Key Takeaways
- Adams Street’s definition of the core mid-market comprises companies with an enterprise value from $150 million and $800 million, and EBITDA ranging from $20 million to $100 million
- The core-mid market offers a sweet spot as deal terms are often more favorable than in the upper-mid market, while the credit profile of companies is generally more attractive than those in the lower-mid sector. As a result, the core-mid market can be less cyclical than the upper- and lower-mid markets
- More control over deal terms in the core-mid market typically allow for better pricing, creditor protections, more conservative capital structures, stronger creditor rights, and therefore a higher likelihood of a successful outcome in the event of a reorganization
- Within core-mid, Adams Street prefers sponsored deals, as private equity managers have a record of success in growing and selling businesses, governance is often superior, sponsors often have the capital necessary to support a business, and sponsored transactions often have more robust diligence data
Transcript
Scott: Hello, and welcome to Adams Street Podcast. I’m Scott Hazen.
We’re joined today by two Adams Street partners, Bill Sacker, who’s the head of our private credit strategy, and Fred Chung, the head of credit underwriting.
For today’s conversation, we’re going to focus on some of the key advantages of private credit’s core middle market and give some insight into why Adams Street believes this section of the spectrum provides some of the best opportunities for investors.
Bill, Fred, thanks for taking some time to be with us today.
Bill: Pleasure, Scott. It’s good to be here.
Scott: So Bill, probably the best place to begin would be to give a brief overview of the broad parameters that define the upper middle, core middle, and lower middle markets.
Bill: I think everybody has a different numerical definition of each of those categories, but I think most would agree that the market can be separated into three broad areas in terms of size.
We define upper mid-market as involving companies with enterprise value in excess of a billion dollars. That usually translates into EBITDA of $100 million or more, and we define lower mid-market as involving companies with enterprise value of less than $150 million or less than $20 million of EBITDA.
The core mid-market, which is our area of focus, is involving companies of enterprise value that run from that $150 million at the low end to $800 to as much as a billion dollars at the high end of the range.
We focus on that area of the market because these involve companies of some scale, which we like for credit reasons. But even at the high end of the range, those companies generally don’t have sufficient scale to be able to access the broadly syndicated loan market, which does tend to drive the pricing in terms and creditor protections in that upper mid-market range for private companies.
And so we want the companies of some size for credit reasons, but we don’t want them so large that they have any choice but to adhere to the credit standards in the core mid-market, which generally involves higher pricing, more conservative capital structures, and much more robust creditor rights.
Fred: So I would just add that it’s really a tradeoff. I think the markets, as defined, you know, the way Bill had spoke about them, is absolutely right. And generally, one of the reasons the core middle market, in our view, is the sweet spot is while you have strong companies in the upper mid-market, those deal terms tend to be very aggressive, and it’s why those credit facilities have lower risk protections, often, you know, yields well inside what we find in the core mid-market. So for deal terms, we find the core mid-market attractive relative to the upper.
Compared to the lower mid-market, I think it’s more of a credit attributes for that underlying company. Those companies tend to be more risky. Even though you’re getting stronger potential yields and covenant protections, I think the trade off with the underlying risk of that business is often not accretive to the investor. So the core mid-market, for those reasons, as you compare them to each adjacent segment, we find really, really attractive.
Bill: And I think a consequence of that is that we do find that the upper mid-market and the lower mid-market tends to be a more cyclical opportunity set. Upper mid-market can be attractive when the broadly syndicated loan market is disrupted or shut down. But it tends to be a lot less attractive in normal times, when the broadly syndicated loan market is up and running and functioning normally.
Lower mid-market is a little bit more dependent on the strength of the economy. During periods of economic strength, those underlying companies tend to perform a little bit better. But in periods of economic downturn, those businesses tend to default more and have lower recoveries.
Scott: Maybe back to you real quick, Fred. Before we get into core mid versus other corners of the private credit universe, can you just outline why Adams Street focuses on sponsored over non-sponsored deals?
Fred: Sure, Scott. You know, I think there are a number of reasons that we tend to like sponsored deals over non-sponsored deals. But I think the overarching reason is really driven by our investment approach.
I think the answer to that question starts with how we think about the core tenets of our investment philosophy, which is, as we’ve spoken to many of our clients about, ultimately about capital preservation and loss avoidance. And to that extension, while you can find attractive opportunities in both sponsored and non-sponsored transactions, we think sponsored deals are just better aligned with the low loss approach to lending.
