Direct lending: Navigating risks and opportunities in the US middle market
Global Investment Insights
with Tas Hasan, Partner & Chief Operating Officer, Deerpath Capital
The US direct lending market is now estimated to be US$1.2 trillion in size, rivalling the traditional high yield bond and broadly syndicated loan markets.
In this exclusive interview with Global Investment Institute (GII), Tas Hasan, Partner and Chief Operating Officer of Deerpath Capital shares his experiences navigating the US middle market, how his organisation is providing investors globally with access to this burgeoning opportunity set in direct lending to middle market corporates, and the key pitfalls for investors to avoid in order to minimise credit losses.
Tas will be visiting Australia from 5 – 9 December 2022. To express interest in meeting with Tas on his visit, please contact Ben Daly, Head of Investor Relations – ANZ, Deerpath Capital, Australia.
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We believe that the US market still has considerable growth and requirement for additional capital as traditional commercial banks continue to reduce their loan book exposure to middle market corporates.
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Q. Can you share with us some background on Deerpath Capital and the key differentiating features that are key to its success?
“Deerpath Capital was established in 2007 by the founding principles Gary Wendt, John Fitzgibbons and James Kirby. I also joined the business at the onset and became a Partner in 2015. Together we set out to create a firm solely dedicated to providing investors access to the large and growing opportunity set in direct lending to middle market corporates in the US.
“Since our establishment (2007) over 15 years ago, Deerpath has invested US$8.1 billion almost exclusively into first lien, senior secured loans to companies in the underserved US lower middle market. We are differentiated based on where we play (lower middle market), how we transact (safety over yield) and longevity (we have not changed our strategy and the market in which we play for over 15 years).
“Our focus on the lower middle market allows us to effectively compete in a much less crowded segment that offers attractive economics and superior structural protections, not available in other parts of the middle market.
“We have developed a comprehensive and robust origination network that is pivotal to our business with 5 origination offices (New York, Chicago, Boston, Los Angeles and Fort Lauderdale) and approximately 23 dedicated investment professionals spread across the US, allowing for complete geographical coverage. We are able to originate over 2,100 deals a year, all the while adhering to our safety-first approach to execute on less than 3% of platform deals.
“Additionally, this year has seen Deerpath open investor relations offices in the UK, Australia and most recently in Korea, growing our total business to over 80 employees.
“We continue to invest in our business to provide an ever-broader range of investors from different geographies the opportunity to access a unique and growing investment class with a differentiated and proven manager.”
Q. What are the main drivers of the growing investor appetite for private credit opportunities and how is this impacting direct lending markets, more specifically?
“The desire from a wide range of investors to access opportunities in the broad descriptor, private credit, has been a growing theme over the last decade and a half, since the GFC.
“A combination of central bank, government and regulatory policies coalesced to open up markets previously inaccessible to most investors.
“This, combined with a structural increase in demand for yield, has seen institutional, wholesale and individual investors progressively look to add greater exposure to private credit markets, like direct lending.
“Crucially, the esoteric nature of the assets requires specialist managers with proven expertise and access to make these opportunities available and appealing to end investors.
“The effects of this increased access have been two-fold. An ever-larger amount of capital coming into the space and an ever-increasing number of investment managers looking to act as the intermediary to deploy it.
“We believe that the US market still has considerable growth and requirement for additional capital, as traditional commercial banks continue to reduce their loan book exposure to middle market corporates.
“The capacity for continued non-bank lending growth in markets like Europe and Australia is not quite as clear cut because these markets have different commercial banking dynamics relative to the US, but, directionally, they are also enjoying increased demand from investors.”
Q. Within direct loan market what are the characteristics that differentiate the lower-middle market from the broader middle market and how do you expect the opportunity set to evolve over the coming 12-18 months?
“Deerpath defines a lower middle market (LMM) company as one with an Enterprise Value from US$50 million to US$150 million and typical loan requirement from US$25 million to US$75 million.
“We deploy capital into the LMM via our self-originated opportunities where we see less competition for deals. Because of this, there are more attractive risk/return characteristics in this market. Yields tend to be higher and leverage levels are lower (<50% loan-to-value, 3.5x-4.0x debt/EBITDA). There are also more robust lender protections in place (maintenance convenance triggers as standard).
“Additionally, our borrowers have many years of operating history (typically 15+ years), a proven level of earnings power and are owned by a private equity sponsor. We compete very effectively for this type of loan. Our size of borrower is too small to be served by the leveraged finance department of an investment bank, which is the part of the bank that competes aggressively for cash flow-based term loans.
“Instead, the banks which want to work with a borrower of this size generally cover the borrower through their local business banking unit. These local business banking units generally do not compete aggressively for the cash flow-based term loans.
“Moreover, the larger direct lenders cover a different set of private equity sponsors that tend to purchase companies valued at over US$150 million. While the risk levels tend to be higher from a leverage and protection standpoint, this space is attractive to large middle market lenders as they can deploy more capital per person, boosting their profitability. This leaves many smaller sized businesses that have the right characteristics for a cash flow-based term loan to be underserved, thus creating an attractive opportunity for Deerpath.
