The evolution of private debt

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The Twin Brook team invests in a wide range of industries, but focuses on private equity-backed borrowers that typically have an EBITDA between $3 million and $50 million, with an emphasis on companies with a EBITDA of $25 million and below – or those in the lower middle market.

Looking at the market today from an industry perspective, there are a few outperformers in terms of growth and stability. “Healthcare would absolutely be one of those industries,” Clark said. “The amount of private transaction activity taking place in healthcare has been enormous and continues to be a growing space.” He noted that business services and technology have also been active sectors that have positive growth prospects.

While there are opportunities in all segments of the middle market, the Twin Brook team continued to focus on the lower middle market due to both the strong opportunity set and the nature of the market. ‘space. “As you go up in the market, we’ve generally seen loans become more and more commoditized,” Clark said, “whereas in the lower middle market, we’ve seen borrowers and their PE sponsors generally take a more relationship-oriented approach. We’re focusing on that part of the market because of that dynamic.”

Company ownership can also be a differentiating factor. Some may assume that private equity firms focus strictly on finding the cheapest funding, but that’s not always the case. “We found that private equity groups focused on the lower middle market tend to view their lenders as important parts of their growth strategies for businesses. Their value creation strategies often include initiatives that require additional financial and ongoing interaction with lenders, so they want a reliable partner who understands their approach and will work hand-in-hand with them and their portfolio companies,” Clark said. . Conversely, he notes that Twin Brook exclusively serves private equity-backed borrowers, as they have found that “the operational expertise and capital support provided by sponsors, as well as their growth strategies, are truly essential”.

As the private debt space has evolved and attracted more capital, investors have become increasingly aware of these kinds of considerations. “They don’t just want untargeted exposure to direct lender,” Clark said. Instead, the focus has been more on diversification. For example, he noted, “An investor who currently only has exposure to the base middle market may seek to incorporate options that provide exposure to the lower or upper middle market, or vice-versa, as its total allocation to private debt increases”.

Bring the macro image
What do the current macroeconomic concerns, such as the disruption caused by the ongoing pandemic and the expected rise in interest rates due to higher inflation, mean for private debt?

Although the outbreak of the pandemic may have prompted some private debt players to change their approach, Twin Brook’s investment processes – which draw on the management team’s more than 20 years of experience in through the cycles – have not changed. “We are senior lenders always focused on limiting downsides,” Clark said.

Looking ahead, with respect to inflation and interest rates, the impact varies by industry and company, so the expected results cannot be generalized to the direct lending space. , he added. “The impact of inflation and changes in interest rates will be related to the type of lender you are, the type of risk profile you build into your portfolio, and how you run different scenarios to account for of these risks during the underwriting process.”

Private equity groups can play a vital role in ensuring companies are well positioned to respond to rising rates or inflationary pressures. Additionally, deal structuring is important in this regard, Clark said, including building broad cash flow cushions and covenants, which give lenders the ability to act and work closely with borrowers in situations of underperformance.

The overall resilience of private debt after the outbreak of the COVID-19 pandemic contains some key lessons. “Before [to that event], I think some may have believed that private debt had attractive returns, but at the first sign of trouble, those returns would evaporate,” Clark said. ” This does not happen. Across the space, risk-adjusted returns have not only held up, they have held up with less variability than in the world of public enterprise debt.