Archives for May 30, 2024

The Dynamic World of Private Credit
Reflecting on the past eighteen months, it’s hard not to be reminded of the old saying, “The only constant in life is change.”

The rapid pace of change and disruption in the credit markets has been reminiscent of the Global Financial Crisis. The commercial bank and broadly syndicated markets have shifted abruptly — especially in the middle market — leaving traditional lending as a less viable option for the average middle-market borrower. While these markets have begun to reopen recently, the landscape has been forever altered.

The void left behind by commercial banks and syndicated markets was a tremendous opportunity for private credit. Direct lenders stepped up to fill the gap – and take market share – in a manner that not only provided borrowers with necessary capital but also captured the hearts and minds of the market. Direct lenders gained market acceptance as the more straightforward and predictable alternative to the broadly syndicated markets.

To be abundantly clear, debt placement is not something private equity firms can’t do — on the contrary, it’s been a part of their business model from the start.

The private credit landscape is clearly more dynamic now than at any time in the past. As the asset class has grown, existing direct lenders have increased assets under management, typically also increasing hold size. In addition, new direct lenders have also entered the market at an unprecedented pace. While some new direct lenders are entering the lower end of the middle market, many have debuted with $1 billion plus inaugural funds.

The frenetic changes in the private credit landscape have led private equity firms to face a hard truth when it comes to sourcing financing — the days of approaching a discrete number of key relationship lenders to achieve best execution in debt financing seem to be in the rearview mirror.

Financing as Table Stakes
To be abundantly clear, debt placement is not something private equity firms can’t do — on the contrary, it’s been a part of their business model from the start. The typical debt financing strategy employed by private equity professionals involves a limited outreach to select relationship lenders.

Although this approach tactic does not offer a true “market test” of terms, it has worked reasonably well in the past — especially in the world of cheap and abundant debt capital. In that environment, the market was relatively efficient, and terms were more or less consistent across direct lenders.

Staying abreast of market appetite at a lender-by-lender level is key to finding the right lender.

In today’s capital markets, which are less efficient and more dynamic, broader outreach is critical to ensure optimal execution. Best execution (and best terms) means finding the right lender for the right opportunity at the right time.

This requires extensive outreach to the right group of lenders —including some brand-new lenders. While it is certainly possible for private equity to execute this plan on their own, it is often not the best use of time for these professionals. In the “higher-than-longer” interest rate environment, sponsors are increasingly focused on value creation strategies at the portfolio company level to drive returns. It is not typically in the best interests of a private equity firm to allocate the internal time and effort required to run a debt placement process. Those resources are best deployed elsewhere — finding the best management team, identifying potential add-on acquisitions, setting portfolio company operating strategy, and a host of other value creation efforts.

Finding the Right Lender…
Staying abreast of market appetite at a lender-by-lender level is key to finding the right lender. The rapidly evolving lender ecosystem requires full-time effort and constant activity in the market. This real-time intel is the only way to effectively navigate and create a healthy competitive dynamic amongst lenders in a debt placement process.

Identifying the right lender at the right time depends on the lender’s current risk appetite — whether they are ‘risk on’ or ‘risk off.’

The right lender for a given portfolio company is often not the last lender to do a deal with the same private equity firm. Instead, the right lender is a function of the borrower’s credit profile. Increasingly, direct lenders have been selecting industries and even subsectors where they will be more aggressive. Conversely, a lender that happens to have a troubled borrower in a given industry may be leaning out of that industry.

The level of effort required to constantly monitor lender activity is not feasible for most private equity professionals as they are typically balancing other higher value creation activities.

…At the Right Time
Identifying the right lender at the right time depends on the lender’s current risk appetite — whether they are ‘risk on’ or ‘risk off.’ This is further complicated in an ecosystem that is changing as rapidly as private credit is evolving. New lenders are being formed on a near-weekly basis, and Configure data shows that 60% to 75% of the most active lenders are replaced by a new cohort of active lenders every six months.

As new lenders raise funds and enter the market, they are under pressure to deploy capital, creating a pronounced “risk on” posture. Conversely, lenders who are actively fundraising or in the late stages of their fund may be more “risk off” over that period of time. The ebb and flow of individual risk appetite within the broader ecosystem of private credit further reinforces the necessity of constant market activity.

