The Changing Landscape of the Debt Markets

I'm going to make a self-congratulatory comment because I'm in that kind of mood, but I think that I've put together a fantastic panel because these esteemed gentlemen on this panel are incredibly opinionated. Most of their opinions are wrong, but they're opinionated, and so I expect and I hope this panel to be lively and engaging. So let's start with introductions, and I'd like to start with Cory, and let's rocket through this so we can get into the meat of our commentary.

Thanks, Justin. Good afternoon, I'm Cory Sklar, managing partner with Brookside Mezzanine Partners. We're a private debt fund, is that allowed, headquartered in Stamford, Connecticut, with an office in Boston. We're focused on mezzanine, subordinated debt financing, and minority equity co-investing. We focus on the lower middle market. For us, that's companies with $15 or $20 million of revenue to $150 million and $3 million of EBITDA to up to $20 million. We primarily invest in private equity-backed buyouts or recapitalizations. We also do look at non-sponsored deals, but that's a smaller part of our business. We're industry agnostic. We invest all over the United States. We are currently investing out of our third fund. It's $260 million. Across our three active funds, we've invested in 64 platform businesses, about $450 million in total invested capital. In the last 18 months, we've been pretty busy. We've invested in 13 new platforms and about $120 million of invested capital. And we're an SBIC, so we have— part of our capital source is low-cost leverage through the SBA.

I'm Peter Rothschild. I'm a partner with OFS Capital. We're a publicly traded BDC. I co-founded our SBIC fund a number of years ago. Similar to Corey, we focus on the lower middle market. We make both junior debt as well as minority equity investments. Size is typically $5 to $20 million investment checks, and it's typically in companies that have 3 to 10 of EBITDA. Our focus, though, is primarily on non-sponsored situations as well as independent sponsor deals.

Hi, Jimmy Rich from Gemini Investors. We've been around since '95. We are now investing our 6th fund, which we just recently closed on, and but remain focused on the same thing from when we started, which is companies typically between 1 and 7 of EBITDA, typically $5 to $50 million in revenue. Either looking for growth capital or looking to do some kind of a recap of some kind. We focus primarily on what we call the smaller end of the middle market. We've done 115 platform investments since we got started and typically invest anywhere from $3 to $8 million in any given transaction. And then for larger transactions, we like to partner with other firms as well. We are an SBIC. All 6 of our funds have been SBICs, and roughly speaking, we look at it on a portfolio basis, but about half of our investments are in current pay securities and half of our investments are in non-current pay securities. So while we will typically oftentimes write the full junior capital check either with a partner or by ourselves, in the buyouts or recapitalizations that we do.

I'm Mike Becker with Plexus Capital. I'm the lone Southerner up here, if you can't tell from my accent. We manage about $550 million, and very similar to these guys, we have 3 SBICs. The most recent one is a $300 million SBIC that we're investing out of now. We've done 75 deals since we started in 2005. We're kind of a little bit different. I'd say we like to price risk. So we're not really in need to find security. We're looking for a current pay on the majority of our dollars, but it can be front dollar, it can be back dollar, it can be equity, it can be mezz, it can be, you know, unit tranche. So we're really more about trying to price the risk in the transactions. And we're focused pretty much— we have a few companies that are probably over $100 million in revenue, but we're really focused under $100 million in revenue. Companies all across the nation. I've had the pleasure of working with most of these guys for a while. So I want this to be fun and energizing in here. And if— please, I don't mean to interrupt Justin, but if anybody's got questions, raise your hand. I'm sure we've got some opinions up here.

Mike, do you want to come stand up? One of the reasons that I chose these guys is because while they're all providing some form of debt. They all approach it from different funding vehicles. Cory primarily works with sponsors. Peter's coming out of a BDC. Jimmy's going from a more of a junior capital holistically approach. And Mike is— he'll do anything, he'll do anything, but mostly non-sponsored work. So you're getting a spectrum of, of the market. So first question for the panel is We've heard all day, and I know everyone in the audience already knows this, the market's hot, leverage is up, pricing is down, lots of competition. So I just want to frame— so with that background, Peter, let's start with you. Give me a sense of your perspective of the market with that knowledge of the market is is pretty aggressive. Sure.