And there are really a few specific reasons why that’s the case. I think it ultimately starts with the quality of the buyer. We are, in sponsored transactions, working with top tier private equity sponsors that we’ve had relationships with for decades. These sponsors often have long track records of success in growing businesses and selling them. And that ultimately derisks the debt when you’re working with that quality of a buyer.
It comes down to a couple specific elements of that. Corporate governance is one. When you’re working in a sponsored deal, typically in these deals that private equity sponsor who has that successful track record, they’re bringing professional management teams and selling those into the company. They’re often bringing very high-quality boards of directors. And all of that’s controlled by the private equity sponsors we work with. And their singular goal is to grow and sell that business.
In a non-sponsored transaction, particularly in the middle market, you often have founders or family owned businesses. Those often come with limited governance. And so from that perspective, we really like what the sponsor brings to that transaction from a derisking perspective.
Another element that’s really attractive from a sponsored deal transaction is capital to support that business, and we saw a lot of this in COVID. We saw some of this in 2022, where the private equity sponsors we work with have deep pockets, they bring fund capital that can support those businesses in times of need, whether that’s liquidity, whether that’s underperformance, or both.
In a non-sponsored transaction, again, in the middle market, it often is the case where there is not a ton of additional equity that can be put into the business from the owner. And so that burden often lies solely with the lender.
And so in a declining environment, it’s often on the lender’s shoulders to put additional capital into that company, which again, as I go back to our investment philosophy of loss avoidance, that’s not always congruent.
And so not surprisingly, as reported by agencies like KBRA, you actually see default rates in non-sponsored transactions be more than double than those in sponsored deals. And I think it’s some of those qualities and elements that I just mentioned that really lead to those outcomes.
Bill: I would make two additional comments. When conducting diligence, the information that tends to be available in sponsored type transactions also is much more robust than what you get in the non-sponsored type deals.
And that includes data room information, usually audited financials. You’ll frequently get a quality of earnings report, you’ll also get an industry study. And so the nature of the information that’s available for due diligence is much better.
The other thing I would add is that the corporate governance that is generally done by a private equity sponsor tends to be much better aligned with the interests of the lenders. The corporate governance is professional, and the private equity sponsor controls the underlying stock, is generally running the board, and is there to monitor performance. They do things proactively to address underperformance, including changing out the management team if that becomes necessary.
In a non-sponsored deal, those companies are generally very closely held – the owners also tend to be the managers of the underlying business. If there’s underperformance, the lender has creditor rights that they can exercise, but that gives them influence, not control. The only way to get control is to actually go through a hardcore workout or a bankruptcy, which is generally pretty destructive to underlying company value. And as a result, the recoveries in that particular case tend to be much lower.
The management teams also, because they’re the owners, are not inclined to replace themselves. And so the ability to make those management changes are generally much tougher, and again, usually result in a hardcore work out or a bankruptcy.
Scott: Now, what differentiates managers within the core middle market where Adams Street plays?
Fred: I think differentiation ultimately comes down to a couple of things. I’d like to say returns, first and foremost, of course, and we’ve had returns that we’re quite proud of.
But if you just kind of go a little bit beyond that and just look at managers generally, within direct lending within the core middle market, it’s been quite a benign environment over the last decade or so, if not longer. And so you haven’t seen huge dispersion returns between top quartile and bottom quartile managers.
And what I think is going to differentiate even further as we move forward, if we do hit a credit cycle or an environment where companies are really under some stress, it’s going to be the quality of that underlying portfolio that ultimately differentiates the manager that will manifest in realized return.
And if you look at our portfolio, on a lot of metrics that are relevant, we just stack favorably relative to the market.
We’ve done this by looking at data provided by our various vendors on middle market portfolios out there on really every metric, whether that’s revenue growth, whether that’s EBITDA growth, cash coverage, quality of income through cash versus PIK,1 we tend to compare favorably to the market. And that’s really because of the quality of underlying borrowers we work with, and of course, our sourcing engine, which is quality private equity sponsors.
All of that is really a product of what we always say is the core differentiator for us, which is the power of the Adams Street platform. It’s not an accident that our portfolio compares favorably to market. We’re just getting better access and better information on these companies that we’re underwriting.
