Crestline Specialty Lending Fund I has received The Hedge Fund Journal’s Alternative and Private Credit 2021 award for Best 2014 Vintage in the Direct Lending – Senior, US category. The awards for closed end funds were based on IRR data from Preqin.1 This leveraged fund had a net IRR of 12.23% and MOIC of 1.48.2 Crestline concentrates on the lower mid-market segment in North America, defined as firms with EBITDA between USD 5 and 50 million, which is less competitive than the BDC-oriented upper middle market and offers some yield pickup over leveraged loans.
The largest return driver has been interest on loans, which has seen some compression in recent years: “The typical range of coupons has come down from a range of 800-1200 to 550-900,” says Frank Jordan, Partner and Head of the Client Partnership Group. Coupons are only one component of Crestline’s returns however. They also receive an original issuer discount (OID) and call protection premiums. “The amortization and call premiums can add as much as 200 basis points to IRR over the average two to three year holding period, which is shorter than the typical five-year tenor of the loans,” says Jordan. Even in early 2021 Crestline has exited some nine deals through re-financings, re-capitalizations, acquisitions, and secondary trades.
When work is required to understand the value of the loan, most competitors don’t want to take the time to do that level of work for a direct loan, they want an asset that is easy to underwrite.
Frank Jordan, Partner and Head of the Client Partnership Group, Crestline
There is also some degree of flexibility over terms: both interest rates and other sources of return have been re-negotiated in light of the Covid crisis. Crestline Specialty Lending Fund II and its borrowers have agreed on higher interest rates, resets of call protection, amendment fees and equity warrants in cases where covenants have been breached, which is the benefit of having covenants with tight cushions, Jordan points out. In the current climate, based in part on prevailing interest rates, Crestline is targeting returns of 7-9% net for the unleveraged strategy, and 10-13% for the leveraged strategy. Higher US interest rates could increase these return targets. Coupon spreads are referenced to LIBOR subject to a floor, and will start to pick up if rates rise through the floor. (The reference interest rate will move over to whatever replaces LIBOR e.g., SOFR most likely, in due course).
Crestline opportunistically makes excursions into public credit markets when they offer better risk-adjusted returns than private markets, and did so in 2020, buying bank debt at deep discounts on the secondary market. Profits have now been taken on this and absent any sharp pullbacks in listed credit markets, capital will be deployed in private lending.
Crestline’s direct lending approach is distinguished by less competitive sourcing and internal cross-sourcing; careful industry selection based on fundamental analysis and industry attributes that support credit quality; having low loan to value ratios and low loss rates; being predominantly in senior, secured first lien loans, and having 2 to 4 maintenance covenants on nearly every loan set with meaningful cushions.
These criteria hark back to the origins of the firm and its direct lending franchise. Crestline – named after a beautiful road on the crest of a hill overlooking Fort Worth, Texas – sprang out of the Edward Bass family office, and his philosophy of protecting capital while seeking reasonable returns continues. “Crestline Founder Doug Bratton recruited Keith Williams, Managing Partner, and Chris Semple, Partner, who built the direct lending business to invest in less competitive deal-flow, and to create return and protection in overlooked assets offering excess return relative to more liquid markets. The strategy builds on the training learned as a part of Goldman Sachs’ special situations group, which invested through the great financial crisis, selecting industries carefully with attributes that support steady cash flows or asset backing and tailoring deals to each company,” says Jordan.
Crestline is raising USD 2-2.5 billion to deploy into 50-60 loans but is very selective. During 2020, Crestline’s opportunistic and direct lending team looked at more than 1,000 deals and invested in only 12 across the direct lending strategy. Companies could seek financing for growth, refinancing, recapitalization, acquisitions, and LBOs. The sweet spot for loan sizes is USD 20-75 million and this has not changed as firm assets have grown, though Crestline is now more often financing the entire loan or a larger slice of it.
Crestline has formed good relationships organically, throughout the US, based on its depth of knowledge and expertise, which provides an edge in sourcing deals that are less competitive. The manager has a rich network of contacts from existing loans made over the course of their careers, specialist investment bankers, to advisers, lawyers, industry specialists and board contacts, where Crestline has a presence both directly and as observers. Sourcing comes mainly from a huge variety of private equity sponsors, including sector specialists, which correspond well with Crestline’s own sector specialisms and lead to mutually beneficial sharing of ideas.
The direct lending strategies, which lend to individual companies and provide some asset backed specialty finance loans, also cross source deal-flow from other parts of Crestline. Crestline runs USD 7.5 billion in opportunistic and direct lending, including middle market, specialty finance and direct lending. Crestline’s private markets strategies currently include lending against private equity NAVs in mature Private Equity funds, and opportunistic lending (and have historically included some opportunistic stressed and distressed debt strategies). “All funds tend to cross-source. If a deal does not fit into one fund, it can end up in another one across the range of direct lending, opportunistic and thematic funds. Our strategies can be lending at spreads between 600 over LIBOR to 25% on a direct loan or an opportunistic asset. If a company needs a capital solution, we will aim to bilaterally negotiate with them to work it out. The firm has an open collaborative culture that encourages this sort of cooperation. We run a one team culture concept: everyone is incentivized to work together,” says Jordan.
Crestline’s European team, based in London, are not focused on sourcing deal-flow for the direct lending funds but rather focus on the opportunistic funds, which have a different mandate that can include liquid distressed funds. “The opportunity set is quite different: we see more asset backed and platform opportunities in Europe. Many deals in Europe would never see the light of day in the US which is a more competitive market. Most European deals could not be found in the US,” says Jordan.