I think everyone talks about proprietary deal flow or tries to talk about proprietary deal flow. The reality is finding proprietary deals is next to impossible. When we work with independent sponsors, it represents about 30% of our portfolio. What's changed dramatically in the last 5, 10 years— and I'd be curious your perspective— but the economics for independent sponsors who have deal locked up, have a specific angle on a transaction, we've seen the economics change dramatically. And there are more firms, more SBIC firms, selected BDCs who are looking more and more at independent sponsors as their partners, not as the traditional equity funds would look at an independent sponsor and would look for a transaction to be handed off to them. But the economics of if you bring some industry knowledge, an operator to the table, a locked-up transaction, the economics today for those independent sponsors can be tremendous. And people typically don't talk about what those economics are specifically, but we've seen in the marketplace where it's significant closing fees, significant management fee, and 20 points on the carry, and those deals getting done, which I think if you look 5, 10 years ago, there'd be many more ifs, ands, and buts around it prior to giving those economics. So it's one big change that we've seen.

Yeah.

And if I can just make one other comment, the other change that we've seen, everyone talks about the competition in the marketplace today. Where we see some craziness is in looking at some smaller companies that are getting junior capital using pro forma adjusted run rate type figures on in less than proven business models?

Yeah, Jimmy, you want to take that?

Yeah, sure.

So, um, a few thoughts. I'd say two big things that we're seeing in the market. One, uh, I would call kind of innovation in the smaller end of the middle market, and the other I'd call proliferation. And I'll talk a little bit about both of those. On the innovation side, I think we're seeing a lot of structures that were historically used in $10, $15 million plus EBITDA market coming down market to the smaller end of the middle market. So we are seeing lenders that are willing to give senior lenders 5% paper, 1% AM, light covenants, and that previously was only available in a $10 million plus $3 million plus market. That is now available in the $3, $4 million EBITDA market. And that's, I think, a relatively new and recent phenomenon. On the proliferation side, I think you have a few things going on. You have obviously the emergence of the BDCs and finance companies, and those have really expanded dramatically over the last number of years. You have the traditional lenders who have come back into the market, and then in addition to that, you have the community banks that are out there, where you have a lot of folks who have come from the traditional lending community and have landed at community banks and are saying, hey, we can do this, and do it, frankly, in a lot more kind of hands-on, personal way. And that's, I think, creating an environment where debt is plentiful and you've got all sorts of alternatives. So I think if you ask me over the last 24 months, those are the two big trends that we see at Gemini.

Mike, not much to add. I think, you know, if you look at risk relative to risk-free rate, I think that's what's driving the hot market. And it really spreads— have not, you know, they've actually widened maybe a little bit in the big industry. So I think it's an expectation. And it's hard for us because, you know, for 10 years we priced it saying, you know, 12 or 13%, give me some warrants or give me some co-investors, this kind of thing. But now you have to kind of think your way through the path of, okay, what is the real risk-reward for this $1 when I've got 1% risk-free rate on the 1-year. So it's a changing of expectations of LPs from our standpoint and an expectation of buyers. And the other thing is it's hot. It's been hot for like 3 years. I never talk to anybody and nobody doesn't say it's hot. So it's just hot. You just got to look at more stuff. It's just a statistical analysis, at least the way Plexus looks at it. Of if we see more, we're going to find some good ones. And that's hopefully coming true because we've done deals with a lot of people in the room. And but I think there's a risk pricing adjustment that's more billboard attempt than truly net interest margin.

Yeah.