The Growing Case for Outsourced Debt Placement
There are two primary factors that contribute to the best execution in a debt financing: real-time knowledge of the market and appropriate breadth of outreach.

Real-time knowledge and market intelligence about the lender ecosystem and behavior form the basis for determining which lenders should be contacted for specific opportunities. Constant transaction activity is the only way to truly know the market. Most private equity firms evaluate between three and seven financings in a given year — a combination of new platform financing and portfolio company refinancings. To put this in perspective, Configure is engaged on 30 to 50 debt placements in a given year. This depth of market intelligence is impossible to create synthetically.

If each lender needs an hour of time — not an unreasonable request — then the time commitment begins to approach that of a full-time job – beyond the already full-time effort of getting a new transaction to close.

Appropriate breadth of outreach is also critical to a true market test and this breadth is directly informed by real-time market knowledge. The “appropriateness” of the breadth of outreach can be violated in both directions — too broad or too narrow. The objective is not to email blast a large set of lenders and wait to see who responds, nor is it the objective to select and approach only a handful of lenders. The objective is to identify the right set of lenders who are high probability and then provide those lenders with the time and effort necessary to address their questions and help them understand the opportunity.

The outreach itself can be time-consuming and often difficult to manage with a private equity sponsors team during the storm of activity involved in closing a transaction. Compounding this time pressure is the necessity to dedicate time and effort with each lender to answer questions, ensure they understand mitigants to key credit concerns, and address a multitude of other important lender questions.

If each lender needs an hour of time — not an unreasonable request — then the time commitment begins to approach that of a full-time job – beyond the already full-time effort of getting a new transaction to close. As the process moves into management presentations with lenders, negotiating term sheets, and ultimately credit agreement and documentation, the time commitment only builds, distracting from higher value-add activities along the way.

Many private equity firms have realized that the considerable investment of time and resources required in a financing process does not deliver an appropriate return. Reallocating those resources to evaluate and close more deals or to improve profitability at portfolio companies is more effective at driving returns and fund performance.

The Configure Difference
Configure Partners is a credit-oriented investment bank specializing in debt placement. The firm provides the highest level of client service and execution to middle-market private equity sponsors in acquisition finance, refinancing, and dividend recapitalization transactions.

Configure is one of the largest firms dedicated to debt advisory. We’ve developed our processes and systems to ensure execution across all types of financing transactions. Unlike other debt placement groups, we don’t treat debt advisory as a secondary service offering to M&A – debt placement is our entire business.

As previously stated, private equity firms often rely on a “relationship” lending approach, typically limiting outreach to a discrete set of lenders that have financed other portfolio companies. Make no mistake: relationships are critical and Configure takes great care to include relationship lenders in the outreach in a manner that is respectful of the existing relationships.

Of course, the pressure of a competitive process often encourages relationship lenders to tighten up on terms to secure the deal. It’s not unusual for a competitive process to drive both increased leverage/proceeds and reduced economics in the form of reduced original issue discount (OID), lower interest rates, lower fees and other areas of savings. At the end of the process, the private equity firm or borrower is able to compare proposals from the set of relationship lenders alongside proposals from new lenders and determine the preferred solution.

This holds true in refinancing engagements as well, where the incumbent lender is typically assumed to be the “best” answer. A broader, competitive process almost always results in a materially improved refinancing proposal from the incumbent lender. Sometimes, the improved proposal of the incumbent lender is determined to be the best solution; sometimes, a new lender will displace the incumbent. In both examples, the benefits of a financing process almost always outweigh the cost of the debt placement advisor. In fact, the fee paid to the advisor by the private equity sponsor or the borrower is typically recouped through improved financing economics in less than twelve months.

About the Author
Joseph Weissglass is a managing director at Atlanta-headquartered Configure Partners. He joined the firm in 2017 from Guggenheim Securities where he was a vice president in the firm’s special situation group. Earlier in his career he was with Barclays Capital in its restructuring and finance group. Mr. Weissglass has his undergraduate degree in construction science and management from Clemson University and his MBA from the University of North Carolina.

If the above article has sparked a question or thought concerning hiring an advisor for financing, please feel free to reach out to any Configure team members. Mr. Weissglass  can be reached via email at jweissglass@configurepartners.com.

© 2024 Private Equity Professional | May 31, 2024