Senior Secured Middle Market Lending – A Credit-Focused Approach for Insurers

Kevin Marchetti headshot

The flow of funds to private assets is undeniable in the insurance space. We are talking today about private debt, and more specifically, senior secured sponsored middle market lending. And we’re joined by Kevin Marchetti, founding partner, and chief risk officer at Varagon Capital. Kevin, welcome.

Kevin: It’s a pleasure to be here. Thank you.

Stewart: Hey, we’re happy to have you and we’ll start this one like we start them all. First, your hometown, first job of any kind, and fun fact.

Kevin: So hometown, I’m from New Hartford, New York. It’s in upstate New York, so I’m a big Syracuse Orange fan. My first job, going all the way back, was as a caddy at a country club in the town I grew up in. My first professional job was at CIT, coming out of business school. And fun fact, I played college football at Springfield college with John Cena, who everyone knows today is a pretty well-known entertainer.

Stewart: Oh wow, there you go. What position did you play?

Kevin: I played free safety.

Stewart: There you go. All right, that is a fun fact. And CIT, there’s a name from the past. You go, “Wow, I remember those guys.” I was not as familiar with Varagon Capital Partners when I first met you, and I think maybe some of our listeners are the same, so could you give us a high-level overview of the firm and what your focus is?

Kevin: Yeah, absolutely. So Varagon was launched in June of 2014, and we manage about $15 billion in assets today. We specialize in, as you noted, investing in senior secured and unitranche loans to performing private equity-backed US middle market companies. We define the middle market as borrowers that generate between $10 million and $75 million of annual EBITDA. But, I’d say we have a specific focus on lending to companies that have sub-$50 million EBITDA businesses. Our core strategy is focused on recession resilient and markets such as critical business-to-business service providers, healthcare, and healthcare services. We like consumer staple end markets in the packaging and the food and beverage space, software, and aftermarket auto.

We shy away from overly cyclical companies, capital-intensive businesses unless there’s a very specific niche, ROI, or ROA that is very tangible for us to get our arms around. And we do not pursue investments in the retail, restaurant, real estate, or energy space. We’ve deployed more than $19 billion across over 245 borrowers since our inception. Our average annualized default rate is roughly seven basis points, which we’ve delivered unlevered net IRR of just over 7% if you aggregate our investments across multiple vehicles since firm inception. We’ve completed deals with over 120 private equity firms. We are the lead lender in approximately 90% of the transactions that we finance. And today we have just over 80 employees throughout our offices in New York, where we’re headquartered, Fort Worth, and Chicago.

Stewart: All right, let’s talk about private debt. So insurance companies are always looking for yield. Private assets have a yield spread to public assets. There’s some liquidity considerations there. And has historically been an income-generating asset with lower vol. Can you talk a little bit about where you’re seeing income generation and that vol… I mean, everybody’s talking about downside risk today in the face of some economic headwinds, that volatility piece is becoming a bigger part of the conversation.

Kevin: Yeah, I think it’s a great question, and I think it lines up really well for this discussion specifically with Varagon, given our roots, we were launched with some large insurance backers, predominantly AIG and Aflac, who are very well respected insurance companies and are integral LPs of our business today, strategic GPs. But I think, look, private debt, and in particular senior middle market loans are a natural fit for insurance company balance sheets. Given the cash flowing nature of the underlying asset, which can be used to match liabilities and generate consistent income over in the investment period. And I think further private debt typically generates a premium to similarly-rated liquid assets. And the volatility we’re talking about, well, in many cases the private debt space has got that lower volatility aspect in more favorable underlying credit metrics.

At Varagon we’ve measured this. We have historically earned it, what I’ll call illiquidity premium in the range of 125 to 175 basis points compared to the liquid markets, and as I noted with our annualized default rate of roughly seven basis points, versus what we view as the middle market default rate of roughly 150 basis points, we think it’s a pretty compelling asset class. I think additionally, it’s important to note a few things. I think loan documentation tends to be much more lender-friendly. We focus on having financial maintenance covenants in our deals with strict reporting requirements, and to frame that for you, roughly two-thirds to 70% of our portfolio today reports on a monthly basis with the balance reporting financials on a quarterly basis. So I think at a high level, the combination of yield premium, solid performance, lower volatility versus the public fixed income asset class are one of the key drivers as to why this is becoming, this asset class is becoming a larger piece of the insurance investor portfolios over the recent years.