So my comments sort of follow along with Jimmy's, although Clearly, he sees himself more as a sponsor because what he calls innovation, I was going to say, is more like deterioration. So we work with a lot of kind of lower middle or middle market sponsors, and one of the trends we're seeing is a lot of bigger market terms coming down. And part of that, I think, is sponsors are moving down market, looking for better value. You know, I know there's a lot of intermediaries here and you guys are doing such a fantastic job that, you know, everything is selling for, you know, 8+ times. So they're looking— so the guys that are used to doing $20 million EBITDA businesses are now looking at 10 to 15. And when they do that, they're bringing the deal terms that they're used to seeing up there down with them. And in most cases, they can get them. And similarly, There's a lot of BDCs out there that may have, you know, generally done bigger market deals also coming down, or other, you know, specialty finance companies. And so, you know, now they're looking at the whole capital stack. So, you know, for a subordinated lender like us, you know, we can get squeezed out because, you know, those guys want to put a certain amount of capital out there. They're pricing it attractively, and it creates a fair amount of competition. Condition. But the terms that we're seeing in our market that are unusual, you know, but becoming more and more commonplace are, you know, accordion features, asset-light deals, you know, big acquisition baskets, a lot of latitude on what would traditionally be considered restricted payments. And, you know, honestly, anecdotally, we recently closed a deal with a you know, kind of blue-chip middle market sponsor. We hadn't worked with them before, and they actually served up the senior loan agreement to the senior lender, you know, from their lawyers, which I hadn't seen before. You know, the first draft came from them. It was a precedent document that they had worked with that lender before, but for a company that was twice the size of the one that they were investing in now. So again, that's how these terms are kind of bleeding down into the into the lower middle market. If and when things change, it'll be interesting to see how lenders try to reclaim some of that lost ground. I think it'll be interesting and probably difficult.

So Jimmy, I just want to follow up on the innovation comment because— so you've got senior lenders coming down market or bigger institutions coming down market offering 5% paper, levering up the company, you know, you're going after a high teens, low 20s type return. How do you combat that?

Meaning kind of—

well, we view it as a— in terms of combating it, we view it as a huge competitive advantage if you can create a relationship with a set of senior lenders out there. I mean, what it's obviously doing in the market is it's inflating pricing. And, you know, that— we know that that story will end at some point. We just can't quite predict if it's a year from now or 2 or 3 or what have you. So, you know, that story will end. I think, you know, how I think lenders are differentiating themselves in the market is really 2 things right now. Price, at least for us. No, no, no, actually. And we don't, we don't tend to focus on the price. We actually tell our lending partners, hey, we're focused. You know, we're not going to negotiate with you over a point. We're going to focus on flexibility and relationship and we're going to look at, you know, the ability for you to be flexible on covenants. Give us a little bit of wiggle room. We want you to feel like you're making money, so when we do hit a bump in the road, you're going to remember the relationship work, because we didn't beat you up on all sorts of pricing and kind of what have you. And what we did is we've looked kind of across the portfolio, and we've said to ourselves, which are the lenders who have treated us well in tough situations? And, you know, we're big boys about it. You know, companies hit bumps in the road, people need protection, people need more pricing, people need us to put more equity in. We understand all that, but were they reasonable and thoughtful in the process? And you naturally go down that list, and I'm sure a lot of other folks say this, and say to yourself, those are great folks to work with because in that situation, they were perfectly thoughtful and reasonable to deal with. And so we've tried to bifurcate who we want to go partner with and work with when thinking about those two factors, which is kind of flexibility and what are they like if we're, you know, likely to hit a bump in the road. And I think that's where you can get away from the pricing conversation and you can focus much more on, hey, we hope to do 4, 5, 6 deals with you over a time— over a period of time. We want you to make money and don't want you to feel like you're getting beaten up on that front. And I think that's a much more constructive way to approach the market. And a lot of the folks that we've worked with over time, we've tried to approach it that way with them so that they don't feel like it's about price.

Yeah, I'd like to echo a little bit of that. I mean, I know everybody falls in love with their financial models, and the only thing that you know about them is they're wrong, right? They're either going to do better or they're going to do worse. And if you're really looking at it— and we tend to work with people like Jimmy because of this, It's about the deal. In the small middle market where this group is playing, you know, kind of under $15 million of EBITDA, you know, we're all smart guys. We can financially engineer returns. It doesn't work. We've done 75. Either invest in a good company or you don't. Or you got a good team or you don't. And I always challenge, you know, when the sponsor VPs call me up and they're like, you're really high. I'm like, run your DCF. I'm 200 basis points out. See what it does to your return cash-wise if you really do well on this. But what are you willing to pay for solution provider flexibility and people who understand what you're doing? Right.

