Stewart: Everybody knows that yields are at historic lows and everybody’s looking for investment income. Middle market lending is often part of that conversation. The question is, is it a good solution for you? We’re joined by Tim Warrick of Principal Global Investors to talk about this asset class today. Tim, welcome.
Tim: Thank you, Stewart. It’s great to be with you here today and look forward to our discussion.
Stewart: Thank you very much. My name’s Stewart Foley. This is the Insurance AUM Journal podcast. Tim what is middle market lending? Can you define it, the market, what that means and how you guys come at it?
Tim: From a broad perspective, middle market lending is lending to those companies that are typically smaller in size than the large, broadly syndicated markets. Middle market typically is defined as either $500 million or less in revenues or $200 million of EBITDA or less. Still pretty significantly sized companies, if you think of it from that perspective. The way we think of it and where we think there’s even more value is looking at the core middle market or even the lower middle market. We consider core middle market, those companies with around $50 million in EBITDA and lower middle market – $5 million to $25 million in EBITDA. Those companies are oftentimes companies experiencing significant growth benefitting from secular changes in the economy and across their industry.
Stewart: Principal manages $8 billion of private credit as of June 30, 2021. I think it would be helpful for our audience to understand the history of the platform and how the investment approach has been formed over time.
Tim: Principal Alternative Credit (PAC) is part of Principal Global Investors and oversees all of the private credit asset management for the organization. And that has grown to over $8 billion. Principal started investing in private credit over 50 years ago, well before my time.* I had the pleasure of beginning my career with Principal in the 90s, as a private credit analyst, as well as covering public credit at that time. So we’re very familiar with being a lead lender in those situations, leading the negotiation with borrowers, leading the documentation process, leading the workouts when there are workouts, potentially. So we’ve always seen value in private credit. More recently, in 2018-19. It was very clear there was tremendous value in the middle market private credit space, or middle market high yield. And we made the determination as an organization that we really wanted to move more considerably, take our credit culture, credit heritage, credit expertise to that part of the market in addition to the more traditional private placement market. So that’s what we did.
Tim: In 2019, I began setting up the team. Principal’s general accounts saw a tremendous opportunity to increase allocation, to drive the efficient frontier, to drive yield relative to the risk that sector offers and so by the middle of 2020 we had the team set up, in part transitioning over some of our key analysts, our head of credit research, in addition, bringing in some key outside talents, including our head of underwriting. We did our first loan in the middle market high yield space in July 2020, and now we’re up over 24 loans in the platform and focusing on that lower and core middle market. Again, we focus on $5 – $50 million EBITDA companies. We think there’s really strong value there; it’s less exploited or less competitive. There are a number of firms focusing in that area, but not like what you see in the public broadly syndicated market, or the upper middle market. We are seeing better pricing, better terms, and covenants; true maintenance covenants; just overall value. We are seeing relative value in the middle markets. And we believe a core competency is to be able to originate there, so we focus on both sponsored and non-sponsored transactions to get that diversity, to get that top of the funnel as wide as we can to see as many opportunities as we can. And we also believe portfolio construction is very significant. We are focused on specific industries that we expect to drive greater performance overtime while avoiding certain industries that tend to have more default characteristics or more operating leverage, higher cyclicality. If you look in the public market the more heavily cyclical industries are embedded in that market, less so in the middle market.
Tim: The last point I’ll make is we really believe our approach to transparency is essential. We have very clear ratings. We rate every loan just like public rating agencies (B+, BB-) But we also have quantitative tools that challenge our thoughts and ensure we don’t have unintended bias including Moody’s Risk Calc, Principal Credit IQ, and ESG ratings which we know is important in evaluating the opportunity relative to risk. So we score every loan from an ESG perspective on a scale of one to 10; importantly engage with the borrower, with the sponsor to drive important improvements over time in that company’s profile. Hence reducing the risk but still getting paid, as we enter into those transactions with an 8% coupon, but then reduce, and mitigate the risk through time.
Stewart: It seems that the COVID-19 pandemic has had an impact on nearly every asset class. How has the dynamics with the middle market direct lending changed over the years and particularly since this COVID crisis?
