MGG: Niche Direct Lending

Sweet spots in mid-market

HAMLIN LOVELL

MGG Investment Group (MGG) was co-founded in 2014 by CIO and CEO Kevin Griffin, and President Greg Racz, with seed capital of $200 million from an affiliate of McCourt Global Capital (MG Capital), which is part of the McCourt Group that dates back to 1893. MGG opened to external capital in April 2016 and has so far taken in $600 million of equity. Some of its vehicles use leverage on top and capital managed is now roughly $1 billion, with more total capital deployed in MGG deals as some involve co-investments. MGG structures and invests in bilateral loans that command a significant yield premium over the loan indices, while arguably being less risky than some other loans, based on various metrics. Griffin has an impressive pedigree: since he started taking on full responsibility for originating loans in 2007, he has not lost money on any deal.

Private lending has seen huge growth over the past decade, with assets rising globally from $156 billion in December 2006 to $523 billion in June 2015, according to Preqin. But MGG’s founders and staff chose to specialise in direct lending long before it became a fashionable strategy, attracting ‘tourists’ from multiple hedge funds and private equity, and other asset managers that pursue a range of strategies. The firm is distinguished by a focus on specific market segments and deal structures. MGG lends to the middle market, especially the less competitive lower middle market firms, defined as having EBITDA between $10 million and $40 million, and revenues of at least $50 million. MGG advances between $10 million and $75 million per borrower, and tends to focus on complex or special situations that deter other lenders.

Middle market neglected
MGG thinks the middle market is the ‘sweet spot’ for various reasons. Griffin claims that some of the largest firms in the direct lending space (including his former employers, Highbridge and Fortress) now run such high levels of assets that ‘they need to do bigger deals to move the needle.’ Conversely, he views smaller regional banks as being ‘out of the picture and unable to grow with their borrowers’. Griffin notices that a few Business Development Companies (BDCs) are active in the space, but they have limited capital to deploy, and typically prefer lending to private-equity-owned borrowers. Griffin worked for BDCs earlier in his career and points out that many US-listed BDCs are trading at big discounts to their net asset value, which makes it more difficult for them to raise additional capital. The net effect is that medium-sized companies are ‘falling between two stools’, leaving the market ‘vastly underserved and with less competition than in larger loans’, according to Griffin. Indeed, MGG is sometimes the very first provider of finance, and at other times replaces lenders that cannot expand with their clients.

Judicious selection and sourcing
The US corporate middle market is a vast one – its output would collectively add up to the fourth largest economy in the world, according to Griffin and the US National Center for the Middle Market. This investment universe offers enormous diversity in terms of industries, yields, leverage multiples, collateralisation, deal structures and so forth. MGG is highly selective in filtering deals to whittle down the universe to a suitableshortlist.

MGG has to cast its net far and wide to catch the right types of companies and loans. MGG lends throughout the United States, and ‘the team have done deals in almost every single state over our careers,’ confirms Griffin, with the occasional deal also done north of the border in Canada. Where bankruptcy law is relevant, the jurisdiction will tend to be New York or Delaware. Around 80% of borrowers are private companies, while a few are microcap-sized public companies (though in the US the definition of a microcap, i.e. a market cap between $50 million and $300 million, would be a small cap or even a mid-cap in some European or Asian markets).

Most industries are on MGG’s radar. The firm is ‘industry-agnostic, with the exception of energy and real estate development where you need a full team of specialists’, says Griffin, who featured in The Hedge Fund Journal’s 2016 ‘Tomorrow’s Titans’ survey, sponsored by EY. Though MGG can lend to stressed or distressed companies, where it is possible to lend at a discount to particular assets, MGG generally seeks businesses with steady revenues. Griffin is wary of sub-sectors vulnerable to rapid technological change, but finds that some software businesses with recurring revenues can be cash cows. MGG is particularly expert in industries such as sports, media, tourism and gaming. The last of these is perceived to be a relatively cyclical industry, but MGG has identified niches that are more stable. Native American casinos, for instance, have ‘fairly consistent revenues over multiple cycles over at least 15 years, with downturns of only 6-8% on the top line. They are more resilient than Las Vegas casinos as they are part of normal social life and you do not need to get on a plane,’ explains Griffin. MGG has also lent to a specialist provider of remittances to certain South American countries, and has continued the relationship after the firm was acquired.