So because of how many private equity sponsors that we’ve been invested in for 50 years, we have an immensely strong sourcing engine. So we’re getting quality deals into the top of our funnel. And by virtue of how present Adams Street’s been in the private equity ecosystem over those five decades, we’ve also amassed an immense amount of information on those particular companies that we’re underwriting.
So it’s not uncommon for us to not only have the offering materials for that financing, but really a much more robust history of that underlying company, because it may have traded through two or three private equity sponsors that Adams Street’s been invested in as an LP.
And so we use that sourcing advantage and that knowledge advantage ultimately to create what we feel are higher quality portfolios of high-quality businesses. And then I think that does manifest ultimately into our returns. And we think as we look forward, we’re just very well positioned for any type of cycle because of the resilience and durability of those business models.
Bill: And without repeating what Fred just said, which covered it, we check all the boxes that are necessary to create differentiation.
We have a proven, disciplined underwriting process. We have a highly differentiated sourcing advantage by being one of the world’s largest private equity fund of fund managers, in excess of $50 billion invested in literally hundreds of middle market private equity sponsors. And we have a significant knowledge edge through the collection of all of this data over the decades that provides us with the ability to make more insightful and informed investment decisions.
All of those attributes are not only differentiated, but extremely difficult to replicate. And so we think this differentiated edge is an enduring advantage that we’re likely to enjoy for the foreseeable future.
Scott: Bill, maybe I’ll ask you to close out with your views on, as we enter 2025, what is your general outlook on the market, and does your strategy need to adjust at all?
Bill: Yes, you know, we’re always adjusting our positioning in the market, depending on whether we are seeing very competitive terms, or whether we’re seeing attractive, disrupted market returns or conditions.
And we take a bit of a contrarian view in that way. There’s a saying that we frequently use that some of the best of loans are made in worst of times. That is true, but the converse is true as well. Some of the worst loans are made in the best of times. And so, during healthy competitive conditions we will tend to play defense, and in disrupted markets where competition subsides, we tend to go a little bit more on offense.
Other than that, the strategy really is unchanged.
Our outlook for private credit remains quite favorable. We believe that we are still in the early stages of an attractive vintage period for the asset class, generally speaking. The drivers for that are relatively high interest rates by historic standards, relatively moderate leverage and robust equity contributions, and in the core mid-market especially, the ability to obtain traditional maintenance-based financial covenants and robust creditor protections.
The combination of those factors will continue to favor private credit lenders, we believe, and we’re seeing those conditions as we speak.
We also believe that interest rates, while at the moment are likely to head downwards, are going to do so slowly, and when they do bottom, are likely to remain at levels that are higher than we’ve seen in over a decade.
The inflation target, which we still haven’t achieved, is around 2%. At 2%, if we’re lucky enough to get there, the neutral rate of interest has to be higher than that. And most expectations, which we would agree with, is 3% plus.
That should continue to augur well for private credit returns if you could avoid losses.
And we also believe that deal flow is likely to begin to become more robust, and that is largely driven by what is currently close to record levels of dry powder in US private equity funds. That dry powder resides in committed vehicles with defined investment periods. That capital generally has another two, two plus years to go, and it is very likely to find its way into the market in that timeframe.
And if you assume that that capital represents, say, 40% of the total capital structure, the visible forward demand over the next couple of years for debt financing necessary to fund those deals is pretty close to a trillion dollars. That is likely to continue to drive the supply-demand imbalance in favor of lenders generally, private credit lenders in particular, for at least the next couple of years.
Fred: Yes, and I don’t have much to add to that except to say our investment style is very bottoms up. So when we’re discussing deals at our investment committee, it’s often about how that specific company will be able to endure potentially in a downside environment from a macro perspective.
And so all of our investment decisions really rely on us feeling confident that, even in a worst case environment or a very challenged operating environment, that that company is able to maintain its ability to service its debt.
And so for that reason, I think while we’re not changing anything, I think we’re always emphasizing the importance of that quality of that underlying asset, and the conservatism in the capital structure, and the creditor protections that we fight for in every single deal. And in some ways, as we look forward, those may be even more relevant than they happen historically, if we do end up in an environment where these companies get challenged.
Scott: Well, that’s about all we have time for today. I hope you found our discussion about the core middle market useful. So it only remains for me to say thanks for joining us, and we look forward to listening in to the next edition of the Adams Street podcast.
Bill, Fred, thanks again for your time.
Bill: Thank you, Scott.
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