Tim: It’s been a really interesting journey that began in earnest post-global financial crisis. As banks’ regulatory environment increased, their level of ability to hold more leveraged assets or loans was constrained. So that void was definitely met by different non-bank lenders. In 2010 banks were about 80% of the true middle market, today they’re less than 20% of the middle market because of the change in the overall mix of middle market lending, shifting to more direct lenders. In addition, we are seeing more middle market lenders and borrowers wanting to come into the private space rather than be in the broadly syndicated space. We’ve seen borrowers and sponsors choose to have certainty of financing, choose to have a relationship with the lender and to be able to grow the business and platform with that lender rather than rely on the public market which can be more volatile and dependent on systemic and economic risks. If you look at 2015 to 2020, the volume of direct lending has increased from about 0.7 times that of the syndicated market to over two times the level of the syndicated market in the middle market space. We’ve seen great growth from taking share from banks or from the public markets and their capital markets groups. The growth of the asset class has been tremendous, we’ve seen tremendous flows into the private equity space. Private equity sponsors have realized considerable capital flow and probably have over 600 billion of dry powder to put to use, to look for M&A and LBO opportunities. In addition, the number of private equity firms has grown to over 700 here in North America. Compared to where we’re at in direct lending, there’s approximately a hundred different direct lending firms in North America that are operating and reputable.
Tim: So the supply demand dynamics look pretty favorable for lenders to come alongside with those borrowers, especially when you consider the sponsors generally contribute a lot of equity capital. Most of these deals have over half of the capital contributed in the form of equity so the loan to value is less than 50%. What we have seen is a continued expansion in enterprise value, just like in the public market, but that’s in part because we’re financing more technology and software, healthcare and business services that we believe are justified to have higher valuation. We’ve seen the loan to value stay pretty reasonable, well under 50%, even with the advent of unitranche, which just means taking a first lien and attaching a sliver of mezzanine debt to effectively to have one larger first lien unitranche.
Tim: During COVID we did see an increase in portfolio monitoring by those managers with a number of portfolio holdings. During that time, however, we were ramping up the platform so we had the benefit of being able to underwrite through that period. In addition, we saw very favorable pricing, covenants, and terms. We saw some secondary trading as well so we were able to buy some assets at three or four points discounted to the original issue discount or to par. But the market snapped back and we are back to almost pre-COVID levels as far as how the market’s behaving now, still reasonably strong covenants, and still getting an exceptional risk premium of almost 300 basis points relative to public alternatives.
Stewart: And geographically. Tim, when you think about opportunities in North America, for example, versus what’s available in Europe and other places, how do those opportunities compare in your eyes?
Tim: We are very focused and see great value in North America. We’re looking at a run rate of almost 750 loans a year and there are well over 1500 loans available in the private middle market space over a year. The market in North America is at least five to 10 times larger than Europe. Cliffwater index data goes back to 2004, before the global financial crisis when the middle market space was developing in North America. Its more recent in Europe which can create numerous opportunities including the benefit of transitioning from banks to middle market direct lenders. We think there is benefit for investors to consider both Europe and North America originated loans and opportunities. Even a few years ago direct lenders would co-invest alongside with banks. And now according to recent data many of the banks in Europe are focusing more on the loans they’re making as a part of the COVID relief effort. They’re not focused quite as much on middle market and developing the middle market lending avenue. Middle market direct lenders are up to approximately 80% of the lending in Europe as well.
Tim: So very similar to what we’re seeing in North America. The one thing I would say is the markets are at different stages in Europe. The UK is definitely advanced and more like where we’re at in North America. France and Germany are probably the next two most developed markets, and the Nordic region and Benelux regions are now expanding as well. So those opportunities will be there. There’s definitely large lenders already over there. One of the very largest funds is a European only fund. So the market is being penetrated. And if you look at the valuations, the covenants, all of that, they are not that different than what we see in the U.S. and North America, very similar. And in fact, the industries of focus are very similar as well, with leading issuance from healthcare, technology, business services. So a lot of complimentary things, a lot of similar things, but any investor should consider both avenues for a fully diversified portfolio.