These sorts of loans are seldom available from the most obvious sources. Abundant private lending deal flow emanates from private equity deals, such as leveraged buy-outs (LBOs) and management buy-outs (MBOs) but these, combined with loans obtained via large banks, rarely meet MGG’s criteria – and so make up only 20% of MGG’s portfolio. Griffin cites a University of Virginia study of 2,000 firms that showed that private-equity-backed firms had default rates 50% higher than non-PE-owned firms between 1997 and 2010.

In contrast, MGG deals come through a grapevine of market contacts and intelligence. Around 25% come from the team’s extensive network of CEOs and CFOs. ‘These are people we did deals with in the past, who know the industry. We have close contact with boards and get an early look on deals,’ explains Griffin. A further 50% of MGG’s book comes from advisory firms, such as lawyers, brokers and accountants, who ‘hold the keys to different companies’, as Griffin has found during his 20 years in the space.

As of November 2016, MGG had only invested in 16 out of 830 loans reviewed, or about 2% of the deals of which it has sight. Why were 98% rejected? Griffin enumerates, ‘About half got thrown out as their capital structure was too levered; others offered yields that were too low; some lacked structural protections such as covenants; certain deals did not permit us to run our proprietary due diligence process, and some were in the wrong industries.’ Additionally, MGG likes to ‘short-fuse the process and take it off the street’, or in other words, disintermediate the banks and deal direct with lenders. MGG obtains exclusivity in order to be in a strong position to structure loans that meet its criteria.

Structuring
MGG’s lending criteria will rule out most potential borrowers. MGG lends directly to companies and is usually the sole lender,thus excluding syndicated deals. MGG makes senior, secured loans at the top of the capital structure, which might eliminate firms that have creditors with prior liens. MGG uses lower leverage multiples than are typical of private equity deals, and requires a cushion of over-collateralisation, both of which will deter the most aggressive shareholder-driven leverage plans. Shareholders, including some activists that seek a substantial and swift return of capital, could also be repelled by strong, negotiated covenants that are intended to provide additional downside protection. All of MGG’s loans pay cash coupons so borrowers need to be generating cash; there are no Payment In Kind (PIK) toggle bonds that in effect ratchet up the debt until maturity.

Yet unusual corporate assets are not necessarily an obstacle to doing business with MGG. The firm lends against a wide variety of collateral and asset types. This is not least because MGG is nearly always the only lender and so offers a full solution, taking a holistic view of borrowers’ assets. Griffin acknowledges that ‘many credits have rather esoteric assets from intellectual property, to horses and horse breeding rights.’ Griffin thinks that MGG could have an edge at valuing some types of collateral, given the team’s experience. That said, around half of collateral is traditional working capital, such as property, plant and equipment. Naturally there are different views on how to value less commonplace assets such as wireless spectrum, where MGG has lent to a Texas TV station with FCC spectrum rights. MGG carries out its own valuation work, and then tends to end at a loan-to-value ratio of around 50%. ‘Discounts to collateral values range between 40 and 80 per cent,’ says Griffin.

Underwriting to recession scenarios
MGG’s borrowers have an average net leverage multiple of 3.2 times Enterprise Value to EBITDA through the whole company and, by extension, MGG’s investments. According to Griffin, this multiple is now almost half the average syndicated bank debt multiple. He is of the opinion that  ‘leverage multiples around six times on a covenant lite deal are aggressive regardless of price.’ This is partly because corporate earnings – as a proportion of GDP – are well above cyclical averages, but Griffin also has a healthy and perennial scepticism about the denominator of the equation. ‘We always believe recession is around the corner and structure deals accordingly. We underwrite to the MGG case, at a discount to actual cash flows, and structure very tight covenants to get back sale amounts and sometimes have potential for excess cash flow sweeps,’ he says. Covenants are drafted in house and will specify the usual restrictions on dividend payments, capital spending, obtaining additional debt, fixed charge coverage and EBITDA ratios. MGG receives monthly financial data to monitor compliance with covenants.