Stewart: I always say I’m the person who learns the most on these podcasts because I get to talk to smart guys like you. And you talked about AIG and Aflac being your initial seed capital. I’ve been fortunate enough to know both of those shops, both the CIOs, very smart people, very smart money shops, very well regarded. As you mentioned in the intro, I mentioned as well, sponsor-backed middle market lending. That’s middle market… That’s not my market. So I may ask you some dumb questions. And the first of those is what do you mean when you say sponsor-backed middle market lending?

Kevin: It’s a great question. So as you noted… So generally the middle market is split between sponsor-backed, where we participate, and non-sponsored deals, with the former being a large and what we believe very attractive opportunity for the following reasons. But just to be specifically clear, sponsor-backed is when the underlying asset or borrower is owned by a private equity firm that has deep economic pockets and a large equity investment in that underlying portfolio company.

Stewart: And the theory, the thinking there is that there is demonstrable or proven capital that’s equity in the deal that is a protection for you in the event of a credit problem with the borrower, right?

Kevin: That’s correct.

Stewart: And that’s the primary difference why the sponsor-backed deal versus a non-sponsored-backed deal. Am I on that right? I’m just trying to get that big nuance.

Kevin: Yeah, you are. That’s one of the fundamental reasons, Stewart, why we believe it’s a very attractive segment of middle market. And a couple of the other reasons I wanted to cover for you. I think, first, I think in the US, it is unique how the economic and business environments have given rise to the consistent creation of small businesses. Today there’s more than 200,000 small businesses, which has provided ample deal flow to the core middle market. And to give you some context, at Varagon we’re looking at anywhere between 1,200 and 1,300 new deal opportunities at any rolling 12-month period of time. Second, I think given the recent levels of fundraising by private equity firms, there’s a record amount of dry powder that needs to be deployed. So as such, we believe that this is going to continue to drive strong activity in the US middle market for the foreseeable future. And for some context, as you know, PE dry powder reached an all-time high in 2021 at roughly $2 trillion. So there’s significant dollars on the sidelines to invest in this asset class.
I think the third thing, which you touched on a little bit, is private equity sponsors can support to companies in several different ways, including leveraging their industry expertise, increasing operating efficiency, making management changes when necessary, injecting equity and/or generally improving company performance through acquisitions or streamlining capital structures. And I think as a tangible example to this, during the peak of the COVID crisis, the sponsor where we work with were willing to contribute significant amounts of equity capital to support their borrowers to mitigate performance uncertainty during an unprecedented dislocation. And they also took unprecedented actions in order to cut costs, bolster liquidity, fortify their balance sheets in order to position the businesses, not for a recovery through 2020, but thinking through “How are we going to get them through to the end of 2022?” And I think that’s another benefit of having a deep-pocketed private equity owner in your business.

I think further we found that sponsors are able to make changes at the underlying portfolio company management level when they need to resolve issues much faster than a non-sponsored deal. And I think these elements are appealing to the lenders like Varagon, and they do make up a fundamental portion of our underwriting thesis. And I also think that we… The numbers are the numbers, and I think we very much like having significant capital beneath us in the capital structure. Across Varagon our weighted average loan to value’s right around 46% today, which clearly identifies that private equity owners have significant economic interest in these underlying borrowers and will support them through their investment period.

Stewart: You mentioned the lower volatility, and it’s my understanding that these are floating rate loans, so you’re going to have less duration, which is by nature going to lower your volatility. Is that feature helpful in the face of rising short rates? You’ve got a weird flat yield curve. I mean it’s, it’s odd to me what’s going on right now, how does the floating rate nature of this type of loan fit into the strategy?

Kevin: Yeah, so as you mentioned, Stewart, it’s a great question. So as I noted, we invest in senior secured loans, which are floating rate in nature. So 100% of our portfolio today is floating rates, and our returns have begun to benefit from LIBOR and SOFR rising to levels above the 1% floors that we’ve had in our deals for the last several years. And I think today current three-month LIBOR is roughly 2.25%, so we’ve started to benefit from that, where a year ago LIBOR was around just under 1%. We’ve run, I think… Benefits to returns, obviously. We have spent a significant amount of time running extensive sensitivity analysis is around our portfolio. The average interest coverage of our portfolio today is just over three times and remains right around north of two times, if the index rate, either LIBOR or SOFR gets to 5% to 5.5%. So these businesses have adequate runways to continue to handle increasing rates over the foreseeable future.

So I think we fundamentally believe our borrowers will comfortably manage their debt service requirements, given the expectations around rates today, and for the next six to nine to twelve months. But look, we at Varagon are pretty disciplined that we remain vigilant around ensuring that the capital structures that we’re putting in place at the underlying borrower are sustainable during rising rate environments and periods of economic dislocation. So with the underlying drivers of higher rates being inflation, Fed tapering, and a reduction or end to the stimulus programs, we also have to be focused on the borrower sensitivity to rising costs and the ability to pass on those costs to the respective end markets.