Stewart: So when I’m looking for deals, I mean, what’s the source of deal flow for middle market direct lending. And in your mind, what’s the best approach?
Tim: The best approach is to have as wide a funnel and be able to see as many deals as you can see. We hired originators that were formerly underwriters, so they’re underwriting and screening. They know what we’re looking for in terms of credit screening, what industries we want to exposure to, but it’s still good to have a pulse for what’s going on in the broad market and then be able to be selective in what ultimately we get to close. So our close rate is less than 5% but so we think it’s appropriate and beneficial to see numerous deals from private equity sponsors. We also think it’s appropriate to see deals from non-sponsored relationships and opportunities. We also think it’s appropriate to work with other lenders in small clubs, not broadly syndicated lenders. We’re working with maybe one or two lenders on any deal, that’s all. It’s a smaller club, but we’re still controlling the deal, we know the terms and conditions, we very much believe in the acumen of the other lenders as well and how we align with them. That gives us another view of a broad sourcing for deals and furthers our ability to be very discerning. So on the sponsored side, some lenders will say, we’re only going to do sponsored transactions, we’re not going to look at non-sponsored at all. And rely on really good sponsors out there that have proven track records.
Stewart: Give us the difference between sponsor and non-sponsor.
Tim: Sponsors are those private equity firms that have raised funds. They may be on their first fund or their 15th fund. They may have a $200 million fund or a $5 billion fund. And they use that capital and expertise to go out there and look for where they think the best opportunities for investment and growth are based on their expertise. So they might come in and look for a platform to grow a business from with the initial investment as the anchor platform, then bolt on other businesses of similar type. They may come in and look for operational improvements in the company. They may just have the specific expertise in healthcare or technology and software. So there’s a lot of different strategies out there. And that’s why we think it’s really important to understand the sponsor, understand their capabilities and understand their strategy and align with those sponsors that we really believe will support their transactions. And we really believe they have a great acumen or great capability in that particular industry.
Tim: In fact, we rate the sponsors and assess those that we work with. We work with over 200 sponsors out of the 700 in the U.S., and we assign them gold, silver, or bronze and that represents how we align with them in transaction opportunities. It’s great to have them alongside in transactions, the expertise they provide in the diligence process, the capital they provide when things go sideways that support the transaction. So there’s a lot of the positives from a sponsor perspective, but we also find value with non-sponsored opportunities. That’s where you don’t have equity coming into the deal; you’re oftentimes working directly with the founder. You’re directly working with the owners of the business, could be a family office, or you’re working to get to that transaction through debt advisors; you’re working through commercial banks; you’re working through accountants and attorneys and such. So again, there’s not private equity sponsor capital coming into the transaction.
Stewart: I always learned the most on these deals. I just find that fascinating as the guy that, I started this business and just in terms of us trying to find financing. I mean, what you’re doing is certainly on the investment side, but just from the standpoint of, as a business owner, the fact that the banks have pulled back. Direct lending has become a really important source of funds for a whole lot of businesses out there that are not General Motors.
Stewart: And I mean, when we talk about middle market lending, there’s also a high-yield component that we really haven’t touched on. You see value there. And how has the spread compression been? I’m making an assumption that there’s been spread compression. I assume that is, how has that spread compression lined up against public markets?
Tim: There has been some spread compression and we look at the asset class or middle market private high yield as providing a lot of opportunity. And part of it is that sure yield benefit; part of it is also the tremendous diversification benefit. So if you think about middle market high yield, and the correlation to other asset classes, for instance, it’s correlated about 0.3; maybe, with investment grade credit, it’s correlated negative 0.3. I’m using Cliffwater reference data back to 2004, -0.3 with the Barclays Agg, and low correlations across the board. And then you think about the return/risk profile. We returned from that period back to 2004 is over 9% annualized, which compares very well to U.S. equities at around 10%, but it has volatility or standard deviation about 4% compared to U.S. equity of 16%. We feel like in the broadly syndicated leverage loan market that we’ve turned during that same time was 4% and volatility at 9%. So you’re getting great sharpe ratios, great ability to move out the efficient frontier, that diversification is just a great opportunity we think for investors, especially those investors that have longer investment horizons that don’t need immediate liquidity, that can provide stable sources of capital to its asset class. If you think about the current time and the valuation, think about what’s happened with all the intervention from central banks, fiscal policy recovery, the economy recovery the markets.