And that's—

if they decide they're not willing to pay that, then they don't work with us. If they are, then we work with them. But there's the trade-off. But I'm always intrigued I understand if it's a $50 million EBITDA business, you can catch 100 bps of savings. It matters. But I'm always intrigued at people who think— and maybe I'm wrong and I've just been living the dream for 10 years— but 100 bps on a rate here or 200 bps on a rate here in this world is not going to affect your return. I mean, you're either making a 3 or 4x, or we're all sitting around huddled at a conference table trying to figure out what the hell to do. And I didn't mean to diatribe, but that's—

No, no, no.

I think it's worth saying.

I want to hammer this theme of differentiation because it's such a buzzword. Everyone talks about it. And sometimes I don't know what it means. I mean, Corey, you work with a lot of sponsors. There's a lot of mezz in that world. How do you think about differentiating yourself? Because at the end of the day, you're all going to be centered around the price. I mean, you're all going to be on top of each other at the price.

Right.

And, you know, really what Jimmy and Mike just said, we— you know, it's cliché, but we really focus on relationships. We think about ourselves as relationship-centric. We've been in business since 2001, and over those 14 years, we spent a long time developing strong relationships with sponsor groups. And, you know, You know, that takes time and they need to see how we conduct ourselves during tough times. So, you know, it may be 2 or 3 or 4 years before we get a shot with a sponsor group, you know, meeting with them, talking to them, you know, trying to get them to call groups that we've worked with. But once we get our shot, they always come back again. And for us, the game is sort of, you know, getting on that short list because when a private equity sponsor signs up a deal, They're not going to, you know, they don't want to canvass 10 different subordinated lenders or mezz funds. There's going to be a shortlist of 2 or 3 groups they're going to go to, and we want to be on that shortlist. And over, you know, kind of the, you know, the period of time that we've been in business, you know, the longevity and the market presence we've established, you know, there's kind of 2 factors to it. One is they know we're going to deliver on what we say. So if we tell them we like the deal and we're going to, that we're going to get there with them, barring something in due diligence that would likely crater the deal for them. They can count on us being there on time, ready to close when they need us to close. And then the second element is during the life of the deal when it doesn't go according to plan or according to forecast, how are we going to conduct ourselves? Our pitch is we've invested in 65 businesses, We don't charge amendment fees when there's a covenant problem or things need to happen. You know, we're not looking to make, you know, kind of the last dollar on that. We want to be partners and help be a, you know, solution and not more of the problem. So, you know, really it's, you know, relationship and, you know, I completely agree. You know, no private equity deal ever was made or busted on 100 or 200 or 300 basis points of pricing, but if you pick the wrong partner when times are tough, that can crater a deal. And, you know, that usually doesn't resonate that great when we're negotiating the term sheet. All private equity sponsors, you know, other times they'll tell you they believe that, but when you're negotiating pricing, not always. So, you know, we need to be kind of within the clearing bid in terms of pricing and structure, but around that, you know, our relationships and the track record we've built.

I just have one quick anecdote on the relationship thing. We had a recent deal that we brought a lender in who we'd done a few things with, and they have a really small group, and they do their lending out of that small group. And we brought them what we thought was a $3 million EBITDA company and levered it up probably 2.5 times. About 2 months pass, the deal closes, and $3 million of EBITDA turns out it was actually $1 million. And that's terrible. You guys can all do the math on that. That's a terrible situation. So I hopped on my horse and we went down and saw the bank and said, well, we got a real problem here. This is not a good situation. And let us tell you what we know and when we knew it and how we're going to try to deal with it. And We did that. And over the course of— we solved the problems. We put in a little bit more capital. We, we figured out what was going wrong with the business. And then we, we, we totally solved it. And it's back to doing kind of $3 million of EBITDA. But as a result of that experience, both on our end and on their end, we're going to do a lot more deals together. Because they could have been terribly difficult at that time and really, you know, really dropped the hammer on us. And they didn't. That wasn't their approach. They really wanted to understand the problem, fix the problem. We rewarded them with more rate for the risk that they were taking, and we put more capital in, and all of those things were appropriate. But the fact that you had an opportunity to sit down, to have a conversation, to dialogue about it, that's what we look for in our in our lending partners, because that's going to happen when you do as many investments as firms do over time. You're going to have things that blow up and things that have, you know, problems, and the question is, is how do people deal and address those situations?