So what we’ve determined today, Stewart, is only a small fraction, roughly about 5% of our total borrowers have a true limited ability to pass on the price of their ultimate end consumer in their markets to offset these. So the result is, look, at Varagon our credit criteria that we put in place in 2014 guided our portfolio construction strategy. Our deep underwriting and active management of portfolio management function, we fundamentally believe has positioned our portfolio to withstand these increases in Fed tightening and the inflationary pressures we’re all seeing. So I think we aim to maintain these rigorous standards. We were running around in 2014 saying we’re peak market and we were ripe for a recession.

Stewart: I’ve made a few of those forecasts myself.

Kevin: But despite the strong market conditions that we did recognize over the last several years, despite the COVID time period we have never changed our deal dynamics to be more competitive. We’ve stuck true to our underwriting nature. So as we come out of this extended period of low inflation, our focus on underlying companies that can pass along these input price increases, handle the labor rate challenges and the increased freight costs, the rising rates to preserve their margins, are what we’re thinking about as we construct our portfolio from this point forward as we always have.

Stewart: So, Kevin, let me ask you this. So many moons ago, in fact, I think before I was even gray, I worked for a firm that did private placements, and a lot of the benefit of private assets is that you can get loan covenants and you can help shape the terms. We were not the lead lender. So if there was a workout, we were along for the ride. You talked earlier about Varagon being in the lead lender position. Can you help me understand the difference in those two positions? I think you said 90% of the time you’re the lead lender. So can you just help walk me through that difference in the ability to structure a deal?

Kevin: Yeah, absolutely. So you are correct. As a lead lender in close to 90% of our deals, we continue to drive documentation and generate incremental economics for our LPs in the form of origination amendment and other fees. Further, I think it’s important… In our experience, sponsors are willing to engage more early on with the lead lenders in their bank group. So, being a lead allows you to have your hands and fingers around initial setting of loan documentation, credit documentation, terms and conditions, whether it’s around your financial maintenance covenants, the management of that, the increased dialogue. I mentioned two thirds to 70% of our portfolio is reporting monthly financials. So we are as the lead in active dialogue with the underlying management teams at those borrowers and sponsors consistently on really a weekly basis, talking to them about what’s going on at the underlying operation of that company.

And I think it allows you to really drive those things that we think are fundamental to being very at the forefront of portfolio management for your investors and understanding what’s going on. We’re not in the game of participating in large deals where we’re not in direct dialogue with the private equity firm and have minimal input on terms, conditions, or legal documentation. And I think it’s exceptionally important, especially during periods of economic dislocation. With COVID, for instance, when we had that period in February, March of 2020, being the lead lender allowed us to move exceptionally quick, do operational reviews at all of our underlying borrowers, understand the steps we were going to have to take in the early days to do the necessary things to bolster liquidity, make the necessary changes, put amendments in place that were going to be needed. So being a lead lender is exceptionally important from our perspective for those aspects of portfolio management, and that is correct, we are at roughly 90% of our deals a lead lender.

Stewart: So our listeners are insurance companies, and I know that you’re managing money for insurance companies. As you also know well, the insurance business has got an area all its own. There’s a host of other considerations. Insurance companies are managing big institutional portfolios inside the belly of an operating entity. And while everybody wants to be a great investor, at the end of the day, the investment group has to be mindful of the operating entity. Can you talk a little bit about managing money for insurance companies specifically and how your approach lines up with the risk appetite of most insurers?

Kevin: Yeah, it’s great. I think Varagon is exceptionally aligned for exactly this. We have significant experience managing assets for insurers, notably AIG and Aflac are, as I noted, key strategic GPS and LPs in our business. So we’ve worked with a variety of insurer types across our platform. I think, as we discussed earlier on, Stewart, the asset class is a natural fit for insurers, due to the income-oriented and credit-centric nature of the asset class that we participate in. It allows these insurers to generate increased yield with solid credit fundamentals versus the similarly rated public markets. But as we touched on previously, what we call our risk acceptance criteria at Varagon, our credit box, if you will, lines up very well with insurance clients. Our portfolio construction strategy around recession-resilient businesses and defensible segments, with ample capital beneath our debt in the capital structure is a very, very strong selling point.

And I think it’s important, we don’t just say that we do this, we measure this. So we’ve actively monitored this since inception. And if you look at our portfolio today at Varagon, only 10% of our portfolio by invested capital across multiple vehicles experienced a top line, the underlying borrower, experienced a top line revenue decline in excess of 10% during the Great Recession, from 2008 to 2010. And I think what’s more impressive is that roughly 40% of our portfolio by invested capital across these vehicles was flat to growing during that period of time at the underlying borrower level. And the balance was somewhere between a 1% and 9% decline on the top line.