Tim: We saw the public high yield market and the public broadly syndicated loan market, yields and broadly syndicated loans and public side did move up relatively rapidly back last year in the second quarter, as everyone witnessed the market was broken and liquidity dried up in what had been a liquid market. So those yields moved at about 7.5%, whereas the middle market, private high-yield market, first lien focus was around 7.75%. So public loans compressed, but there really was an inability to execute. Nobody could pick up that falling knife if you couldn’t get many assets bought, but you could still transact in a private high-yield space, private middle market space. Now today, because of intervention from central banks, those public assets have fallen dramatically in risk premiums. That’s been driven by the intervention from central banks that search for yield with negative yielding assets all around the world, negative real yields, negative nominal yields. So we’re seeing now about 275 basis point pickup in middle market, high yield compared to public alternatives. So deal might’ve been seven and three quarters last year in the second quarter. Now we’re still talking about seven and a quarter average yield to down 50 basis points. Whereas public assets, public broadly syndicated loans are down around 400 basis points because of that intervention and the demand that comes through that.
Stewart: So you mentioned the unprecedented level of monetary and fiscal stimulus and its impact on spreads. What about the flows coming off of passive investing, which has been such a huge trend, has that had a comparable effect as well?
Tim: In part that’s driven by the search for yield that has been in part impacted by central bank policy and, you could argue, excessive monetary accommodation, monetary policy accommodation. So that search for yield has come through passive ETFs, has come through passive mutual funds, passive mandates in general. We’re actively investing for core and core plus mandates as well as credit mandates. So my perspective is those passive investors are price takers rather than price makers. They’re just executing at wherever the marginal bid is versus the offer, and so they’re really not delineating what the true credit risk is. They’re really potentially not even considering the economic conditions and the impact on true valuation or the true credit risk of an opportunity, let alone a broad index they’re investing in. So we think that’s pretty impactful because you can argue an equity that makes sense. You’re getting exposure to the best companies that are growing the most considerably and attracting capital in a positive manner. Here, those companies that are just the largest borrowers are getting more and more access to capital.
Tim: I lived through 2002, 2001, that’s WorldCom, that’s Enron. That’s not where we think you want to put your capital for a fixed income investor looking for limited downside, but upside that middle market high yield can provide. And that’s the great thing about middle market, it’s so idiosyncratic. We consider the macro environment, we’re focused on industries that are going to perform through secular changes and macro-economic changes, but we’re underwriting with so much rigor, every single loan as are our peers. We are using expert advisors. We’re doing diligence alongside with the private equity sponsors like we talked about. So again, we’re a price maker, not a price taker. And I think that’s something that investors should really consider when they’re investing capital. So to me, the risk return profile is so much more attractive in middle market private high yield right now than it is in public markets in general, public credit sectors in particular.
Stewart: I want to get to liquidity, which I think is always on the table when you’re talking to insurance companies. But you touched on this with regard to terms and covenants. How have you seen terms and covenants hold up through this most recent cycle here?
Tim: In our approach and in our process we always require true meaningful covenants, so true maintenance covenants. No covenant light, we just won’t do it, that’s not our strategy. We don’t think that’s the best approach. And so we’re always going to be looking for fixed charge coverage and debt to EBITDA covenants as true maintenance tests, in addition to any incurrence test that would be associated with a delayed draw facility. But if you look at what’s going on in the market, if you kind of bifurcate and say, okay, the transactions which are a 100 million and smaller in size for overall debt capital in the middle market space; this is the true direct lending, not the public space. Those transactions only have about 1% that are considered covenant light. So almost none that are considered covenant light. Again, that’s what we’re focused on primarily. And then if you go a little bit into the core and upper middle market, so those transactions are 100 million to 500 million in size, about 10% of those are covenant light. So not as appealing as smaller transactions, but most of those deals still have meaningful covenants, meaningful maintenance covenants.