Third-party checks
Most of MGG’s deal legal work is done externally, and Griffin has used the same counsel for 20 years. MGG’s due diligence process includes using third-party experts to carry out background checks and forensic accounting. Background checks have sometimes revealed questionable ethics: that management misstated educational qualifications, or have gone bankrupt on a personal level. Forensic accounting is designed to ‘make sure we are lending based on an appropriate metric of cash flow’, says Griffin, and forensic experts have, for instance, identified that accounting adjustments to EBITDA are in fact recurring rather than once-off. Warren Buffet and Seth Klarman are famously sceptical and critical of EBITDA as a measure of valuation of cash flows, and MGG also feel it can be misleading. Whereas MGG is more likely to curtail its proprietary measures of EBITDA, some lenders, Griffin has noticed, are entertaining a much more expansive perspective on the metric by adding back line items, which drastically increase the actual underlying leverage and risk.

When MGG helped to finance the acquisition of China Branding, the standard due diligence process applied: background checks and forensic accounting, designed to ensure that cash flows and revenues were repeatable. The due diligence process is the same for private and public companies, though Griffin thinks he may obtain more information from public ones if anything. A deal is not done until all checks are made, and this can entail some wasted work: four deals fell through towards the end of MGG’s process. Potential investors can review MGG’s due diligence.

Above market yields and spread per turn
Despite all of these risk mitigants, MGG is able to charge yields well above market rates. The middle market loan indices are currently yielding between 600 and 800 basis points, which offers a premium of up to 2% over large loans, according to Griffin. MGG is charging spreads of between 1000 and 1200 basis points, or between 300 and 500 wider than the index. Thinking in terms of spread per turn of leverage, a widely used metric in credit markets, the difference is even greater. The loan indices offer between 100 and 150 basis points per turn of leverage, whereas MGG is getting between 300 and 400 basis points per turn. Of course MGG’s yield premium is partly an illiquidity premium: although MGG structures deals with multiple potential exit points, direct loans are less liquid than publicly traded ones.

Most of MGG’s return comes from cash coupons, typically around 10%, but these can be enhanced by original issue discount (OID) and fees. Sometimes there is also an equity kicker in the form of warrants. MGG’s average expected internal rate of return (IRR) is 13% unlevered (18% levered). The unlevered range is between 10% and the high teens, with the odd deal around 20%. Though these returns seem high compared with high yield corporate debt, the types of companies to which MGG lends might need to pay even more – as much as 20%, according to MGG estimates – for equity.

Given that yields in the low- to mid-teens can be obtained at the top of the capital structure, all 16 deals MGG has done so far are senior, secured and first lien (which can also allow for some investments in distressed debt, such as Debtor In Possession (DIP) loans). As of late 2016, Griffin saw little point in doing other types of deals but MGG’s team has an extensive repertoire of deal types, including last-out financings, bridge loans, pre-packaged bankruptcies, dividend recapitalisations and many more. As market conditions evolve, there is potential for MGG to opportunistically rebalance the portfolio towards the most attractive prevailing opportunities. MGG team members have substantial experience of workouts, portfolio monitoring and deep dive underwriting, drawn from firms including TCW, Oaktree, TPG, Cerberus, AEA, JP Morgan, and Partners Group.

Griffin’s unblemished track record
Griffin has had no losses since he started taking responsibility for deals in 2007 and this is true at the individual deal level, not only at the portfolio level. This does not mean that Griffin saw no defaults, however. ‘Deals do not always go as planned, and I have been through workout processes that can take two months or two years,’ Griffin recalls. In deals such as DIP loans, he acknowledges that ‘it can take much effort and energy to get the money back.’ But the essential point is that Griffin has always recovered principal amounts, and then some. ‘My worst deal in 10 years still had a 6.1% return,’ Griffin says. Though recovery rates on publicly traded senior secured loans may average around 70%, with much variation through cycles and between companies, Griffin’s recovery rate has, in effect, been above 100% because ‘if deals are underwritten correctly there is upside for the lender to get additional recoveries,’ he explains. Overall Griffin projects that ‘double-digit returns should be the normal case and high single-digit returns the worst case’ for investors. Potential investors can review Griffin’s track records from his time at Octavian. Griffin can also talk investors through the types of deals he and his teams did at Highbridge, Fortress and American Capital Group.

