Macro Environment Impact on Middle Market Lending with Kevin Marchetti of Man Varagon

Stewart: Welcome to another edition of the InsuranceAUM.com podcast. My name's Stewart Foley and I'll be your host. Welcome, welcome, welcome back. Today's topic is a very good one. How is the macro environment impacting middle market lending? And we are joined today by Kevin Marchetti, Partner and Chief Risk Officer of Varagon. Kevin, welcome, man. Thanks for being on.

Kevin: Yeah, pleasure to be back with you. Thank you so much.

Stewart: Because credit markets are moving so quickly we try to timestamp these things. So this is around noon Central on Thursday, April 6th, that I'm looking over your shoulder and the Masters is on and it's a good time of the year. It always seems like this is when spring is coming out. This is good stuff. Let's start with the icebreakers like we always do. Where'd you grow up? What was your first job, not the fancy one, and a fun fact?

Kevin: I grew up in Upstate New York, true Upstate New York, in the Syracuse, New York area, so closer to Canada than New York City. My first job, it's timely. I was a caddy at the local club that was in town. I was a big golf fan, but that was my first real job in high school. A fun fact, I played Division III college football, and my claim to fame is that my teammate was John Cena who is-

Stewart: Oh, there you go.

Kevin: ... an entertainer, movie star, and WWF Champion.

Stewart: Nice job. And a car guy. He's a big car guy.

Kevin: And a car guy.

Stewart: Yeah, he's a car guy.

Kevin: And a car guy.

Stewart: Yeah. I was watching, he was having a custom car builder build him like an MG GT. The primary modification was to allow him to fit in it, which is no small feat.

Kevin: Right.

Stewart: Just as an overview for folks who may not be familiar with Varagon, can you talk a little bit about who you are, where you focus, and just some overview facts? It would be helpful, I think.

Kevin: Yeah, sure. Absolutely. So Varagon Capital Partners, we were formed in June of 2014. We manage about $15 billion in assets today. We specialize in investing in senior secured first lien and unitranche loans to performing middle market businesses that are backed by private equity firms, prominently in the US. Our core strategy has always been focused on recession-resilient end markets, such as critical B2B, healthcare, consumer staples in the packaging and food and beverage space, as well as established software companies and aftermarket auto.

We've deployed in excess of $24 billion to over 300+ borrowers in the middle markets since inception, with an average annual default rate of about 5 basis points over that period of time, and an unlevered net IRR of about 7.1% over that same period. We've completed transactions with over 140 private equity firms in the US, and we are a lead lender on 90%+ of the transactions that we do. We've got about 85 to 90 employees across the US, predominantly in New York, with offices in Fort Worth and Chicago as well.

Stewart: That's terrific, thank you. You were on with us about 8 months ago. A few things may have changed since then. Can you talk a little bit about the macro environment, higher rates, inflation, et cetera, since we last spoke?

Kevin: Look, the notable changes to the US macro environment in the last 8 months or so have absolutely, as you said, been driven by Fed policy and the overall uncertain economic environment. The Fed's been trying to fight inflation with these rate hikes over the last year plus, which have driven the 10-year Treasury, I think, north of 150 basis points since the last time we caught up before the recent decline because of the banking-wide system events, which I'll touch on in a bit.

I think specific to the market segment where Varagon operates, again, which is senior secured, sponsor-backed middle market companies, loans are typically floating rate. 100% of our portfolio is floating rate. So as such, this move in rates has had an impact on our portfolio and the new investment opportunities that we pursue, with the reference rate for our underlying loans now eclipsing 500 basis points, I think, 3 months SOFR today's right around 500 BPS, three month LIBOR, still there, is over 500 basis points. We've seen borrowing costs and correspondingly, investor questions, around the stress in the middle market increase pretty dramatically over that period of time. So given this dynamic, we've spent a tremendous amount of time stress-testing our portfolio and continuing our deep credit focus as we evaluate our existing accounts and new investments that we're pursuing.

I think Stewart, I think what we've seen with those macro challenges, it's a reinforcement really of the Varagon strategy that we talked about 8 months ago. Resiliency in recession-resistant end markets has been the key for us. And these dynamics have reinforced for us that our investment in portfolio construction strategy is performing exactly as we would've hoped, mainly given the fact we focus on those segments and that we're the lead lender on 90%+ of our transactions. It allows us to control both the credit terms, the structural terms, and the documentation terms, and that's very important in the environment we're operating in today.

