CJ Doherty: Welcome to the Lending Lowdown. I'm CJ. Doherty, Director of Analysis at LSEG LPC. Our most recent podcasts have covered topics ranging from the CLO market to library cessation to the commercial real estate market. Today we're going to talk about private credit and BDCs in what is our 16th podcast in the series. And so I'm delighted to be joined today by Laura Holson, Managing Director and Chief Operating Officer at New Mountain Capital. Laura, thanks for joining me.
Laura Holson: Yeah, happy to be here. Laura, before we dive into the Q and A, can you give us a little bit of background about New Mountain for anyone who's not familiar?
Laura Holson: Sure, I'm happy to. New Mountain Capital is an alternative asset management firm. We have about $40,000,000,000 of assets under management across private equity, credit, and net lease. And we focus across all of our business lines on investing in what we call defensive growth sectors like software, healthcare, tech enabled business services. All sectors that are growing and that we think will be resilient in all macroeconomic environments. And I'm one of the portfolio managers for our direct lending business where we focus on lending to the same types of defensive growth industries. The New Mountain Capital has studied over its past 20 plus year history. And we do have a publicly traded business development company, NMFC, as well as some private credit funds as well.
CJ Doherty: Okay, great. So let's kick things off by discussing retail money. As you know, a large amount of retail investor money has flowed into the private credit space in the last two years. Can you talk about the evolving interest in private credit from retail investors?
Laura Holson: Sure, so I think of interest in private credit has really grown dramatically, both from retail as well as institutional investors. I attribute the increased retail interest to a couple of things. Namely, the enhanced yield that direct lending offers, combined with the exposure to floating rate loans. As base rates have risen, investors have really benefited from that rise in underlying base rates. If you compare the volatility adjusted returns of direct lending to the high yield market or leveraged loan, the direct lending market stacks up very well from just overall return perspective. Direct lending has been a very resilient asset class. We've seen really good credit performance despite the broader market volatility. Obviously the floating rates that I mentioned, the fact that the underlying assets are senior secured in nature. So I think it is a very attractive risk adjusted return, which is why retail money I think has flown in in particular.
CJ Doherty: Okay. And so how has the money from the retail investor base impacted the direct lending market and will it continue?
Laura Holson: Yeah, it has helped. I think the industry really grow in terms of both size and visibility. The industry has definitely evolved a lot over the last decade. From I think, something that most people had never heard of, to an industry where some of the players are really more household names. The data isn't great, but just to give you a sense of the scale, the private credit industry is probably about 1.5 trillion dollars today. So it's really grown dramatically, putting it on par or even greater than the high yield and leverage loan market. It's something that cannot be ignored by either retail or institutional investors. At this point, we do think the direct lending market is really poised to continue to grow. If you look at the dry powder for private equity firms, that gives us really high conviction on the outlook for the direct lending market as well.
CJ Doherty: And your firm manages BDC's business development companies, you know. So given the current market environment and the economic backdrop, do you see opportunities to generate strong risk adjusted returns for investors through public BDC's? And what are the opportunities and the challenges?
Laura Holson: Yeah, absolutely. I mean, we're bullish on private credit for I think a variety of reasons. We do see deal activity picking up the direct lending market has taken meaningful share from the syndicated loan market. In addition to that, we've seen capital structures, they're very attractive. Right now we're lending at dollar one in the capital structure where 60 to 70% of the capital structures really sponsor equity or junior capital below us. It feels like a pretty safe place to be in the capital structure. And in doing so, we're generating a double digit unlevered yield. The BDC is, I think, a pretty attractive structural wrapper in that it delivers enhanced yield for lending to a pretty diversified, but also very curated underlying portfolio. There are multiple forms of BDC's out there. You have public BDC's, like our NMFC, where investors have daily liquidity, pretty good transparency into the underlying assets while receiving a pretty consistent dividend yield. We do think the returns are pretty attractive for BDCs. And from a challenge perspective, it's all about like it is in credit, always avoiding mistakes. Underwriting is key because it's hard to make up if you have an underlying loss in one of the underlying assets.
CJ Doherty: Now to touch on credit quality, I think as we all know, interest rates have risen sharply in the last 15 months or so, but non accrual and default rates remain relatively low. Our portfolio company is showing signs of much stress. What's your outlook here?