So— Yeah. One question I wanted to ask Peter in particular, because he's got the BDC vehicle. I mean, every day you read about Fed Chair is contemplating or eventually going to raise rates. And so it's going to happen. And so when that happens, you in particular, Peter, I suspect that that's probably going to be moderately a challenge for the BDC vehicle or not.

You know, we actually look at it a little differently. So every time— most of our loans at this point are LIBOR-based loans. Portfolios. If interest rates increase by 50 bps, yep, how that affects the portfolio is we then are— we're going to be able to raise our dividend yield by a certain amount. So if interest rates raise by roughly 100 basis points, we can end up increasing our dividend yield to our investors by— I think it's approximately 10 cents a share, which is a great thing for our investor base. So there has been a change that's what's going on in the marketplace, though, at least that we've seen, where we're providing unitranche, we provide sub-debt, we provide equity. We try to essentially be a problem solver for the companies that we work with, for the investment bankers that we work with, of trying to structure the right— put in place the right capital structure for the company where there's not a one-size-fits-all. But we see raising interest rates as an opportunity for us, and where the market is of being able to get the yields that we all want to try to get.

So, Mike, is our rates rising, is that good for us or bad for us?

I'm probably in the minority here. I think it's great for the sole reason that you think about right now with all the global risk you're going to pay, you're going to give the government your money and they're going to give you 1% for a year. That doesn't feel like a risk-free return, or I'm taking so much risk there, especially where the bond market is. So if you can bring yields back up, I think a lot of money leaves our market because there's a lot of people— money flows into our market chasing yield, for lack of a better term. And if money flows, kind of go move more back into CDs or corporates, or things like that. I mean, really, you see this proliferation of, if I can get 5% or 6% yield, I'm hitting a home run from a lot of people. And if rates rise, I understand that, you know, there's the variable rates, but that gross number is very important to people. So I think it's a positive for the lower middle market, in my opinion, from a standpoint of just money kind of pulling out of our market and going to find other places, because right now we're the only place to find yield really for the risk involved. I see. But I'd love to hear you guys' opinion.

I think the other interesting dynamic that's going to happen is I think when rates do start to rise, I think you're going to initially see a meaningful rush to the exit gates. Not that there isn't a rush going on right now, but even more to try to get things done because that's going to ultimately change pricing. For the multiples that people can pay. So the deals that are currently getting done at 10x, you know, in the interest rate environment that we exist in today, I don't think they get done for those levels.

Yeah.

When the, you know, when interest rates come down, it's just so easy to, to finance deals at those levels, but you just can't make the math work. Paying 10x for a lot of the deals that are going on. You're going to have to write another turn or turn and a half of equity check to get these transactions done. And I think people just say that's when pricing comes down. So it will be— that will also help not our exits, but obviously our entry multiples. So it'll be interesting.

So last part of the panel that I'm particularly pleased about, I like making predictions and I I particularly like making predictions from these guys when they're being videotaped, so in the hopes that I could use it against them down the road. So I've asked them to come up with 1 or 2 predictions, whether for the rest of the half of the year or for '16, whatever they're— I gave them a choice. So Corey, we'll start with you. What's your prediction?

So I just have to pick 1 of those 2? I don't have to make 2 predictions?

No, one. One's good enough.

Oh, great. Well, I'm terrible at predictions, so I'm going to take the easy way out. My prediction will be that for the remainder of 2015, I think the markets are at a peak, but that they're going to kind of be at a plateau. I don't think— I don't see a huge change over the next 6 months. Although, you know, just one— another story, one of the sponsors that we work with told me that they're seeing a little bit of a trend in a couple of busted auctions where bankers told them that, you know, their initial LOI didn't hit the clearing bid, so, you know, needed to be 10 times, and they took themselves out of those processes, and then the bankers had to come back to them and say, well, you know, look, you know, throw in your bid, let's see where you're at. So maybe the market's, you know, cooling a little bit. So I think we're going to be kind of where we're at for the next 6 months.