For example, we require at least one financial maintenance covenant in all of our transactions, and we benefit from attractive economics at the time of origination because we're a direct originator. And these core tenets have allowed our portfolio to perform what we believe exceptionally well, given the recent turbulence over the last 12 to 18 months. When I talk about stress testing, and this is very relevant right now for many of our investors but specifically our insurance investors, when we mentioned our stress testing, one of the questions we've gotten from our large insurance clients is, “How's the portfolio been performing from an interest coverage perspective, given the rising rates and the impact of inflationary challenges on the underlying performance of the borrowers?”

And I think what we've done, and we can include this analysis alongside this podcast, is stress-tested the portfolio at a borrower level. So we have over 180 borrowers in our portfolio. We've done a bottoms-up analysis, then we've also stressed and manipulated the reference rate on an earnings basis for all of those borrowers, and the results are pretty impressive. Utilizing benchmark rates again for our transactions, today's SOFR, so 5%, using a benchmark rate of 5% and looking at debt service going forward, so this is a look forward test, we're not doing an LTM test based on earnings, our weighted average interest coverage across the Varagon portfolio is 2x. Pretty healthy. When you simulate SOFR rates going from 5% up to 6%, our interest coverage is still north of 1.8x, so we still feel pretty comfortable there.

And then what we said was, all right, at benchmark rates of 5% going forward, if we stress test, because of the inflationary pressures, stress test earnings across our portfolio by 30%, which we believe is a pretty draconian calculation, weighted average interest coverage is still north of 1.4x. And then we've got an analysis where we also take benchmark rates up the 6%, stress earnings 30%, and we still have a coverage of 1.3x.

So that's a proof point that the sustainability of the capital structures that we underwrote to and put in place, those underlying borrowers, is there, and the performance of the earnings is there. And I think we're really pleased that north of 90% of our borrowers, Stewart, in the portfolio today can adequately cover their interest expense with SOFR benchmark rates going up to 7%. We're just under 500 basis points today so we've got some run room there. And we still can cover our interest coverage on a weighted average basis up north of 1x, up to SOFR 15%.

Again, this is one example of the analysis we're doing for our investors in order to assess and stress the portfolio to factor in rising rates, factor in inflationary challenges, and how that's playing through with our portfolio specifically.

Stewart: One of the things, and we really didn't talk about this and you can pass on this question, but I'm fortunate to have conversations with insurance CIOs and folks kind of in similar spots. And one of my recent conversations was, this person said, with some of the cov-lite transactions that have taken place, you're going to see fewer Defaults, big D, capital D Default, and it'll be more of an amend-and-extend environment and that, while defaults would be lower than expected, recoveries in that person's opinion would be lower than expected. What's your take on that? I mean, what's your commentary there?

Kevin: Yeah, it's a great point, it's a great question, and I think for that exact reason is the sole purpose is why Varagon, our investment strategy, we've steered clear of covenant-lite financings since inception. So our portfolio today, 99% of our portfolio has financial maintenance covenants, at least one financial maintenance covenant. In some cases, we have multiple financial maintenance covenants. Because we need to be back at the table talking about situations before you have liquidity events because you will just be at a point where a company's out of money and there's a situation at the table.

So we've really tried to stay true to our investment thesis that you stick to the most resilient end markets that you can, don't deviate, don't have style drift, you're a lead lender because you need to be driving terms and conditions in the negotiation of those, and you have to have a maintenance covenant because you have to get back to the table when there is some bumps in performance to negotiate adequate protections and manage through those situations accordingly. Versus a cov-lite scenario, or what you'll heard called cov-loose over the last few years, where you have a covenant at close that never steps down and you literally, you'll have liquidity and payment defaults before you even be back at the table. 
I think, for us, I think we've solely focused on being in deals with financial maintenance covenants with teeth that get us back to the table well before there's any type of a potential big D Default on the horizon. And what I mean by that is, most of our covenants, Stewart, we have cushions of, call it, 25% to 30% off of the closing earnings of the company stepping down. So we're getting back to the table, and we're seeing that work. Last year alone we had 13 companies that defaulted on their financial maintenance covenant. Got back to the table, we were able to renegotiate an amendment that was adequate. In all of those instances, for the most part, liquidity was invested in those businesses by the private equity firms that we work with. We were able to negotiate an increased rate for our investors, and we had a very constructive solution. And it's working exactly as we expected it to.

But yeah, cov-lite's a very interesting scenario. I think in the great financial crisis it was really reserved for $100+ million EBITDA businesses. Over the last 6 years, it crept its way all the way down to $30 million EBITDA businesses. And I think there's going to be folks that have some difficult situations if we remain in a choppy environment for a prolonged period of time.