Deals very seldom overlap between the distinct strategies of opportunistic and direct lending. “There have only been three occasions when an asset met the loan to value, duration and return criteria for both funds,” says Jordan. For instance, the direct lending funds target net returns of 10-13% including leverage, whereas the opportunistic funds target 15% net with no leverage.
Crestline runs USD 7.5 billion in opportunistic and direct lending, including middle market, specialty finance and direct lending
Crestline seek industries with one or more of certain key attributes, including contractually recurring revenues, predictable cash flows, sticky customers, and diversified streams of revenue from multiple sites. Such qualities have been found in healthcare; waste and environmental; software; consumer services; specialty finance; business services, and data centres/telecoms. These industries also tend to show above average growth and have historically had well below average default rates.
They do not include the obviously controversial sectors such as tobacco, alcohol, fossil fuels or weapons, which get screened out as part of the ESG policies. “There are also much more nuanced ESG issues that are considered as part of the underwriting process,” points out Jordan.
The majority of loans are cashflow loans, made to companies with positive cash flows and various types of collateral: “They are generally based on “intangible” assets, but contractual revenues can be sold, and intangibles can be underwritten as a secondary exit or risk mitigation tool. For instance, brands can be evaluated based on their standalone free cash flows. Asset backed deals are collateralized by pools of assets,” says Jordan.
Crestline is lending at around 50% loan to value ratios and other risk mitigants include avoiding bad management, avoiding major secular changes in industries, careful structuring, and nipping nascent issues in the bud. Crestline underwrites with the aim of making a full recovery on loans but “black swan” events could cause losses. Covid had limited impact partly because the Government stepped in, but it does explain the one and only payment default that Crestline has seen: “A cinema operator defaulted on payments and ultimately went into Chapter 11. It is now being worked out and is owned by Crestline and the other lender. The operation is being downsized to focus on more profitable sites and operating spending is being lowered. The borrower is now EBITDA positive, and Crestline expects a full return of capital,” says Jordan. Only one loan has been extended beyond its original five-year term due to performance issues.
Some loans may have been involved in a hiccup of some kind before Crestline got involved, but none are stressed or distressed at inception in the direct lending strategy. “We will figure out complications because that is where the value can be found. When work is required to understand the value of the loan, most competitors don’t want to take the time to do that level of work for a direct loan, they want an asset that is easy to underwrite. Crestline seeks those safe loans that take longer to understand and to underwrite, we will work to find 200 to 300 basis points of additional return for our investors. We do not have a CLO mentality of making a hundred or more loans and diversifying to reduce risk. We have an underwriting mentality of selectively making 15-25 loans per year for a portfolio of 50 to 60 loans,” says Jordan.
At least 90% of the loans are first lien and this is hard coded into the prospectus of the fund in line with the emphasis on capital protection. “Since inception, fewer than five second lien loans have been made, all in unique situations in industries that the firm knows very well and always where we have buyout rights to the first lien if we choose to exercise them. There have to be special factors for second lien loans,” says Jordan.
Though warrants can be a marginal return driver, minority equity is even rarer than second lien loans: there were none in Crestline Specialty Lending Fund I and only three cases in Crestline Specialty Lending Fund II, all of which were small positions. “Minority equity would be part of a package with debt and would not be invested in on a standalone basis. One deal involved warrants in order to expedite the closing and another one very unusually converted an exit fee into equity,” Jordan adds.
Crestline’s direct loans have an average of 3 maintenance covenants in SLFI. (As of mid-2021 headline statistics for the recently launched third direct lending fund suggest a decline in the number of covenants, but this is not meaningful. “The fund briefly took advantage of the Covid selloff to buy some liquid publicly listed leveraged loans that averaged only one covenant, which skewed the average lower,” explains Jordan).
We did not have any material revolver draws during Covid unlike a number of BDCs that used rights offerings to raise cash to meet their revolver draws but at the cost of diluting their shareholders.
Frank Jordan, Partner and Head of the Client Partnership Group, Crestline
Crestline also structures the investment vehicles carefully. Leverage is needed to push returns into double digits and comes through a competitive process. The terms leave enough latitude to withstand some stressed market conditions: “We operated well within the cushions of the loans even during the Covid crisis, and were not forced into selling any positions. Unlike some BDCs, Crestline offers very few revolver facilities and where they are offered, we have very tight constraints over how they can be drawn and used. We did not have any material revolver draws during Covid unlike a number of BDCs that used rights offerings to raise cash to meet their revolver draws but at the cost of diluting their shareholders,” says Jordan.
The leverage provider has recourse to the loan portfolio but not to limited partners (investors). The unleveraged strategy is separate, and some loans could be shared by both strategies.
Co-investments have seen enormous growth in recent years, but Crestline is only participating in this trend to a limited degree. The firm naturally sees plenty of investor demand for co-investments, but realistically has limited capacity to accommodate all such requests. “The volume of co-investments has certainly grown, but in the middle market space, smaller deals do not always leave that much room for them,” says Jordan. Crestline also makes a big effort to treat clients fairly and equally and takes care to avoid a perception that certain clients might have preferential access to deals or capacity. “All of the deals in the fund are our best ideas, but they each have a different risk/return profile,” says Jordan. Nearly all the assets in the direct lending strategy are from North American investors.