Daring prediction. Daring prediction. All right, Peter.

So I'll look out a little bit. I think that second half of 2016, you're going to see— interest rates at some point rise, I think you're going to continue to see a shakeout at the lower middle market by some of the banks. And I actually think that the secondary market in the lower middle market is going to start to heat up as different players who came down to the lower middle market start to exit that market where they chase yield today because of regulatory concerns, because of interest rates rising. They're going to start to leave that market as well. I don't think it's going to happen in the next 6 months. We We have seen a few players who have actually started to exit where the scuttlebutt is that they're looking to get out of the portfolio investments where EBITDA is less than $10 million of some of the larger— of some of the larger players. I think that trend is going to continue. I think any time you see a very hot market, some of the bigger players, whether it be traditional private equity funds, whether it be lenders, start coming down in terms of investment check and company size chasing those yields. But that inevitably reverses itself. It goes in cycles, and I see that taking place again, again, more likely in 12 to 18 months though.

Okay.

Yeah, I agree, I agree that there's going to be a plateau for the next, um, at least 15. I— it's hard for me to think about much farther beyond that, but certainly a plateau in the market. But I do think when the market, when the market turns, I think the deleveraging story is going to be much worse this time. And I say that because, you know, just looking at a few businesses that we've sold over the last 24 months, one business in particular I can think of, we sold for 12 times EBITDA. 6.5x leverage was used in the transaction. And I just wonder, with businesses in deals like that, how the lenders respond and whether they still want to be in that space when the market turns the other way. And I don't think leverage like that existed to that degree in this end of the market last go-around in 2008. It was, I think, probably in the 10-plus EBITDA market, but not in the 5 and 10 market and not in the— probably not in the 10 to 15 EBITDA market. And I think that's going to be a new experience, a difficult experience for a lot of middle market private equity funds that are between, you know, $250 million and $750 million that are doing deals in that range. What is that like to delever? And how are they going to deal with these companies that are levered at between 5 and 7 times when many of us are used to paying those purchase prices for companies.

Okay.

I predict in March that the UNC Tar Heels will win the national championship in basketball, which I'm super excited about. No, I think we're pretty frothy, and I do think it plateaus the rest of the year. There's a couple of things that can change. If the BDCs get 2-to-1 leverage, That's a big change dynamic in the debt market. I think you can see them get hotter because they're going to push that paper out as fast as they can. And that's, you know, up to the Fed and the governments to see how that all pans out. But in essence, you take a really big subsector of capital and you multiply it by, you know, a third, in essence, and you get 33% more capital just hitting the market. And no matter what it is, 33% more of anything overnight, it floods the market. I think the big banks are just pulling out of our space. They don't want to be in it, they don't care about it, they kind of look up at it. And so there's a barbell effect now in banking that I'm seeing. I don't know if you guys are, but big banks, former lenders of big banks are falling down to smaller banks, and they're doing what we call leveraged lending and things like that. So that's a dynamic that's really starting to happen quite a bit across the country, which then concerns me because the same thing happened in '06 and '07. And, you know, when the banks start to get in heavy again, it's like 18 months we crash. So, you know, those are— there's a couple of things. And then the interest rate environment, if interest rates can go up, maybe that will hold off and people will start to get a little bit more conservative with with pricing and leverage. But to me, I think we're probably going to peak the second half of this year. I think the markets are already starting to turn. And then next year might be a little bit sleepier because people don't really have direction. Because we knew we were going nowhere but up from '10 to kind of right now. I mean, you couldn't go anywhere but up. And so now we're kind of at this spot. And that's all I got.

Okay, all right. I was going to open it up to questions at this point if anyone had anything, but it looks like we were so well spoken that you're just all questioned out. Well, thanks for your time. I appreciate your attendance.

Thanks, guys.

Thanks, everyone.

Thank you.