Laura Holson: Yeah, clearly when you see interest rates rising, I think about 500 basis points in 18 months. That is going to have an impact on the underlying companies, but our portfolio continues to perform really well. There's a handful of underperformers, but overall not a lot of stress. We developed a heat map actually during Covid to try to just visually show how our underlying portfolio is doing. And we rate the names from green to red, where green is indicating in line or stable performance and red is obviously indicating very challenged performance. To give you a sense, our portfolio for NMFC today is 93% green and 5% yellow, with only 2% in the orange and red category. We attribute that to the industries that we focus on, which have what we think are innately attractive cash flow characteristics such as high bad margins and free cash flow. Generative natures just given a lot of what we're doing. As I said upfront are more technology and services type businesses. These are pretty asset light and therefore don't have a lot of Cap X or working capital needs. I do think it's important to remember the loan to value also. I touched on this on your last question, just around capital structures and the amount of equity cushion that's in a lot of these companies. To give an example for $1,000,000,000 deal, that's maybe structured with $300 million of debt and $700 million of equity, which is a pretty typical capital structure that we're seeing. If rates move 1% that's $3,000,000 of incremental interest. Or if it's 2% it's $6,000,000 and you need to put that in the context of the $700 million of equity already in the deal. It's pretty de minimus impact as long as the company is still a good business. Sponsors should be incentivized to support it even if rates have gone up. And we've seen that really in practice where sponsors have been really proactive supporting companies with additional capital, either for liquidity or for M and A. Maybe a little bit long winded, but generally, we feel good about the state of our portfolio for the reasons I just mentioned.
CJ Doherty: Yeah, makes sense. Sounds pretty good there. Now we want to talk about private credit versus banks so it's another area which has evolved in recent times. And I think you mentioned it in passing a little bit earlier. From your vantage point, what role will private credit play going forward given changing banking appetite and the recent volatility in the regional banking sector?
Laura Holson: Yeah, we expect private credit to continue to play a bigger and bigger role in the market. We've seen a secular shift towards direct lending over the last ten plus years because of the benefits that it offers private equity sponsors. The way I think about those are it's faster, easier, and more certain execution because you're not taking market risk because you're not in market for weeks, you're not getting flexed on terms because again, you know the terms up front and you're not needing to go to the rating agencies to get a rating. And it also tends to be more flexible capital and a lot more relationship oriented. As I said, that's been a shift that's been occurring for a while, but it's been accelerated. I think recently in light of the volatility that you mentioned. The syndicated market has was closed for a while. It's slowly reopening, but only for certain credits with certain capital structures. Over the last several months, the direct lending market was really the only market open to sponsors. During this period of time we've had sponsors who previously only ever went to use banks, but now they've tried the direct lending market and realized, I think, all the benefits that it offers. You also have a phenomenon where growth begets growth to some extent. Because $1,000,000,000 financing used to have to go to the syndicated market in order to get done because the direct lending market was just too small. But again, now given the scale of the industry that I mentioned before, you can pretty easily club up a 2 billion $3,000,000,000 or larger direct lending deal together. Size is really no longer a limitation for all of those reasons. The fact that it's actually a really good and elegant financing solution for sponsors and because of the fact that The market has grown to really accommodate larger borrowers. We're pretty excited about the outlook for direct lending.
CJ Doherty: Okay, cool. And in terms of just so far this quarter, what are you seeing in terms of deal terms and conditions? Anything interesting? Yeah, we think 2023 is a very attractive vintage for direct lending. As I talked about, overall deal volume was down in one versus 2022, but deal activity has been picking up in recent weeks. We're seeing some really high quality businesses be acquired by top private equity sponsors at very high multiples. And at the same time, leverage has been pretty reasonable because when you're writing with base rates at five plus percent today, they're really constrained by interest coverage. So they can't take leverage necessarily to the same level that they might have been able to do so in 2021, for example, when you're underwriting. With that in mind, the capital structure set ups are really compelling. And then you overlay that with spreads that are pretty attractive by historical standards, you can easily pence out a double digit. Unlevered yield documentation terms have also probably tightened a bit from where they were a couple of years ago. As I said, overall, 2023 vintage for direct lending in our view, is attractive.
CJ Doherty: Yeah, before we finish up, it's always good to look ahead. What's your look for the rest of the year in the private credit space? What should we be keeping an eye on?
Laura Holson: Yeah, we are optimistic for the rest of the year. We expect deal activity to continue to pick up. When you think about the private equity dry powder that I mentioned before, as well as the overall maturity wall for existing issuers, we think there will be a busy back half to the year here. I think in terms of what we need to keep an eye on, clearly we always need to keep a close eye on credit. We think that's the most important. Again, in light of a little bit more challenging times, I talked about why we think our portfolio continues to be well positioned in light of that. But certainly there's a lot going on in the world, and so we need to keep a close eye to make sure the underwriting standards remain as high as ever and we can be pretty picky from a credit quality perspective.
CJ Doherty: Okay, great. And with that, we'll wrap up for today. We'll certainly continue to monitor the private credit and direct lending in BDC's space as it continues to evolve. Thanks for joining me, Laura, and sharing your insights.
Laura Holson: Yeah, great to be here.
CJ Doherty: Thank you and thank you all for tuning in. I invite you to check out our private credit and BDC news and analysis at loanconnector.com. Follow us on Twitter at LPC Loans. I'm CJ. Doherty. Subscribe to the Lending Lowdown on your favorite podcast platform.
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