In the first of our series of interviews about middle market lending, we speak with Jonathan Simmons, a Managing Director and Co-Head of Corporate Development at Golub Capital. We discuss lending to middle market companies, how non-bank lenders came to dominate the space, and what the future looks like for Golub Capital and for other non-bank lenders.
Tell us a little about your role at Golub Capital.
I joined Golub Capital in 2009 in the middle of the Financial Crisis. I initially joined the underwriting team to help underwrite and execute middle market loans. Today I co-lead our corporate development efforts, where we seek to grow the business in a number of ways including launching new investor vehicles, expanding our loan product suite for our sponsors and borrowers and evaluating both organic and inorganic ways to grow the business.
How did you first develop an interest in the middle market lending space?
I started my career 15 years ago as an investment banker at J.P. Morgan, helping to raise debt capital from institutional fixed income investors on behalf of financial institutions – global money-center banks, insurance companies and alternative asset managers. Through my work with alternative asset managers, I got the chance to lead some of the industry’s first-ever institutionally targeted unsecured debt capital raises for several pre-crisis business development companies. Those included capital raises for Ares Capital, Allied Capital, and American Capital. Through working extensively with the management teams of those companies, I got direct exposure to the world of US middle market direct lending. I found the industry to be fascinating and decided to join a startup sponsor finance middle market direct lending firm in 2007 as a loan underwriter, to jump on the then-booming leveraged finance industry bandwagon – conveniently, just before it went bust.
What was it you found so fascinating about the space?
While the global Fortune 500 companies – Apple, Google, Amazon -- get much of the press and the attention today, I’ve always been fascinated with middle market companies and the industries in which they operate. There are literally hundreds of thousands of middle market companies in the US, and there are more popping up every day. Most outsiders to our industry don’t appreciate this, but these are the companies that drive the US economy. And for the most part, many of them fly under the radar. They do things that we don’t appreciate or know about. But many of these companies are important. They have compelling competitive advantages. They have strong customer bases and supply networks. As a whole, if you lifted out the set of US middle market companies and it formed its own economy, it would be one of the top three or four economies in the world, by GDP. These are important, value-generating businesses, and they need both equity and debt capital to grow to drive the overall health of our economy. I’ve always been interested in how firms like Golub Capital can play an important role in that.
It must also be intellectually rewarding to get early exposure to some companies that might become the next big thing.
Yes. A lot of big companies start small and grow through acquisition, which is one of the types of financings Golub Capital provides. And it is interesting when these companies have a compelling business model and they're able to grow effectively and gain market share. We do see middle market companies that grow into large-cap companies, or companies that start off very small, maybe too small for us to finance, and over time grow into bigger companies that we would be happy to lend to.
Given where we are in the cycle, we think the best risk/reward in middle market lending today is to stay senior at the top of the capital structure.
How do you at Golub Capital define the middle market space? Is it the size of the borrower, the size of the loans, or something else?
That’s a good question, because if you were to ask different parties, they’d have different definitions of the term “middle market”. We define the U.S. middle market in the US as companies with annual EBITDA, which is a measure of earnings, of up to $100 million a year. In general, a middle market company is an established business that is too large to finance itself through a local community bank, but too small to go to a large money-center bank like a J.P. Morgan or a Citigroup or a Bank of America, or the liquid capital markets. While regional banks do play a role in middle market lending, increasingly the space is dominated by non-bank lenders like Golub Capital. Collectively, we’re the predominant source of loan capital to U.S. middle market companies.
Does Golub Capital tend to lend directly to freestanding middle market companies, or are these companies typically owned by private equity firms?
We’re typically lending to a company that’s being bought by, or is already owned by, a private equity sponsor. And so by the nature of the private equity firm’s goals and the fact that it has limited partners and it’s trying to achieve a certain return on its investment in the company, it often seeks debt capital to finance part of its investment in the company. That debt capital can be sought upfront when it buys the company, and it often is. And it can be expanded over the life of its ownership period before it looks to sell the company.
What other reasons might a company have for taking out these loans?
After a private equity firm buys a company, that company often seeks to make a series of smaller acquisitions to grow that initial purchase further. Often times, the sponsor and the management team seek additional debt capital from their lender (and possibly new lenders) to finance the additional acquisitions. We call that an add-on acquisition.
Sometimes the loan capital could be used to refinance the company’s existing debt. Maybe it’s overpriced. It could be to recapitalize the company. For example, consider a private equity firm who has owned a company for several years and isn’t ready to sell it; there are times when a private equity company may want to take a small dividend and want to use debt to finance that dividend. That’s also something that is a common use of proceeds.
As you said, Golub Capital typically lends to companies that are being bought by or are already owned by private equity firms. But is that the same for other non-bank lenders?
