In Bain & Co.’s 2016 Global Private Equity Report, the consultancy rang the alarm bells for the asset class, highlighting just how important it is for buyout firms today to “mine” their sweet spot in both sourcing and executing upon investments that play into their areas of specialization. This focus on developing and then leveraging the value proposition of the partnership is even more critical in an era marked by high valuations where outsized returns are harder to find. And while most private equity firms have at least begun embarking on their journey toward a defined niche, it’s still a rather novel concept among most private debt providers. This will soon change, however, as specialization provides distinct competitive advantages that are as apparent in the lending universe as they are among private equity sponsors.
Specialization, of course, can take on many different forms. In the middle market – a specialty in and of itself – most equity sponsors will define themselves as either sector specialists or regional firms active in a particular geography. But these so-called “sweet spots” can also take shape around the investment lens employed, whether it’s sourcing turnaround opportunities or candidates for growth, or even the type of assets acquired, be it founder-led or closely held businesses, corporate carve-outs, or public companies’ taking-private situations. The key, though, is that to drive consistent and repeatable returns over time, private equity investors today must operate from a playbook in order understand the intrinsic value of acquired assets, drive top- and bottom-line growth, and then secure an attractive exit. As evidence, Bain offered an analysis showing that in one sample portfolio, “sweet spot” investments yielded a return of 2.2x invested capital compared to a lackluster 1.3x for deals considered out of scope. Moreover, nearly a third of those deals Bain labeled as “opportunistic” in nature, generated negative returns.
In the private debt markets, however, the competitive landscape is not yet as crowded as it is among private equity firms. Still, specialization is becoming a critical differentiator that not only helps serve borrowers with a value-added, non-dilutive source of capital, but also supports the lenders themselves. Specialization allows private debt providers to help build strong relationships in the regions or industry sectors they serve, similar to the regional and community banks they’ve since replaced in many local markets. At the same time, specialization translates into better industry credit analysis, allowing firms to understand the real opportunities in front of the companies they’re backing or root out the unseen risks.
In the debt markets, specialization has some critical differences, however. Similar to buyouts, lenders will often focus on a particular area of the market defined by the size of the companies they’re backing. Even the demarcation between the lower middle market and the middle market can be a critical distinction for lenders, affecting everything from the due diligence that goes into underwriting a particular credit to the type of debt or structures that are prevalent in the respective segments. The lower middle market, for instance, is far less influenced by the flows of the high yield market, so structures such as covenant lite loans rarely trickle down to companies between $3 million and $30 million in Ebitda size.
Specialization among lenders can also take the form of sector expertise, but unlike private equity, there is rarely the tendency to focus on either one or just a handful of industries. For lenders, it’s about developing the capabilities in a given space, but there is no real demand to place limits on a firm’s target industry sectors. At Monroe, for instance, we operate in verticals ranging from healthcare and technology to media and consumer products, as well as specialty finance, and we leverage past experience across a wide range of other sectors. Whereas private equity firms may pursue three or maybe four investments in a given year and seek a proactive role in managing the assets, lenders may back ten times that number and take on a more passive role as it relates to oversight. In this regard, the focus on specialization is largely about being able to navigate a given vertical and understanding the distinct capital needs of the companies in that space.
Lenders will also seek to define their value proposition around the type of debt they offer, be it cash flow-based loans, asset-backed facilities, or enterprise value-based debt. It could be facilities that help effect an Employee Stock Ownership Plan, or it could be a unitranche facility that allows borrowers to consolidate their term debt, mezzanine financing and working capital lines of credit into one aggregate loan facility at a blended interest rate. Others may seek to compete purely on price or find their niche serving just one layer of the capital structure. Again, it’s about having the capabilities in place and the teams to execute upon the distinct needs of clients. Private equity borrowers, for instance, have far different needs than unsponsored companies seeking non-dilutive financing for growth initiatives, such as mergers and acquisitions, or to meet seasonal working capital needs.
At the end of the day, the real value in specialization comes from an ability to see value where others don’t or avoid over-valuing assets to the point that the companies can’t easily service the debt, together with some margin of security. This expertise also allows lenders to move far more quickly in providing answers. Take our commitment to Forbes Media, a company that following the financial crisis was considered a contrarian media deal by most observers. We offered the company a refinancing arrangement that allowed several other lenders to exit. This was in an industry – publishing – that was being turned on its head by the disruption of digital media, and focused on a segment of the market – financial services – that was in total disarray in the wake of the Lehman Brothers failure. Our familiarity with the space and conviction around the opportunity in front of Forbes, which had already begun its digital transformation, allowed us to see the potential in the business. It has since proved to be a very successful relationship. On the other side of the coin, the collapse in energy prices over the past 18 months caught several lenders by surprise, particularly those that rushed into the sector amid the fracking boom enticed by high interest rates. We tend to avoid areas that we can’t adequately value, so while we missed out on the returns available on the front-end of the shale energy ascent, the ensuing downturn had virtually no effect on our overall portfolio.
As the private debt market continues to grow, with existing lenders growing assets under management and new players emerging every day, the need for specialization will only become more pronounced. Those that compete on price alone, as has always been the case, will find borrowers who are looking for nothing more than cheap, commodity-type financing to fill a hole in the capital structure. Providers who define themselves purely on price will come and go with the markets. Increasingly, though, borrowers are going to demand the value add that specialization brings, not only because this expertise represents a valued resource, particularly in the lower middle market, but primarily because it will serve as the mark of a lender that understands their clients’ needs and can bring a level of attention to detail and awareness that will help redefine the role of private debt over time.
Ted Koenig is the CEO of Monroe Capital LLC, a Chicago-based provider of senior and junior debt and equity co-investments to middle market companies in the U.S. and Canada.