Private credit - coinvestment deal flow considerations

I work at a credit asset manager, and have been asked by friends in the LP ecosystem on how to distinguish good private credit co-investment opportunities from bad ones. Here is a brief write up on key considerations regarding private credit deals, across LMM and UMM, especially when the deal sourcing is an LP.  Looking forward to what others think as well.

• LMM direct lending vs UMM direct lending
  • Many LMM funds will say that LMM is less competed than UMM and therefor the deals are more differentiated and have more terms
  • This is largely no longer true - due to the amount of capital that has gone into private credit in general, if we talk to deal lawyer, they say that LMM terms are highly competed on, light, and converging toward UMM
  • In reality, UMM is a higher barrier to entry market - UMM sponsors do not open their doors to smaller private credit shops (no need), and therefore, not everyone can play in that private credit market
  • Conversely, when the ticket size is small, every one can play in the LMM market. All you need to do is to hire a few originators with LMM relationships, which is not hard. The market has a lot of originators on the market now, given platform consolidation (fewer, larger funds)
• How does that impact deal quality
  • Before we go into the details, it's very important to understand one thing - sponsors (PE funds whose assets the debt support) are all direct lending fund's clients, just as LPs are also their clients. Private credit funds can not survive without sponsor relationships
  • What does that mean? It means that if a debt goes default, the PC fund is unlikely to really take the key unless absolutely necessary, because that will hurt their relationship with their clients, their future deal flow, their future ability to deploy at volume, and their future ability to charge fee on these volume
  • Therefore, I generally think it's best to stay on the safe side of private credit - picking up more yield by forgoing quality is not worth it
• Deals I will generate not do / "orange" flags in deals
  • New sponsor relationships
    • When a direct lending fund is new to a sponsor relationship, they tend to underwrite "bad deals" to create the relationship. Ie, they would ordinarily not want to do a deal, no other funds want to do a deal due to pricing / business quality / leverage etc, but they did it to enter into the relationship.
    • From that perspective, it's better if a co-investment comes from a seasoned relationship of a direct lending fund
  • All PIK interest
    • When these deals go wrong, they can easily be a 0 since no cash interest was paid in the interim
  • Sources & uses
    • What's the debt raised for? dividend recap is usually not a great idea because it lowers sponsor's skin in the game
  • Sponsor with weak return itself
    • If the sponsor / PE fund has weak return itself, when the business goes wrong, it's unlikely to be able to put more cash in to defend the business
  • Why is the DL fund syndicating a part of the deal out if they can do all themselves?
    • Are they trying to decrease their own exposure in a potentially not so great deal?
  • Certain sponsors are known to be not good to work with from a lender's perspective, such as HIG (generally, those starting from a distressed legacy)
  • Regular credit metric assessment - attach / detach leverage and LTV, cash flow characteristics, quality of earnings, EBITDA adjustments
• Overall expectations on return
  • In this market, LMM and UMM and public credit market are all at their tightest in history. If a direct lending deal says it can yield 15%+ return but there is nothing special about it, there is something wrong with it. In reality, even sponsor's own equity is only returning 12%-15%, so there is no reason for a lender to be able to earn a significantly higher return