“The next 12 to 18 months may prove to be a pivotal time for private credit markets. With borrowing costs amplifying the rising level of expenses already caused by severe inflation, it will be interesting to see which managers have portfolios that will were built to withstand the continued pressure on earnings. On top of this, once revenues take a hit in a recessionary environment, we believe that we will see a clear separation between those lenders who played it safe during the boom times and those that took elevated risks.
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The next 12 to 18 months may prove to be a pivotal time for private credit markets. We expect to see the concerns that have seen the more liquid leverage loan and high yield bond markets sell off this year to start to be reflected in the quarterly revaluations of private credit manager loan books.
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“Lenders who have exposure to larger borrowers are most at risk to deterioration in their loan books. Larger companies tend to carry far higher leverage and maintain lite or no covenant terms within their structures.
“We believe our loans, with their higher yield compensation and additional lender protections, will weather any deterioration in the broader credit cycle well, as our historical (very low) loss ratio would attest.”
Q. What kind of risk management do you apply when evaluating deals to manage risks and minimise credit losses?
“At Deerpath we have always maintained a safety-first approach to investing our clients’ and, indeed, our own capital because at the most basic level, credit investing has an asymmetric return profile, with a capped upside and potentially a large downside. Therefore, our conservative philosophy is fundamental to our entire organisation and investment process.
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We have always maintained a safety first approach to investing our clients’ capital. Our conservative philosophy is fundamental to our entire organisation and investment process.
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“We look at each investment decision independently. At every stage in our process, we look to identify and then mitigate the key risks associated with the investment. Some typical examples of considerations we take into account when considering a potential investment and how risky we perceive it to be include (among others):
We avoid second lien or mezzanine investments.
We will decline a deal if the business is not of good quality or is not consistently profitable.
We avoid highly leveraged businesses.
If the management team is not seasoned and well regarded or if the primary thrust of the overall transaction is that a company founder is looking to cash out.
We do not take bets on customer concentration – this is a very important metric in the lower middle market to diligence.
Any unethical or illegal activity on behalf of the company, management team or owners would cause us to decline a new investment.
High exposure to technology risk or regulatory risk also typically causes us to decline a new investment as does any sector that has high sensitivity to the broader economy.
We do not invest in businesses we do not understand. Our portfolio is made up of commonplace service-based businesses that can be found in any local economy; these are the businesses that will hold up during a recession as they are needed services.
“Finally, our sole focus on sponsor backed companies provides the key safety protections as we negotiate terms that clearly incentivise the sponsor to play a big role in protecting Deerpath in the advent of any deterioration in a company’s financial health.
“Importantly, we also have a strict ESG policy that restricts investment in companies that operate in industries that are not susceptible to reputational or headline risks and are not involved in ethically challenged or controversial businesses.”
Q. As demand for direct lending increases what are the potential pitfalls for investors looking to access these markets?
“At Deerpath we recognise that there are many other non-bank lenders with larger amounts of capital to deploy who provide cash flow-based term loans, but they often focus on company sizes larger than US$150 million. There are powerful economic reasons for this.
“Many other non-bank lenders are managing much larger pools of capital than Deerpath but have an organisation headcount of similar size. They do not have enough people on their team to deploy all of their capital in small size loans (US$25 million to US$75 million).
“In addition, it is much more profitable for a fund manager to focus its team on larger loan sizes. As a general rule, it takes about the same amount of time and effort to put together a US$25 million size term loan as it does to do a US$100 million size term loan. A fund manager who has their team focused on originating loans in the US$100 million facility size can manage 10x as much capital as it could if it had the same team doing US$25 million size loans. This makes a big difference in the profitability of the Investment Advisor if it is receiving a fee stream tied to AUM.
“Not surprisingly, many managers who have the ability to raise capital move “up-market” over time, to the US$100 million size loans, because this is much more profitable for them. The negative is that this pushes them into a more competitive segment of the market where organisational leverage is higher, structures are less conservative, and yields are lower.
“Another key area that investors should focus on when looking at private credit is what are they using an allocation for and where will it be funded from. If an investor is looking to add additional yield to a traditional fixed income allocation or defensive alternative bucket, then senior direct lending is an optimal way to improve overall risk and return.
“Allocations that can have a higher tolerance for risk of loss and volatility could look at the more ‘story’ credit sectors like special situations, distressed or mezzanine which can potentially meet the higher return thresholds required.
“At Deerpath we have been fortunate to grow quickly but strategically, and we want to continue to do so; but we plan to grow by investing in a larger volume of loans at the same, smaller loan size, rather than by increasing our average loan size to compete in the crowded core middle market space. We plan to continue adding people to expand our organisation to support this growth.”
Tas Hasan, Partner & Chief Operating Officer, Deerpath Capital
Tas is a Partner and Chief Operating Officer (COO) of Deerpath Capital and a senior member of the organisation’s investment committee. He joined Deerpath Capital in 2007 and has 21 years of industry experience. Previously, he was an investment professional on credit investment teams at Dune Capital and GSC Group.
He began his career in investment banking at RBC Capital Markets in 2001. Tas is a graduate of Ithaca College (B.S., 2001).
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