… and in private credit: beware ‘stretching’ for yield


Institutional investors are combing the private credit markets, searching for higher returns. But the key to understanding higher-yield investments is to appreciate the kind of credit risks their managers are taking, according to Randy Schwimmer. There are implications in “stretching” for yield.

Schwimmer, the publisher of the US private markets information service ‘The Lead Left’  is also the head of origination and capital markets at Churchill Asset Management, a New York-based alternative debt fund manager. He is widely credited with developing loan syndications for middle-market companies.

Schwimmer says in his latest newsletter*, published last week, that there are various major categories of business characteristics that veteran underwriters are able to analyse to ascertain where companies fall on the risk spectrum.

This should help investors understand the “implications of stretching for yield”, he says. Some considerations for investors in the private credit market include:

Management experience – This is the most critical element of corporate risk. It’s a serious misunderstanding of the role of private equity to think that sponsors manage portfolio companies. As one managing partner told us, “That’s what we hire management teams to do. We spend more time getting the right people in place than any other issue.” Having the wrong C-suite members can destroy enterprise value faster than any exogenous factor.

It’s also key to any successful growth strategy. Management needs to understand how to steer companies through product extensions, expansions into different markets, and respond to unexpected competitive challenges. Sponsors often turn to executives with whom they’ve enjoyed past portfolio company successes to run new investments.

Integration risk – Beyond generating organic growth, successfully integrating acquisitions and add-ons is high on the list of capabilities sponsors and lenders demand of management teams. This is particularly true of retailers or multi-location strategies. Seemingly simple tasks such as reconciling accounting systems have been known to wreak havoc on cash flow. How can you manage what you can’t track?

Integration risk has taken on greater urgency in this low-growth era. Sponsors are increasingly looking to blend down high purchase price multiples and improve overall returns by tacking on smaller businesses. But returns will founder if companies can’t quickly eliminate duplicate overhead costs, or if they lose control of “one-time” integration costs.

High capex – Senior secured debt providers are repaid through free cash flow. And nothing impacts free cash flow like high capital expenditures. Some businesses – retailers, for example – make it hard on lenders because most of excess cash goes to build out new locations, or refresh old ones.

Capex is divided into two categories: “maintenance,” the minimally required spend to keep the existing stores up and running, and “growth.” Inexperienced lenders often underestimate what it takes to keep a business going, particularly ones relying on costly frameworks like truck fleets and heavy-duty manufacturing facilities.

“While some debt providers gain comfort from hard assets, most middle-market lenders know PP&E [property, plant and equipment] doesn’t repay debt. Reliance on liquidation values often ends in tears,” Schwimmer says.

*The article is the first in a series available on the ‘Lead Left’ website: www.theleadleft.com