private credit opportunities we are investing in provide the best risk/reward balance. It’s not an “at the moment” strategy. It’s an all-weather approach that works regardless of cycles. If you’re looking to time the private credit market, that’s a challenging strategy. It’s about maintaining risk discipline and remaining focused on our senior position in the capital structure for only the best credits.

Who knows when the next downturn will come? Our experience is that private equity sponsors that are most aligned with our own credit philosophy tend to be the most successful in protecting both equity and debt value. That alignment of interests proves itself over the long-term, particularly during downturns.

---

Under the spotlight