Vehicle choices
The MGG strategy can be accessed through a variety of investment vehicle structures. Cayman offshore and Delaware US onshore domiciles are offered. There are limited-life, closed-end funds that draw down capital as and when needed, and also evergreen funds. Some investors can obtain leverage at the portfolio level, in vehicles that are legally separate from the unleveraged one; roughly 70% of MGG’s capital is levered and 30% is unlevered. MGG invites investors to co-invest in certain deals on a fee-free basis. ‘Investors can in effect use us as a free underwriting resource and get more exposure to certain deals, albeit on a more concentrated basis,’ Griffin explains. Performance fees, or carry, apply only to realised returns, in accordance with normal practice for private equity vehicles. The investor base includes pension funds, endowments, foundations, insurance companies and high-net-worth individuals.

Post-Trump outlook: the economy, the Fed and the banks
Recession probabilities may be receding, according to those investors who are optimistic about fiscal stimulus from the new American administration. Overall, Griffin thinks Trump’s proposed policies could improve opportunities for middle market US companies, but he still sees a 25%-plus chance of US recession. Though MGG’s main offices are in New York City, much pan-US coverage informs Griffin’s perspective that ‘the coasts have done well but the middle market still hurts, and a downturn could be very deep. We remain very concerned about the economy.’ His caution is based partly on an assessment that credit markets are at a late stage of the cycle. ‘It feels like 2006, with aggressive deals, very levered capital, and poor covenant protections,’ Griffin observes. He also views equity market valuations as ‘toppy, because trees do not grow into the sky’, and worries that ‘pressures on corporate earnings could overshadow recent market euphoria.’ What could be the catalyst for any recession? Griffin doubts that it would be real estate this time around, but sees no shortage of other potential tipping points, listing: ‘defaults could rise; China is always a time bomb; there is more political uncertainty with more aggressive attitudes; some chance of a country exiting the EU and/or a single European currency, and terrorism is a threat.’

Further Fed rate rises are a near certainty – and have preceded previous US recessions. MGG portfolio yields are referenced to floating rate interest rates. If there are three more rate rises in 2017 (the consensus expectation in December 2016), reference rates on a growing proportion of MGG deals could start to break out above their LIBOR floors, and would then move up in tandem with rate rises.

Griffin acknowledges that a lighter regulatory burden, such as mooted relief from Dodd Frank for smaller banks, could revive bank lending in some areas. He predicts that more buoyant bank lending could make it hard for some asset managers to compete with lower rates from banks, and consequently expects that some asset managers could exit direct lending strategies and return to more liquid areas. Yet under this scenario Griffin still sees a strong opportunity set for MGG, which occupies a number of very niche market segments where banks are less keen to compete.

Tax considerations for offshore investors
Offshore funds pursuing US lending strategies are structured in various ways to avoid exposing investors to US tax liabilities. This article is not offering tax advice, but can briefly outline the methods used. The tried and tested approach is ‘season and sell’, whereby loans are originated by an onshore vehicle and later bought by third parties, including the offshore fund. ‘This is like any offshore fund buying any other credit in the secondary market, whether it is high-yield, IG, or bank debt,’ explains President of MGG Investment Group, Greg Racz. He adds that ‘MGG has set up a “blocker” that helps, among other things, address UBTI [Unrelated Business Taxable Income] and ECI [Effectively Connected Income] issues.’ To mitigate these taxes, some other funds seek to rely on cross-border tax treaties but MGG currently does not. The US is clearly making it more difficult to minimise some types of withholding taxes; however the IRS section 871(m) rule change applies to dividend equivalent income, and not to coupon income on loans.