Tim: And if you look at the public high-yield space or the public leveraged loan space, approximately 80% are covenant light or in that range. And that’s been growing and trending in that direction for some time because of that search for yield, that need to be accommodative to borrowers and such. So again, you don’t have the controls; you don’t have the ability to get to the table with the borrower, and you have higher leverage typically in those transactions as well. So they may be larger, we would argue different risks and most likely, in our perspective, oftentimes more risks than just the financial perspective in those business models. So that’s where we see the value. Now, there is a lot of cash, a lot of flow coming into the private middle market space. There are a lot of our peers that are bringing a lot of capital. We’re planning on bringing in a lot of capital as well, but we will never give on true meaningful covenants. And typically the cushion on those covenants are 25% to 35% above the level for fixed charge coverage at closing and debt to EBITDA at closing. We know some peers are looking to invest capital so rapidly right now because the flows are so significant. So we do know, especially in the upper middle market range, where they’re doing larger and larger transactions, there is a give on the overall threshold, how tight the covenant needs to be. So effectively watering that down a little bit, but still beneficial compared to what we see in the public market.
Stewart: And there’s obviously a liquidity give here versus public markets. And I’m assuming that I’m getting some liquidity premium here. Can you talk about the comparison between the liquidity, the securities versus a public market and to what extent you’re getting paid for that liquidity give?
Tim: We look at liquidity in a little different way; we think investors should consider that as well. So for middle market direct lending high yield, you should get paid for the credit risk, for liquidity premium, and then we believe there’s an additional premium just for the inefficiency of the market because many investors don’t have direct access to the market. More and more managers will be coming up with strategies that provide more ongoing liquidity. But for the most part there’s gates that are in closed-end funds that don’t allow investors to have access to that capital and they may get income distribution. So they don’t have access to the capital for four years potentially, or a window of it gets through the re-investment period. Also, gates, oftentimes in institutional separately managed accounts. So we think that’s really reasonable and that’s how credit should be managed. If you invest in credit, you should want to think about investing for the intermediate and longer term. And so we think about liquidity in the sense of how stable is the capital that’s supporting that investment and how stable is the capital broadly that supporting that investment. So if you think about the public markets and think about liquidity, to us, liquidity is volatile in the public markets. So the premium you get in the private markets is just an exceptional opportunity from our perspective if you have an investment profile and horizon that’s intermediate to longer; if you have liabilities you’re trying to back that are intermediate to longer or sticky and you know the duration of those liabilities.
Tim: So what you want is a steady capital source and we have a growing capital source coming in the middle market space. You don’t want the volatility that comes along with public markets, at least not for all your portfolio, because central bankers and systemic risk, geopolitical risk can affect liquidity overnight. Sponsors and borrowers don’t want that either. They want the certainty of financing. That’s why they’re coming more and more to the private market and moving away from the public market because they want that certainty. They want that relational lending. They want to know that the lender is going to be there through good times and bad, both in the market environment, as well as when a credit goes sideways. If you have the investment profile, meaning liabilities or an investment horizon that is appropriate, this asset class provides diversification, downside protection, and you don’t get the swing that you get in a pricing and valuation we’ve seen in the public market and that’s justified we believe. It should be a more steady valuation and it has been proven to be over time.
Stewart: And we have talked about this on a variety of our podcasts, in some of the articles that we publish, but the trend for insurance companies is to alts and private asset classes because that’s where the yield is. And that’s where the value is. And I have yet to find anybody who said that won’t persist, right. The question I have is, will the value persist here relative to public credit? Do you think it holds up here? Can you just give us your view, given the flows?
Tim: It definitely holds up. We believe it will be impacted over time because of those flows and the technicals causing it to richen up a little bit relative to other alternatives; but we think it persists for a number of reasons. And one of the reasons I haven’t talked a lot about is the investment capital that’s going into these companies is intentional through the private equity sponsors. So it’s capitalism at its finest. These are industries and companies that are benefiting from secular trends, taking costs out of the system, creating efficiencies for the economy. So that’s always going to provide diversification and value in that sense, from our perspective. It’s not the old industrial lines, the commodities and the heavy manufacturing. It’s going to be the industries and issuers that I’ve mentioned before that are benefiting from secular changes. So diversification is huge and really important.
