PitchBook January 07, 2016
Chris Flynn is co-CEO and co-chief investment officer of THL Credit and THL Credit's Direct Lending platform. To contribute to our recently released 2016 Crystal Ball Report, he took some time to chat with us about the current credit environment, investment structures, and leverage and pricing levels, among other topics.
Can you speak to the leverage levels and pricing seen in recent transactions relative to what has played out over the past couple of years?
Driven in part by a supply-demand imbalance with too much capital chasing too few deals, and further supported by strong underlying performance within most sectors, leverage and pricing have reached increasingly aggressive levels over the past couple years, back to pre-recession levels. Although more recently the broadly syndicated market has seen some volatility with ripple effects into segments of the middle market.
By contrast, THL Credit focuses on the lower end of the middle market where, although still competitive, we have consistently seen better opportunities to structure with more conservative leverage and attractive risk-adjusted yields. The equity returns of our sponsor clients are typically driven by significant growth in their portfolio companies, and although leverage and pricing remain important considerations, they put a premium on relationship, certainty and flexibility when choosing a lending partner.
Has competition shifted the way you view, structure or manage your direct lending approach? If so, how?
As commercial banks pull back due to tightened regulations, the void has been filled by finance companies, private funds, SBICs, BDCs and other asset managers that are not subject to such tightened regulations. Middle market direct lending has gained more attention as an asset class with new and existing lenders raising significant capital in recent years.
Aside from leverage and pricing, some of the competitive factors distinguishing lenders today include certainty and speed to close, hold size and flexibility. The first three can help sponsor partners compete in frothy auctions while the latter provides the wiggle room often needed to execute on their investment thesis. The unitranche product continues to gain market share, and has been a growing part of our portfolio, because it checks a lot of these boxes and allows an efficient documentation and closing process.
Another way THL Credit seeks to differentiate is through the delineation of our investment team into distinct industry verticals. This sector-focused approach has allowed us to build stronger relationships with our sponsor partners by seeking to add value during due diligence, underwriting, and throughout our hold (e.g. getting more aggressive on the front end in sectors we like, and trying to avoid surprises post-close by better understanding risk factors). This follows a broader trend with sponsors and their investors who are seeking greater industry specialization.
As we approach the later stages of the current economic and credit cycle, how do you view credit quality and appropriately structure the credit investments you make?
With the caveat that we are not economists and do not rely on timing the market, but based on a wide range of opportunities viewed this year, we see a mixed bag of sectors with strong growth, slowing growth or early declines. As for the credit cycle, in our opinion we are at or nearing a peak based on high leverage and low default rates. The exercise on a deal-by-deal basis is assessing macro and micro factors that could impact cash flow available for debt service and structuring appropriately. In general, the quality of opportunities brought to market this year has been slightly down, but in our experience attributable more to mix shift than cyclical factors. We have seen many of the stronger businesses which performed well in the last downturn sold or recapitalized, maybe multiple times, since the recession. As a result, deal flow this year has been comprised more of storied businesses that may be cyclical, capital intensive, have high fixed costs, or concentration issues. In these cases lenders may need to build in additional cushion to sustain through any softness, usually through a combination of lower leverage and contractual deleveraging (amortization or cash flow sweeps). Although many of these deals are getting done, among the lending community there seems to be a broader flight to quality; meaning a preference to lend to businesses with stronger and more stable cash flow characteristics given where we are in the cycle.
What are some of the most vital factors you consider before deploying capital in the present environment? How do you shift your investment approach due to these factors?
A key factor for THL Credit has been a multi-year shift towards being higher in the capital structure. Given where we are in the cycle, we have generally seen more attractive risk/return opportunities in secured loans (first and second lien as well as unitranche) where our attachment point, leverage, and security protections give us greater comfort in weathering the next storm and allow us to be in a better position to support our clients. We believe our funding model allows us the flexibility to propose the best structure for a wide variety of deals.
The most vital factor remains the relationships that we have with private equity sponsors, other lending institutions, and management teams. In any transaction, we are not just underwriting the business and its cash flows, but also the people that we will be investing alongside.
To get free access to our 2016 Crystal Ball Report, click here.