Even as the credit cycle gets long in tooth, the draw of private credit seems to endure. Mark Emrich, Managing Director, Business Development at Murray Devine Valuation Advisors, explains why private credit remains so appealing to investors in the middle market.
What do you think of the timing of new direct lending funds and private business development companies (BDCs) that are coming to market or contemplating doing so?
There's an argument to be made that if you're coming to market with a new direct lending fund or private BDC, it's actually a good time to commit to the strategy.
There are fears, though, that the market is getting long in tooth, now 10-plus years after the credit crisis. The persistence of this current cycle is in part because lenders have remained disciplined and the economy, even amid some macro and geopolitical uncertainty, continues to churn ahead. With so much capital gravitating to private debt and BDCs, the market also remains very liquid. Coupled with the propensity of covenant lite loans, today, even troubled credits can find funding necessary to stay afloat. But if at some point over the next several years, there is a down market, those entering the space now should benefit from better terms, higher quality credits as the competitive environment tapers off, and more appealing capital structures and terms. I think this is particularly the case in the middle market.
The key, however, is for the manager to come to market. If they can port assets into the fund or BDC to straighten the j-curve and mitigate the blind-pool risk - and if they have the track record, team, and infrastructure to navigate a dynamic market - then managers launching new funds today should find success and be able take advantage of this window of opportunity.
What are some of the risks associated with the ‘race to scale’ within the BDC sector?
There are two main risks, which are related: competitive risk and concentration risk. The former, stemming from the broadly syndicated loan (BSL) market, comes into play as deal sizes escalate, usually at the $100 million threshold. Borrowers can typically fetch better terms in the BSL market, characterized by cov-lite and cov-wide loans, as well as more leverage and cheaper pricing. The competition in this area, which has become more pronounced in recent years, is starting to crowd out the upper middle market lenders and club deal or loan syndication participants.
The risk for BDC and direct-lending managers is that as they move up market to chase larger deals, with many offering a one-stop solution for private equity sponsors, large amounts of capital is being channeled into fewer deals, which increases concentration risk within portfolios.
What are some of the major themes within the BDC sector from a regulatory perspective or otherwise?
An improving or more-accommodating regulatory environment for BDCs continues to be a much talked about theme. With the passage of the SBCAA in early 2018 - the SEC's proposed securities-offering reforms for BDCs earlier this year - and the recent proposed changes that, if implemented, would potentially accelerate the granting of co-investment relief for certain types of exemptive-relief applicants are all welcome developments. Continued speculation that the SEC could support changes to AFFE rules, however long that takes, will also be welcome news for the BDC industry and support its continued growth.
The number of institutional investors without any private credit exposure is surprising. There has been something of a bifurcation, with some asset owners making outsized allocations to private credit and others that have certain constraints or views. But for the latter group, the market today represents an opportune time for them to jump in. Given the exponential growth of middle market direct lending since the credit crisis, some large U.S. pensions and insurance companies are just beginning to understand the myriad of opportunities within the broader asset category.
Approximately $10.4 billion of middle-market collateralized loan obligations (CLOs) have priced in 2019. This is close to the pace in 2018, which was the fastest on record since the financial crisis, according to Bloomberg. Specific to the middle market, how do you see this affecting terms, quality of credit, and overall returns in the debt markets? What has this liquidity meant for valuations and the impact on private equity returns?
One of the main benefits that some are seeking to capitalize on reflects the 'race to scale' in the BDC market. Large private credit managers want to offer a 'one-stop' solution to their private equity clients. As deals become larger, managers may need or want to hold larger amounts of the loan, versus syndicating it out to other managers. Having access to the middle market CLO market vis-à-vis your own dedicated CLOs provides needed liquidity and attractive leverage to the manager. At the same time, it offers attractive returns to yield-hungry institutional investors.
From a valuation perspective, the development of the CLO market for smaller, mid-sized deals is negligible. I don’t believe middle market CLOs necessarily mean that a manager has to 'overpay' to get into a credit or that loans owned by a CLO are worth more or less based on structure alone. Most managers in my opinion have very sophisticated valuation processes in place to safeguard against any structural biases. Traditionally, most loans also get valued by a central finance team, creating a baseline valuation that is then used across the platform whether the credit resides in a BDC, CLO, commingled fund, SBIC or any other type of fund that holds the loan.
Is there anything else you think investors should be mindful of when investing in private credit in 2020?
While the credit cycle remains strong, there are specific areas that warrant attention. We continue to see weakness in the oil & gas sector as well as in certain consumer discretionary areas. I would keep an eye on whether that weakness is indicative of broader challenges in the middle market or it will be isolated to those specific sectors.
I would also note that private credit is a big tent, so even when the plain vanilla strategies encounter headwinds, other areas within the asset class may be able to capitalize on the shifts in the market. So, it's certainly worth the time for investors to familiarize themselves with the more "off the run," smaller niche strategies. Sponsored direct lending, of course, is the most mature, well known, and largest strategy within private credit. Large asset owners often overweight their allocations to this area of the market, which comprises the core of their portfolios.
Many of the more sophisticated institutional investors are opportunistically looking to add different strategies, such as distressed/special situations credit, aircraft leasing, trade finance, and litigation finance, among other areas. These niches carry unique risks, but they also offer true diversification to an overall private credit portfolio, which is part of the draw for institutional investors and what makes the space so compelling.
Under the spotlight: Mark Emrich
Mr. Emrich is a Managing Director and leads business development for Murray Devine in the New York metropolitan market. Mr. Emrich’s primary clients include leading private equity and private debt firms, hedge funds, and financial intermediaries. Prior to Murray Devine, Mr. Emrich was a Managing Director at Anagenesis Capital Partners, LLC a middle market healthcare and consumer focused private credit investment firm.