Since MGG Investment Group (MGG) was founded in 2014, credit investors have been concerned about rising leverage and declining creditor protections in the corporate credit markets. Both metrics have reached extreme levels in 2018, argues MGG President and Co-Founder, Greg Racz.
“Leverage has now surpassed 2007 peaks on some measures, with roughly 20% of mid-market US LBOs now levered above seven times EBITDA. This is a gargantuan number that will be very hard for a business to cope with when inevitably this current expansion ends,” says Racz.
In a recession, the seven times could suddenly be eight or nine times or even more – and it may already be, when more conservative or simply conventional headline measures of EBITDA are used. Some 35% of US middle market deals have EBIDTA adjustments, according to Covenant Review. They are not based on last year’s real and actual EBITDA, but rather on both backward-looking and forward-looking adjustments. EBITDA figures may add back exceptional losses or non-recurring costs or both for “Normalised” EBITDA. Forecast EBITDA measures such as Run-rate EBITDA, or Pro-forma EBITDA, might reflect anticipated future revenues, cost savings, or potential merger synergies that may or may not be realised. In many deals, there is no cap on the quantum of adjustments, which can sometimes more than double the EBITDA figure. Professional investor groups such as CFA Institute have flagged how the growing use of non-GAAP financial measures, which nearly always increase reported profitability, make it more difficult to compare and reconcile financial statements. Ratings agency Moody’s classifies many of the adjustments as “aggressive”, based partly on historical analysis suggesting that cost savings are not always achieved.
Regulators are also wary of some earnings adjustments, according to a Proskauer report, though the 2013 Federal and OCC guidelines – that say that regulated US lenders should not lend more than six times EBITDA for LBOs – are now being reviewed by Congress, and some regulated banks have recently done deals around the seven times level. Sponsored deals, often involving unregulated lenders, on average entail higher leverage than unsponsored deals.
MGG’s leverage ratios have been steady, typically starting around 3.2 times EBITDA, but often falling over time through amortising loans and Excess Cash Flow (ECF) sweeps. In contrast, some conventional (e.g. broadly syndicated or sponsor) loans have Payment in Kind (PIK) toggle structures that can increase leverage over time, by adding coupons to the debt rather than paying them in cash. It remains to be seen if some companies will be able to refinance maturing debt: one issuer in late 2017 reportedly failed to get away a PIK deal offering a 10% coupon in kind.
The number of small US banks with less than $100 million of assets has dropped from nearly 11,000 to little above 1,000 since 1985, due to mergers and periodic crises.
Greg Racz, MGG President and Co-Founder
“Meanwhile, investors’ appetite for yield is often letting private equity borrowers drive very shareholder and borrower-friendly terms,” says Racz. The percentage of loans that are covenant lite (cov-lite) has been steadily rising for several years, with 70% of mid-market loans in US and Europe now cov-lite.
Cov-lite mid-market issuance has reached record levels of around USD 25 billion in 2017. In some structures, private equity firms enjoy the optionality of moving assets out of the collateral pool, often into affiliates, such as shell companies, unrestricted subsidiaries and SPVs, where the lenders cannot foreclose, so they do not have a lien over all assets. For instance, so called “trapdoors” and “phantom guarantees” have allowed private equity firms to appropriate cash-flows and assets out of creditors’ reach. Excluding some types of “equity contributions” from collateral pools also facilitates transfers of value from creditors to shareholders. Equity cures to covenant breaches, and incremental loan facilities, including “amend and extend” provisions without lender approval, are other risks, amplified by the multiplier effect of arguably aggressive EBITDA figures. Though credit investors have, in a few cases, especially in Europe, successfully pushed back against EBITDA adjustments and cov-lite terms, the big picture is that terms are riskier than ten years ago, on the precipice of the credit crisis, according to Racz. Credit ratings agency, Moody’s, would seem to agree: their Loan Covenant Quality Indicator (LCQI) ended 2017 with the lowest yearly rating ever. MGG cites research showing that historically, full-covenant loans had recovery rates 50% higher than cov-lite loans (per the Credit Suisse Fixed Income Research Leveraged Finance 2014 Outlook).
MGG’s financial and operational covenants typically include minimum levels for one or more of: EBITDA, liquidity, revenue, free cash flow, interest coverage, fixed charge coverage ratios (FCCR) and maximum levels for one or more of: secured leverage, senior debt, loan to value ratios, capital spending, and operating spending. The majority of MGG deals have at least three covenants. MGG takes the lead in negotiating customised terms and does not usually participate in syndicated deals where others have dictated terms. MGG’s covenants also leave less latitude for management to fall short of their projections, than do those on sponsor, bank-led and syndicated loans.
“Leverage has now surpassed 2007 peaks on some measures, with roughly 20% of mid-market US LBOs now levered above seven times EBITDA,” says Racz.
Clearly, concerns about ballooning leverage and evaporating covenants have applied for years, without much mishaps for most credit investors, outside a few idiosyncratic failures and sectors such as resources and retail. Racz acknowledges that if global growth continues at 2-3%, and rates remain low globally, conditions could remain benign for credit investors. Still, Racz fears that amid the second longest US economic expansion in history, a Trumpian trade war, or another 2% of US interest rate hikes, are possible flashpoints that could trigger a recession, or at least defaults for some companies. The US tax reforms are, “net net” broadly neutral (or a positive) for most borrowers, but limits on tax deductibility could be adverse for some of the most heavily leveraged firms, according to Racz.
MGG is not alone in seeing potential risks for some types of credit investors – and in expecting direct lenders to be resilient. 190 mid-market loan participants, surveyed by Carl Marks Advisors in December 2017, were asked which types of lenders were likely to face the greatest challenges. Some 26% of them identified mezzanine lenders; 23% Business Development Companies; 18% distressed investors; 14% traditional banks; and 6.84% speciality lenders. Only 6.84% singled out private direct lenders.