That’s not the case for all middle market lenders. There is a whole market for lending to non-sponsored companies. We prefer to focus on private equity-backed companies. We also tend to be pretty risk-averse, and we think that in general, lending to private equity-backed companies helps in three ways. First, with two filters (theirs and ours), we get better credit selection. Second, our sponsors often improve the performance of our obligors. Third (and probably most importantly) it helps achieve better problem resolution. As a result of these three things, we should be able to achieve fewer defaults, better recoveries and strong overall risk return management. If you were to talk to a non-sponsored lender, they might say that their area of focus is less competitive and could perhaps offer higher pricing. But I would also venture to guess that it offers higher risk.
Apart from size, how do middle market loans tend to differ from loans to larger corporations?
One of the big differences between large company loans (or the broadly syndicated loan market) and the middle market is that ours is an illiquid market. If a company underperforms, one of the options is not, “Oh, we’re just going to sell our loan to another party,” because these are small, illiquid loans that, for the most part, can’t be sold. So we do a lot more work up front, before we make the loan. We hire third parties to enhance that diligence work in order to know that we have a very high likelihood of getting paid back through cash flow and through the going-concern value of the company and its ability to get sold for a value in excess of our debt even in a distressed scenario. That’s one of the things we spend a lot of time on, looking at the distressed-sale value of a company and not just the value today. Given the illiquid nature of the asset, there’s a number of ways in which the loans that we make differ from loans to large companies. One involves getting compensated for that illiquidity: Often there’s a premium rate that we’re able to get by lending to smaller companies. Often the fees that are paid for providing the capital are higher. The other key difference, structurally, is that middle market loans often have covenants. What the covenants seek to do is provide a series of financial and non-financial triggers. If the underlying borrower were to perform worse than those triggers, we would have a seat at the table with the management team and the sponsor to work out a solution that either compensates us appropriately for the increased risk or gives us an opportunity to force the management team and sponsor to put in more capital or consider selling the company or consider replacing us with another lender. These rights, remedies and control are harder to get access to in the liquid loan market.
If you lifted out the set of US middle market companies and it formed its own economy, it would be one of the top three or four economies in the world, by GDP.
Where in the capital structure do Golub Capital’s loans tend to fall?
In addition to focusing on sponsor versus non-sponsor, middle market lenders have a number of choices on where in the capital structure they choose to invest. You have a number of lenders that focus on providing senior debt, you have a number who focus on providing one-stop or unitranche loans, and you have junior-capital lenders. With our scale, our platform and history of having done all three, we have the ability to continue to do all three. But given where we are in the cycle and the competitive nature of the market today, we think the best risk/reward in middle market lending today is to stay senior at the top of the capital structure. So almost all of the lending that we do today to companies backed by private equity firms is in some combination of traditional senior secured loans, where another party provides the junior capital beneath us, or our biggest product and what we’re most well known for, which is what we call our one-stop or unitranche loan. That is typically the only tranche of debt in the capital structure, and it combines the strengths of traditional senior and junior debt into one security.
What’s the appeal of the unitranche loan from the perspective of the borrower?
We think it’s an interesting value proposition for a private equity firm because they only have to work with Golub Capital. They don’t have to work with one class of lenders to provide the senior debt and another on the junior. And they can continue to only work with us as they look to make add-on acquisitions and make other modifications to their debt capital after they buy the company. This tends to make one-stop loans more convenient, reliable and flexible for sponsors than alternatives. So today, one-stop loans represent around 80 percent of our overall middle market lending origination activities in a given year.
There’s no question that the middle market is not immune from investors’ search for yield, and as a result, our market has in recent years gotten more borrower friendly.
So we’ve talked about the sponsors and the middle market companies they own or buy. But what about the investor side of the equation? Who do Golub Capital’s investors tend to be?
We have a highly diversified investor base of several thousand investors. It includes public and corporate pension plans, insurance companies, endowments and foundations, family offices and high net worth individuals. One of the things that we pride ourselves on are repeat investors. Over 50 percent of our investors have investments in more than one active Golub Capital fund. And we’ve got a very large number of investors who have been investors of ours for 10 years or more. That’s just by virtue of having a long history of investing in middle market companies that goes back now 25 years.
A lot of people have a cautious eye on the middle market lending space as they look at current market conditions, expecting things to deteriorate. What do you think will happen?
