Robert Hamwee, CEO of New Mountain Finance Corp., the business development company managed by New Mountain Capital, recently shared his thoughts on the private debt market with LCD, an offering of S&P Global Market Intelligence.
New Mountain Capital LLC has three businesses: private equity, credit and net lease capital. New Mountain Finance Corp. sits within the firm’s broader credit platform that invests across private and syndicated loans, targeting companies generating annual EBITDA ranging from $10 million to $200 million. It provides first-lien/unitranche loans, as well as select second-lien loans, bonds and mezzanine debt.
LCD: How would you characterize the current market?
Hamwee: The market is busier than it’s ever been. I can say that definitively based on the data from New Mountain, and based on the flow we believe our clients, private equity sponsors, are seeing.
There are several reasons for this. First, it’s a function of a general snap-back of the market from the depressed levels of COVID times. Second, it's a function of the new work environment that has come out of COVID. The pace of activity, when people don’t have to travel as much, is much higher. It used to be you had to visit a management because eight other firms were visiting management. The result was you’d have to go to New Mexico, and it would take a day and a half to go there for a 90-minute meeting. Now, you can do six meetings like that in one day.
This is true for everything from fundraising to carrying out due diligence. The same is true for IPOs and the SPAC phenomenon: It used to be a two-week roadshow. You’d have to go to Europe. Now the whole process takes three days. Not having to travel has had a remarkable impact on our activity. Our whole industry is seeing it. People got comfortable with this new way of doing business, and making decisions, over Zoom.
Thirdly, which is more specific to us than our peers, is the types of deals that have come our way. New Mountain invests in defensive growth industries: enterprise software, healthcare, tech-enabled business services. These have become an increasingly larger part of the economy. The equity capital has moved away from, say, coal industry or heavy metal industry deals. Equity capital has moved away from those.
How have yields on new debt investments been affected?
There’s been tremendous capital flows into private credit. We’ve seen some rate and spread compression compared to a year ago. On balance we are busy with attractive new investment opportunities with market-clearing yields that work for us.
The market’s hyper-competitive. We have a lot of great competitors. But it’s a $1 trillion market for U.S. non-investment-grade debt. We’re trying to deploy $2 billion a year. So we can afford to be selective.
We are trying to go after a piece of as many deals that we know and love through private equity. We’re not going after every deal. The hyper-competitivity comes across through the spreads. We tell our investors that we’re never going to take incremental credit risk just to pick up 50 bps in yield. That math doesn’t work.
Can you comment on trends in loan structures?
I wouldn’t say there’s been dramatic structural change. We’ve seen an evolutionary increase of the private unitranche. The private unitranche is being used more and more, and in bigger and bigger deals. People are getting increasingly confident that they can do a unitranche in size. That obviously takes money away from the mezzanine and second-lien market, because now the whole tranche has been spoken for.
There’s been an increasing preference for the unitranche structure by private equity sponsors in the past three to five years. Private equity sponsors prefer the structure since it means negotiating a single credit document with one group of lenders via a single lead agent. At the same time, the first- and second-lien market is very robust. There’s a ton of BSL loans getting done. I don’t want to paint a picture of a sea change, but at the margins the unitranche has become more popular.
We see increased use of preferred capital. It’s because purchase multiples have gotten so high. The unitranche will only stretch so far. We’re seeing people not batting an eyelash at paying 15x, 18x, 22x EBITDA.
In the broadly syndicated loan market, a typical first-lien loan may tolerate leverage of 5x debt to EBITDA, depending on issuer and industry, increasing to roughly 7x via a second-lien loan. By comparison, the unitranche leverage may range from 6x-7.5x, a number that could increase to around 9x via a component of 12-13% of preferred equity in a capital structure. We’re seeing demand for some preferred capital to allow the sponsor to have a little more leverage. It’s often from an additional investor.
Ten years ago you could buy a quality enterprise software company for 11x. People thought that was expensive. You could still leverage it 6.5x. Now that same enterprise software company will cost 18x. The lenders haven’t moved much: Instead of 6.5x, leverage is 7x-7.5x. The rest has to be from equity.
That’s one of the critical trends you see in the market generally — the magnitude of capital that sponsors are putting at risk. In the 'true' LBO days, it was buy a company at 80% leverage, 20% equity. Now it’s almost reverse. It’s no longer true LBOs — it’s more like growth capital. The debt has become secondary, not primary. The equity cushions have become 45-75%, which is radically different from 10 years ago and certainly 20 years ago.
In our current private fund, the average loan to value is roughly 38%, so the average equity check is 62%. Ten years ago, the average equity would have been 30%-50%.
In 2020, New Mountain’s credit business took ownership of a borrower company, Benevis.
We knew we were going to own some companies. When you make hundreds of loans, some go bad. Our track record speaks for itself: Our defaults and default losses have been de minimis. But we still have defaults.
In the throes of the pandemic, Benevis and non-essential medicine was closed. When your revenue goes to zero, and you have a levered capital structure, it’s a challenging position. Different sponsors reacted differently. The sponsor didn’t elect to put in capital to fund the business during the COVID downturn. The conversations surrounding who wanted to put more money in were very rational and professional. One of the things that gave us the confidence to write that check ourselves was our leadership at an NMC private equity company that operates in the same industry, who we immediately brought in to assist in re-underwriting the Benevis position. Having a top-tier management team in the space showed us how the cash burn at Benevis could be significantly minimized by doing things the company wasn’t already doing. Benevis had great bones, but wasn’t optimized.
Every one of our deals is led by private equity deal team members. Credit underwrite, and credit monitoring, is led by PE deal members. That’s one of our competitive advantages, including when there’s a problem, and occasional workout.