Stewart: That's great color. And I just want to talk to you a little bit about, so you mentioned you do sponsored deals, so that alleviates me trying to figure out how to get financing for insuranceaum.com. Talk about my understanding of this is that the term "sponsored" means that there's a private equity firm involved and that under duress that private equity firm could add to their capital position, or you're not just lending to an independent company like ours. Talk to me a little bit about how that works just from, as a layperson I'm asking because this isn't my world, and why are you focused there and not lending directly to businesses that are just without private equity backing?

Kevin: Yep. It's a great question. Our fundamental thesis is there are inherent benefits from focusing on private equity-backed middle market businesses. I think there's an element, Especially in Varagon's case, we do all performing companies, we're not doing distressed or opportunistic. These are very well-capitalized businesses. Our weighted average loan-to-value across the portfolio is about 42%. So you have significant capital invested in all these underlying companies from deep-pocketed private equity firms that have track records that they're building and have displayed over time of their portfolios and the way they invest and grow.

So in challenging times, it's very beneficial to have those private equity firms to look to for infusions of capital. We saw that during COVID. We talked about this when we were on last time, when there were bumps in the road and uncertainty, they move very swiftly to cut costs, manage, bolster liquidity, manage vendors, invested equity in those businesses, to solve those balance sheets through kind of 2022. Perfect, that's one of the fundamental things that we like too.

But in this environment, which we really like and we think is an inherent benefit of it, is it's a challenging market right now on the new deal side. There's hung deals in the broadly syndicated market. There's liquidity scarcity because of lack of repayments and the rising rates and the delta between enterprise values. But when you have a portfolio of private equity-backed companies and those sponsors are invested and focused on growing those platforms, it drives inherent volume out of your portfolio, which we really, really appreciate and like during this period of time.

So when you look at 2022 for Varagon, we drove about 65% of our deployed volume out of the portfolio, as private equity firms are continuing to look to execute on M&A opportunities for their portfolio companies, so doing add-on acquisitions that they finance with both equity. It also drives incremental financing for us, which is good for our investors. And we benefit from those inherent cash flows that they're adding to those companies, in many cases they're deleveraging events.

I think we fundamentally think having the sponsor involvement is great from a few perspectives. One, it's absolutely when there's bumps in the road and you need to go for that liquidity and that step, and they can usually move faster than a founder-owned or non-sponsored-backed company where you have family members or something like that. Sponsors move swiftly, and they also bring lots of capital. And then times of this, where you've got 180 bars in your portfolio, they have an economic interest to grow these businesses, invest in these businesses, and that drives volume for us on the financing side when the new deal side's a little bit more choppy.

Stewart: And I got to think that with that many loans outstanding that you've got good familiarity with some of these sponsors, and you know their personality. You have what I would refer to as tribal knowledge with some of these folks. I mean, you know it matters because you were there yesterday, you're there today and you're going to be there tomorrow. And I've got to think that there's trust that gets built in there. Is that fair?

Kevin: I mean, that's a fantastic point. With respect to familiarity, we take comfort in the fact we already know and we've worked with this private equity sponsor, we have a very good sense of how they underwrite and manage positions within their underlying portfolios. And then when you look at it in the next step at the borrower level, we've already underwritten those companies. We're receiving, in most cases, monthly financials, detailed MD&A, ongoing weekly discussions with the management teams at those various borrowers. We have a very good grasp on a granular level of that performance of those assets.

And that's a fantastic way to deploy more dollars in a situation that you're in now, when new deals are scarce, credit quality overall is questionable. We love this. Familiarity is key and on both the sponsor and the underlying asset level, and we love to drive volume out of that. I mean, it's just a great way to deploy more dollars into very good operating business.

Stewart: Yeah. I'm going to talk just a little bit about the market here. There's been stress in the banks with SVB, with FRC, Signature, Credit Suisse. And I'll harken back to this conversation that I was having with someone who is also a very sizable insurance investor, who said that, in their opinion, banks are not going to lend more, they're going to probably lend less. And that middle market direct lending is going to be key, and private credit in general driven by insurance capital, is going to be key to maintaining economic growth in the US economy. Do you agree with that, and can you talk a little bit about how these stress scenarios have impacted your market?

Kevin: Yeah. Look, it's a great topic. I mean, the ongoing situation within the banking sector, SVB, First Republic, Signature Bank, Credit Suisse, et cetera, is certainly something that we're focused on, is a part of our portfolio risk assessment. The first item we had to check the box, we checked across all of our names. And when you looked at it, because we don't invest in venture or ARR or software deals, our underlying portfolio and sponsors didn't have exposure to those banks, which was great.

