For those that are working in direct lending, credit HFs, broader private credit, etc., what is your methodology in determining which part of the capital structure is most attractive? Understand that equity is a little different where you're underwriting to the growth story versus credit where returns are capped. But if we were considering a structure with multiple tranches of debt ... first lien, second lien, mezzanine ... what items would you consider in determining the best risk/reward ratio? I'll start with my thoughts, feel free to add and/or comment with your criteria:
- Returns: obvious but what the return profile is across each tranche and how it compares to the broader market. If you're being offered 10% flat cash rate versus L+800 in the broader market without a floor, you might be guided towards seeing 100bps of alpha in the 2L/mezz. Obv becomes more difficult / growth story becomes more important if its a decision between more complicated rates that include PIK components, etc.
- Conviction in the growth story. I'd say this is dependent on the quality of the sponsor, history of the company, and broader industry tailwinds. Consolidation play - is the sponsor experienced, is the market fragmented enough, has the company grown inorganically in the past, is there a set integration playbook? Continued price increases to customers to boost margins and top-line - doable but not as readily believable. All of this ofcourse matters if you have a junior piece with warrants.
- Downside case. Where does value break leverage?
I don't have credit investing experience at a firm, but I have looked at credit in the past.
High level view: Growth is not really something credit investors look at unless you have some warrants or some upside in equity, which is not something easy to get in this market (I think) given the flow of capital to private credit in recent years... It becomes very important to understand the downside case, and be as conservative/realistic with it as you possibly can. You can come up with a few scenarios and assign probabilities to them. Stable fresh cash flow generation with limited capex requirements is sought after, and then you determine the recovery across different tranches of the debt based on seniority / collateral assigned / assets pledged etc. You pick the tranche that fits your risk profile, meaning the lowest tranche (mezz or something) might theoretically give you the highest returns, but if the probability of those returns materializing are low, you may want to move upstream and go with the senior. BTW: something important to look for are these springing events.
Also with respect to sponsor, you'd want to work with someone that has a reputation for not screwing the credit guys over, and with whom you have an existing relationship. I am generalizing here but based on what I have seen / heard , PE sponsors tend to have the same 3/4 firms for the credit. If you're going to be locked in for 5-7 years, not worth taking a risk by going in with someone you don't know and getting possibly screwed over.
Thank you. That's very helpful. When thinking through downside cases and I understand that this varies significantly by company and industry, what are common scenarios that you've seen been modeled out? For example, top-line decline based on prior recession performance. Customer Loss.
Additionally, when thinking through the recovery analysis, wouldn't it also be appropriate to factor in what EV the company could potentially be sold at? Thinking through assets pledged seems to me as thinking what would happen if the company went bankrupt.
Yes you should think through what the waterfall recovery might look like but also potential debt / equity / cash splits and what your form of recovery might look like. I.e., you may find your tranche is covered by asset value but may conclude the investment is ultimately unattractive if your form of recovery is becoming the new equity owner.
RE: first one, it really depends. Yes, you can see how the industry (if it's a mature one) has performed over the last 20 or 25 years to get an idea of what really can go wrong / performed over different macroeconomic cycles; how would the loss of their most significant customers (not really valid for B2C, but more for B2B kind of businesses) impact the business; how would unprecedented increases in the most important input costs (for instance price of coal / oil or any min wage increase resulting from labor shortages) affect bottom-line and thus FCF generation; unfavorable trade regulations (for instance when China banned recycling stuff from the US, waste-management companies would have felt the impact)...There isn't really a right answer here, industry and company dependent. You got to identify the key drivers first, what cost inputs drive those key drivers, and then come up with the downside cases.
RE EV multiple: this would be hotly contested. Distressed investing is a zero-sum game, pie is not getting bigger, we're taking it from each other, so what that theoretically means that senior guys might argue for a lower multiple, while the junior tranche for a higher multiple, to keep more for themselves in the event their expected recoveries are not whole. Reality is senior might throw some bone to the junior to get their buy-in. As far as how the multiple is actually determined, again looking at comps or companies in other industries with broadly the same FCF generation profile and / or similar capital structure (post bankruptcy-emergence) to see what multiple was applied. I think that the comp criteria is less stringent here. BTW, I haven't worked on any distressed deal, so might be wrong.
If you're curious, I suggest you read Moyers' Distressed Debt book, that will answer many questions you might have
I want to make the highest return possible at the highest point of the capital structure and be indifferent to whether the company works or not but have built in equity convexity just in case...
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