Tim: I think the other thing we didn’t talk a lot about is the floating rate nature of this asset class, how it can buffer rising rates. If you’re concerned about rising rates. In addition, there’s LIBOR floors on all of the loans that we’re investing in. So typically a 1% LIBOR floor, no matter where LIBOR is at, and now less than 25 basis points. And then there’s an original issue discount that’s in these transactions to give additional benefit to the performance and the internal rate of return that we might expect. So we do think it’s a tremendous opportunity that regard to provide further diversification. And again, we’re talking about first lien loans here, for the most part, first lien including unitranche, which means just a broader first lien tranche, as we’ve spoken about earlier. Again, I mentioned earlier, this will always be a price maker market rather than a price taker. This can’t be ETF’d. You can’t just have a passive fund generated overnight that can invest directly into these assets. This asset class is very idiosyncratic, very bottom up. It can’t be replicated. You have to actually do the diligence and the work that goes into this decision-making process. And then ultimately find the best companies, put the best structure around them and value will take care of itself on an idiosyncratic basis, as well as the broader exposure to the middle market private high yield space. Another thing is we believe we’re still at the very early stages of the capital flows coming into this market.
Tim: So, 10 years from now there’ll be less value in this market than there is today, but we haven’t really cracked the code on how to provide this access more readily to retail and high net worth. So institutional investors that can get access directly through separately managed accounts, closed-end funds, even interval funds to some extent for high net worth, you’re still at the early stages and that inefficiency of the market is still being explored. I think that value is still going to be extracted in performance as we look down the road. And then again, sponsors are always going to be willing to pay a little bit more for the certainty of financing and the certainty of the relationship, certainty to close on transactions as they grow a platform. So they’re not that extremely sensitive to whether they pay 50 more basis points or a 100 more basis points. They’re more sensitive to the relationship and knowing that they could access to capital and not be reliant on a public market that can be a little bit whimsical in nature because of intervention and systemic risk.
Stewart: I have learned a lot about middle market direct lending, and I appreciate that very much. I do have one additional question, Tim, this is during what you may not be aware of, which is the ‘Ask Me Anything’ portion. So I’m going to take you back to a time, a day that I know you remember, well. This is the day that you graduated from your undergraduate institution. Now, your last name starts with “W” so you’re at the bottom of the list and you have to wait a long, long time, right. So finally they call your name, up the stairs, you go across the stage, you get the diploma from the president of the college, quick photo opp. The crowd is going crazy. Tim. I mean, crazy. And then you walk down the stairs, right, and you run into Tim Warrick today. What do you tell your 21-year-old self?
Tim: Wow you made me feel young. Thank you for that. That was awesome. Awesome, reenactment. Yeah. I’d tell myself to be open to change, be open to evolution that you can have as a person. Entertain ideas from others, never be close-minded. So I think that’s really been something that suited me well at Principal. I’ve had a number of different roles. To me, you can always be learning, not just book-smart, but you always are learning from the market, and your peers, colleagues, market changes. Whoever would have thought that we’d see things we’re seeing today in the economy, in the central bank policy, and then the opportunities we’re seeing as well. The other thing I would say, there’s always opportunities, and we’re seeing those opportunities today, despite where things are compressed and such, there’s always opportunities because you can always be looking forward to those secular changes and that impacts you on a personal basis. Also, it can impact your clients and that’s what we’re most focused on, how we can make positive impacts for our clients.
Stewart: Great advice. Great advice, Tim Warrick, Principal Global Investors on direct middle-market lending. Tim, thanks for being on.
Tim: Thanks a lot Stewart. Really appreciate it.
Stewart: Good stuff. Thanks for listening. If you have ideas for podcasts, please email us at podcast@insuranceaumjournal. I’m Steward Foley, and this is the Insurance AUM Journal Podcast.
*Experience includes investment management activities of predecessor firms beginning with the investment department of Principal Life Insurance Company.
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