But I think at the end of the day, this drives more opportunity for direct lending middle market providers like Varagon, because we all know this will likely drive increased regulation within the banking sector over the near and medium term. And that will continue to drive better opportunities to be financed within our marketplace from the private lender side, private credit side, that the banks aren't able to do. 
So I think absolutely. I mean, look right now you're in an exploratory period between rising rates and value conversations between buyers and sellers, but that's going to normalize when people have better visibility on where rates will go and how the inflationary challenges are hanging out with general economic sentiment. But I'm telling you, I think this drives tremendous volume for providers like Varagon in the near to medium term because I think banks will pull back a little bit, not provide capital where they historically have, which can drive attractive relative values for us. Nice businesses that historically would've been done by a regional bank, now they need financing and we can get a really attractive senior secured financing at attractive rates in this environment.

So I totally agree with that. And I think that the situation today hasn't had an impact on us directly, but I do think the near to medium term is really going to drive more opportunity for us on the financing front.

Stewart: Let's just talk about market and strategy as you look forward here. We had someone on talking about private credit. They referenced the idea that deal size is smaller, sometimes valuations are challenged when somebody has to go back out front of the round of financing. Can you talk a little bit about deal flow, what you're seeing? How's the market shaping up right now and where do you see the puck going?

Kevin: I think what we've seen through Q1 and what we expect really for the majority of this year is, given the current environment as you described, our expectation is that we will, at Varagon, continue to drive most of our deployment via add-on acquisitions within our existing portfolio, which we really, really like. But that will be the vast majority of the deployment, at least in the first half of this year, while selectively looking to bring in and add new platforms to the portfolio.

The new platform segment has been slow to develop this far in 2023 as a repricing of credit, as we talked about, has caused leverage to decline. And then you've got the exploring on enterprise value as a result of that with the equity checks and making those returns work for the private equity side. But also, credit quality has really been spotty at best in the first quarter of this year, and we're very selective to begin with. Where we think the puck's going is, new deal volume's going to be probably few and far between in the first half of this year. We do expect it to pick up in the back half of the year as people start to get better visibility.

But that being said, Stewart, there's some really attractive opportunities for you to capitalize on if you have capital right now. We just did a deal, I'll give you an example, a real example. We closed a transaction where we co-lead with another private credit lender. We did a 4.5x deal, that's about 40% loan-to-value. So you're senior secured, at SOFR plus 850, with 3% upfront.

So we're going to pick our spots. We'll absolutely love to add those to the portfolio, but I think we expect that to remain the standard course for the next 3 to 6 months. We're going to invest heavily in the portfolio, continue to support companies and benefit from the cash flows that are added to that. But I think that once the market stabilizes, which we think should be Q3, Q4 of this year, you should start to see an influx of deal flow, because there's a lot of good companies that are just waiting to come to market. Waiting to see where price exploration lands and, at that point in time, where the sentiment is on rates. Are we going to operate? Are we going to go up another 100 basis points? Are people triangulating in with the banking crisis that will peak then we'll work our way down? TBD. I think that's where people want to kind of analyze over the next couple of months.

Stewart: That's really helpful. I learned so much. I mean, and you and I have had a chance to become kind of friends over the last little bit here. And it's really helpful, instructive for me to be able to talk to somebody who's a real expert in this market. I've got one new fun question for 2023. We're going to try it out right now. It's not that new, but it's a little bit new. Who would you most like to have lunch with, alive or dead?

Kevin: That's a fantastic question, and I think-

Stewart: Doesn't have to be one person, it could be more than one. It could be a group.

Kevin: It could be a group?

Stewart: Yeah.

Kevin: Oh man, you really got me here. I'm a huge sports fan and I read tons of books and watch lots of documentaries. If I could sit down and have lunch with anybody, and I'm not even a Bulls fan, I think I would want to sit down and have lunch with Michael Jordan, just so I could ... I watched The Last Dance, it was fascinating. I've read a lot of books about him, and I would love to just ... His way of leadership and just his way to motivate people to me is ... and getting the best out of folks is impressive. So that would be mine.

Stewart: There you go. Great stuff. Listen, man, thanks so much. We've been joined by Kevin Marchetti, who is a Partner and Chief Risk Officer at Varagon Capital Partners. Kevin, thanks for being on.

Kevin: Thank you, Stewart. Appreciate it.

Stewart: Thanks for listening. If you like us, please rate us and review us on Apple Podcasts. We certainly appreciate it. My name's Stewart Foley and this is the InsuranceAUM.com podcast.

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