Conventional wisdom is that we’re late-cycle, and if you go to any industry conference, poll the audience and ask them when the next recession could be, I think for the most part you will hear, “It’s not coming this year, but next year or the year after seems pretty likely.” I think that folks still feel that way, but what’s interesting is that we’re not really seeing the idea that we’re late-cycle in our own data. What we’re seeing in our own data is that the US middle market economy is strong. And while there’s lots of different ways of looking at this, one of the ways that we look at it is through a report that we publish called the Golub Capital Middle Market Report. That report looks at the more than 150 middle market companies in our portfolio, and we look at trends in quarterly revenue and EBITDA growth, overall and in specific industries. And what we saw in the most recent quarter, the first quarter of 2019, is a sixth consecutive quarter of robust year-over-year revenue and EBITDA growth. What this tells us is that the overall economic backdrop for US businesses selling primarily to other US businesses is quite healthy. And it signals to us that a recession is not imminent. We’re also seeing the fact that private equity sponsor-led M&A remains very robust. Private equity firms are buying companies at a record pace. That certainly doesn’t seem to suggest that a recession is just around the corner. And then from a credit perspective, at Golub Capital we have few underperforming credits. Industry-wide, default rates remain pretty low. Despite the conventional wisdom that we’re late-cycle – and it certainly feels that way in some ways -- the data actually says that we’re mid-cycle.
Whether we’re mid-cycle or late-cycle, what is Golub Capital doing to ensure the kind of resiliency you’ve been talking about? Is it just a matter of taking the lessons from the Crisis and continuing to apply them?
There’s no question that the middle market is not immune from investors’ search for yield, and as a result, our market has in recent years gotten more borrower friendly. I think what we’ve been doing in response is we’ve been leaning on our competitive advantages. We’ve been staying extremely selective on the loans that we choose to make. We’re focusing on our relationships and our industry expertise and our portfolio. Most of the loans that we close are backed by existing private equity firm relationships. In any given year, about 90 percent of our origination volume is loans to companies that are owned by private equity firms that we've done multiple deals with. And over 50 percent of the loans that we make are to companies that are already existing portfolio companies. So we know the management team, we know the industry, we’ve already done a significant amount of diligence on the company, and all we’re looking to do is to lend a little bit more capital to that business. From that standpoint, we feel like that’s a very attractive risk-adjusted return as long as that company is performing well. We’re being very careful about competing in auction processes where every lender is looking at it, where it’s more of a jump ball. Those are the most competitive situations where companies get the best terms that are the least lender-friendly. And frankly, other lenders who are more desperate to put capital to work are more likely to offer more attractive terms, particularly attractive structures in the form of looser credit agreements than what Golub Capital is prepared to offer given our focus on being credit-first.
Given a lot of the handwringing in the press about middle market lenders’ ability to survive a downturn, what do you think is the most likely scenario for how another crisis would play out? What you’ve just portrayed is maybe a separation out of companies like yours that are in a good position to carry out a strategy that’s been honed over time, and some others that are still going after the jump ball and thus might not fare as well.
The saying, “History doesn’t repeat itself but it often rhymes” is very relevant here. In the Financial Crisis, there was a shakeup and a massive consolidation of players in our space, and the firms that won out were the firms with distinct and strong competitive advantages. I would expect that that will again be the case the next time that there’s a cycle. I think that it’s a very difficult time to be a new middle market lender today, where all you have to compete on is the fact that you’ve got capital to invest. Golub Capital has better relationships and stronger industry expertise. We have a history of investing in middle market companies for 25 years, and we have the scale and the balance sheet to be able to lend more capital than almost anyone in the industry. So there has to be some distinct reason why a sponsor would want to go elsewhere, and that’s why we will continue to rely on our relationships and our platform and our advantages to help us navigate the next recession as successfully as the last one. We know that what’s served us well is to invest using a late-cycle perspective. We never know when the next recession will come, so we’ve been operating the business for years as though the next recession is just around the corner. And that means that we’ve moved up the capital structure. It means focusing on existing sponsor relationships and existing portfolio companies. It means staying selective on underwriting and being focused on resilient recession-resistant industries. If and when that next recession hits, similar to what happened in the Financial Crisis, it will allow us to play offense when others are playing defense.
Mr. Simmons is a Managing Director and serves as the Director of Corporate Strategy for Golub Capital BDC, Inc. (NASDAQ: GBDC), Golub Capital Investment Corporation and Golub Capital BDC 3, Inc. Previously, Mr. Simmons was a member of Golub Capital’s Middle Market Lending team, where he underwrote, executed and monitored investments. Prior to joining Golub Capital, Mr. Simmons was a Senior Associate at Churchill Financial, where he executed senior and junior debt investments, as well as equity co-investments in middle market companies, and managed the workout of distressed investments. Prior to this position, he was an Investment Banking Associate at J.P. Morgan Securities, where he originated, structured and executed senior and subordinated debt, as well as hybrid and preferred equity transactions for specialty finance and banking institutions. Mr. Simmons earned his BA degree magna cum laude in Mathematics and Economics from Colgate University.
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