So our credit box is focused on truly building out a resilient portfolio for a true economic dislocation. And then I think, look, our credit box also winds up well. We’re focused on EBITDA adjustments, fundamental enterprise value of our underlying borrowers through our own DCF and underwriting cases, not the equity cases provided by the private equity firms. And then we look at private and public comparable data. We do stress testing. We do significant downside case modeling and deep dive, fundamental due diligence. And I think when you put all of that into a package, Stewart, it lines up very well and provides good downside risk protection, sleep at night risk, if you will, for insurance-related investors.

Stewart: And the other part of it that always comes up on the insurance side is the capital treatment. So not a consideration for other institutional asset management types, but certainly key to insurance companies. A lot of times they get dinged really hard for particular strategies, and I know that you’re familiar with that. If I’m a CIO, is there a way for me to get access through any sort of a more capital-efficient vehicle?

Kevin: Look, it’s a great thing. I appreciate your raising that. I think given our history with insurers, especially two of the very large ones that I noted, our platform has evolved from managing simple SMAs of unrated loans, to having virtually all of our underlying loans rated to improve capital efficiency. We have established relationships with all the private letter rating agencies, and we obtain those on all of the deals that we originate to improve the capital efficiency charges for our insurer clients. I think we also have the ability now to offer custom structured solutions for our clients over the years. We’ve done that for specific insurance clients to focus on capital efficiency for that individual investor. And I think given the evolution of the market and the demands of the insurance clients in general, we’ve now launched a strategy that seeks the dual goal of capital and operational efficiency. We’ve seen insurers gravitate towards this strategy because it provides simplified access to our underwriting and direct lending strategy that we talked about today, which has brought appeal to the insurers for the asset class, but also provides that capital efficiency that you just asked about.

Stewart: And I guess the last thing, what about capacity? Is there enough capacity in this space? Insurance companies is a large, $8 trillion market and growing. Is there significant capacity here in terms of sponsored middle-market lending?

Kevin: I think there’s a tremendous amount of capacity. I mean, I think when you think of the shift to the private credit asset class from traditional banks and over the last, call it five, seven years, I think the amount of capital that’s been raised in the private credit space has been substantial. And I think the deal flow as a result of that has been substantial. We had a record year last year, closed 140 transactions at the firm. We’re seeing very strong demand for opportunities this year, despite some of the choppiness in the market. But our fundamental belief is the deal flow and the opportunity to invest in quality assets that provide attractive relative value is here, and it’s going to be here for the foreseeable future.

Stewart: Man, I love it. I learned a lot today, Kevin. Thanks a lot. It was a very good tutorial. I came away… People go, how do you know about that?” I’m like, “I learned from the smart people.” So it works out good. So thanks for being on.

Kevin: I appreciate it, Stewart. Thank you.

Stewart: My pleasure. And I mean, I don’t know if you know this or not, but we have just surpassed 80 podcasts and 11,000 total downloads. So I want to say a sincere thank you to the people who listen to us and subscribe to us. We’re available on all the major platforms, Apple, Amazon, Spotify, Pandora, and Google. And you can also find us on our website. One of the things I’m not sure everybody knows is that all of these podcasts get converted into an interview article as well. So if you’d rather read them, that’s fine, but they’re available to play on our website as well. So thanks so much. Kevin Marchetti is a founding partner and chief risk officer with Varagon Capital Partners. Kevin, thanks for being on. My name’s Stewart Foley, I’ve been your host, and this is the Podcast.

Man Varagon
Man Varagon

Man Varagon is a specialist middle-market direct lender, focused on creating value-added financing solutions to private equity sponsors and investors in private credit since 2014. The firm’s approach is highly selective, focusing exclusively on direct lending to the core middle market, structuring loans to non-cyclical businesses in the US operating in recession-resilient sectors, typically with an EBITDA of between US$ 10 million and US$ 75 million. As a trusted partner for sponsors, Man Varagon has completed financing for over 330 borrowers.

Man Varagon is part of Man Group, a global active investment manager, powered by cutting-edge investment technology. With a trading heritage stretching back to 1783 and listed on the London Stock Exchange, Man Group manages US$ 161.2bn* across alternative, long-only and private market approaches for its global client base (as of Q3 2023)

Nick Humphreys
Global Head of Insurance, Man Group
+44 20 7144 3549
US Sales: (212) 649-6600
151 West 42nd St., 53rd Floor
New York, NY 10036

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