Loans originated by MGG CIO and CEO, Kevin Griffin, performed well in 2007-2008 with no defaults of interest or principal. Griffin featured in The Hedge Fund Journal’s 2016 ‘Tomorrow’s Titans’ survey, sponsored by EY.
A recession might even increase the opportunity set for some alternative lenders such as MGG. In 2017-2018, MGG have not been entirely immune from spread compression. The hundreds of deals that MGG reviews each year remain several percentage points above the average of 6.31% on US mid-market loans, but are seeing somewhat tighter spreads. MGG’s book has weighted average coupons of LIBOR +9% whereas the pipeline is more often LIBOR+8%, for senior secured first lien loans. As these spreads are on top of floating interest rates (and have LIBOR floors of 1-2%), MGG’s overall gross coupon yield is still in double digits. And there are other sources of returns: up-front fees, original issuer discounts, and call protection are usually worth 1-3%. Equity warrants, exit fees and penalties for covenant breaches can add to returns. All of these fees go to fund investors, and not the management company or deal sourcers. There are no affiliated advisers. In total, MGG projects a gross c.12%/net 8% IRR for unlevered investors, and a gross c.15%/net 10% for levered investors.
With or without a recession, MGG has a huge menu of potential deals to choose from. Though regulatory reforms, such as the Small Business Credit Availability Act, are making it easier for BDCs to increase issuance, and use more leverage, there remains a shortage of credit for the vast US mid-market firms with EBITDA of $10-40 million, seeking to borrow $10-100 million – which would collectively rank as the world’s third largest economy.
“The number of small US banks with less than $100 million of assets has dropped from nearly 11,000 to little above 1,000 since 1985, due to mergers and periodic crises and few in the US are starting new banks or challenger banks. The industry has become ultra-concentrated with roughly 90% of the money coming from ten giant banks, that have a preference for lending to large companies,” says Racz.
MGG remains selective. In 2017, only seven out of 700 deals reviewed were selected.
Intermediaries, brokers, and advisors, have provided 55% of MGG’s deal sourcing, and banks have provided 9%, with 26% coming direct; only 10% have come via sponsors. MGG generally lends to private companies controlled by families and entrepreneurs. Griffin and a very senior team have built up a strong reputation and network over nearly 20 years in the space.
Though MGG is primarily a debt investor, the manager is often investing in growth companies. Acquisition finance accounts for the largest number of MGG’s realised deals (16) and growth capital makes up seven deals. Refinancing has been the reason for six deals, or eight including dividend recapitalisations, which account for three deals; and there has been one bridge loan.
MGG has now invested in a total of 30 deals and remains very selective. In 2017, only seven out of 700 deals reviewed were selected. MGG do their own “deep dive” underwriting including forensic accounting and background checks.
Key focus sectors for MGG include sports, media, tourism and gaming, with logistics and healthcare including urgent care and behavioural health, having seen some pick-up.
MGG tends to avoid energy and real estate development where specialists may be better placed to assess risks. But MGG is certainly seeking to pick up complexity premia in special situations.
An example of growth capital is a recent deal to factor invoices for a fast-growing Amazon logistics supplier, for goods that have already been shipped. The yield is 10% with a 2% OID. The deal size is around USD 70 million, with some fluctuation according to business volumes. MGG won this business partly because they can act faster, within 60 days, whereas bureaucratic banks might need longer to get approvals from committees.
An example of acquisition finance is a funeral homes consolidator. This is a steady but low growth industry with huge potential for consolidation, as some 18,000 US funeral homes are small “mom and pop” type family business.
While some loans may have little or no hard asset backing, MGG is lending against assets as well as cash-flows. MGG’s weighted average loan to value ratio is 46% and if collateral does decline in value, MGG nearly always has the first claim. Some 95% of its loans are first lien, whereas most middle market loans are uni-tranche, second lien, mezzanine or equity tranches. BDCs in particular have a higher proportion of second lien and unsecured loans.
But more importantly, MGG’s covenants should let investors extract penalty fees, and ultimately to enforce foreclosure or other remedies if necessary. MGG borrowers have breached covenants between 10% and 25% of the time, and MGG has the power and control to monetise this. Covenants can both protect principal and enhance returns. When lending against an esoteric asset class, namely horses, MGG’s loan to value covenant was 50%, so some horses could be sold in case of a breach. When a gaming slot machine operator breached covenants, returns jumped to an IRR of 20% from 14%. In a deal involving TV spectrum rights in Texas, MGG realised an IRR of 18% partly because a delay in the auction process increased the rate to LIBOR+12 from LIBOR+9.
MGG is prepared for the possibility that defaults could require workouts. Griffin, Racz and other team members, who have worked at TCW, JP Morgan, Oaktree Capital, TPG Special Situations, Cerberus Business Finance, and DE Shaw Direct Capital, have experience of out of court workouts, restructurings/exchange offers, distressed lender takeovers and workouts, in-court bankruptcies involving DIP loans, Chapter 11 financings, Chapter 7, and rescue financings. MGG likes to stay in the driving seat in cases of covenant breaches, and deals are expected to be profitable upon defaults.
At Fortress between 2003 and 2007, Griffin belonged to a team with peak assets of $10 billion and at Highbridge Principal Strategies, between 2010 and 2014, the specialty finance portfolio peaked at $6 billion. MGG has a much lower capacity target and expects to hard close at net assets of $1.5 billion in late 2018. Current assets are around $1 billion, with $230 million of leverage, though many investors use no leverage; some investors also co-invest in MGG deals.
Performance is the priority and staff are paid on performance.