Alt Thinking Podcast - Private Credit, an Opportunity to Seize with Dayna Kleinman

As an investment, private credit is just hitting its stride. Monroe Capital’s Dayna Kleinman believes it’s not too late to for Canadians to catch up to world investors and include this alternative asset class in a well diversified portfolio.

Part of Ninepoint’s Alt Thinking Podcast Series. Available at Google, Apple, and Spotify Podcasts.

Michael Hainsworth:

Depending on who you talk to, the private debt market is entering a new era. To Dayna Kleinman, private credit is just hitting its stride. Interest rates are up and so are yields. For the head of business development for wealth management solutions at Monroe Capital, it's not too late to diversify into alternative asset classes such as private debt. The lower middle market in which she operates is lender friendly, and she's seeing lasting opportunities for investors as banking regulations leave the top tier banks on the sidelines. We began our conversation by discussing the fact that in her 30 years of experience in the investment industry, she's never seen an environment quite like this.

Dayna Kleinman:

Absolutely not, and it's scary to think that I've got 30 years to look back on now. But that being said, I'll take that in stride. It is actually very interesting cycle, because not only has it been so dramatic in terms of the amount of hikes and the number of hikes, the expediency, right? We went approximately 500 basis points in a year. Although we have seen rate hikes in the past, we've seen the occasional 75 basis point hike, we have never seen that much that quick. But the flip side of that is how expected it was. That for the most part, there weren't any surprises.

Everything was very much anticipated. That makes it really unique in that sense that you have this combination of dramatic nature, yet expectations. I think in the long run that will have served a lot of people well in the sense that they were able to manage things through the cycle.

Michael Hainsworth:

If, as you say, we saw this coming, where are we now as far as that forward-thinking view? Because the latest reading on Canada's GDP suggested interest rate increases are still on the way. The Fed's been still hinting that there may be more to come as well. Are we as certain as we had been at the start of the pandemic, at the start of the Russian invasion of Ukraine? Do we have a sense now that we still have a very clear path, or are things starting to get a little more volatile?

Dayna Kleinman:

I would say nobody, of course, has the crystal ball. I think we went through the day of Silicon Valley (Bank collapse). The Fed still marched ahead as anticipated with a 25 basis point hike. People stood back and said, "Really? A bank just failed and you're going to still raise rates," which says to me there is somewhat of an intentional path still going forward. Now that we are maybe in the seventh inning of that, does it get less dramatic? Does it slow down a little? Does the debate come in as to when do they pause, when do they shift gears and start to lower rates?

I mean, your guess is probably as good as mine. I would say though, seventh inning feels about right. And then at this stage, probably minor moves and then hit pause button for a while, reset and may be switch directions. But I don't know that we have any shocks coming in terms of three 75 basis point hikes in a row left.

Michael Hainsworth:

The Reuters columnists working in your industry recently described the private debt market as entering a new era. What is this new era as you see it?

Dayna Kleinman:

I would say not a new era. Maybe a continuation of an existing era that came to be after the great financial crisis. When we went through the great financial crisis, that really created the void where banks can no longer lend in the traditional way that they had under the same regulations. They had new constraints on them, new restrictions of the amount of risk that they could take. That just opened up the opportunity for direct lending private credit to come into its own. We saw that happen. You saw the shift of market share go from over 50% of the banks in the lending space to down to about 25%.

Now, when they say new era, I'm assuming they're implying, well, Silicon Valley, First Republic, I won't name the other ones, but that is going to send a message that regional banks maybe we need to re-look, maybe there's a new scrutiny that needs to be involved, and again, opens that door wider for private lenders, the direct markets. And that trend will keep coming our way. I think between that and us earning more on loans because of the higher rates makes it feel like the stars have aligned, so to speak.

Michael Hainsworth:

I was just going to say then, in light of the recent challenges in the banking system, it sounds like you're adopting an optimistic view at Monroe Capital.

Dayna Kleinman:

Absolutely. We look at our experience having been around since the great financial crisis as a real asset more so than ever, having been able to navigate different cycles, having the playbook in place of how to underwrite these companies with the right interest rate sensitivity forecasts, how to look at their ability to meet payments and absorb higher rates, to consider what sectors we're in, to work with them as a true partner to help them navigate volatility. It becomes an opportunity to really prove that our experience, our consistency, providing that security really wraps itself around as a good partnership. At the end of the day, that makes it worth paying a little premium.

Michael Hainsworth:

What would you say the biggest myth is about investing in the private debt market?

Dayna Kleinman:

Risk. Oftentimes people assume if you're going direct or if you're in the lower market like us, for example, that smaller means newer, smaller means riskier, private means they don't have a rating. The reality is there are reasons to go to a direct lender versus a traditional avenue like a bank that are beyond that. And that could include, again, the deep partnership in terms of being able to grow with a borrower, add on financing later to work with them, to customize the terms to really meet their needs, speed to close, certainty to close, so that once they're working with us, they really know what to expect.

Oftentimes people assume in the lower middle market, for example, smaller means newer. The average age of the companies we work with or we lent to is often anywhere from 22 to 30 years on average, which means those companies have shown their stability through multiple cycles. I think that's where people just always hear the word private, they hear alternative, they hear direct, and they just start to assume there's a mystery behind it. The reality is it's just a more personal, customized way to get business done with a true partner that can really work with them to meet their needs.

Michael Hainsworth:

If this is a lender friendly market and you look at say 2,000 deals in the private market a year, how many are you actually executing on?

Dayna Kleinman:

Great question. It is definitely lender friendly in the lower middle market, to clarify. I would say where we sit in the lower middle market, meaning EBITDA $35 million and under, it is more fragmented. Oftentimes that allows us to create a little more alpha in the deals. If you think about larger deals, there's fewer of them out there. We have the same players going after those same deals. That part of the market might actually be a little bit more borrower friendly. In our part of the market, we command covenants on every deal we do. We can get the yield premium. In the lower middle market, yes, we see approximately 2,000 deals a year, and that is going to come from multiple sources.

We work here at Monroe with both private equity, private equity sponsors, and non-sponsored deals, meaning we go directly to companies. We have a wide range of those sponsors we work with, and we maintain very, very high criteria. We are still only executing an approximately 5% of the deals that we look at. Even if that universe shrinks a little, we're not willing to bend on our terms or our criteria. We feel there is enough out there that we can still and we choose to be picky.

Michael Hainsworth:

Tell me what is that criteria?

Dayna Kleinman:

Well, I can't give away the whole secret. Diversification is really a theme in everything we do. We don't work with just one PE sponsor. We want multiple. We're not in just one sector. We want multiple. We want a fund to have enough loans that no loan represents a certain percentage. That diversification when we look at our companies is going to apply to what does their customer base look like? If they have something that needs to be manufacturing, what does their supply chain look like? We want to make sure that at their level as well that there is that nimbleness in terms of then to be able to adapt to an environment and be prepared.

We prefer areas that are non-cyclical. We tend to focus on deals that are a little more business to business or what we would say is mission critical. If you are going to as a small company engage a new software program, call it for compliance, CRM, whatever it might be, that's a big lift for that company to invest in that, to vet out the right new vendor, to implement it into your organization to make that change. You're not stripping that out the minute the talks of a recession loom. You've put that in for efficiency. Those types of non-cyclical sectors are extremely appealing to us, to have that business to business mission critical approach and to be almost one step away from the final consumer.

Now, again, we also look at the size of the firm. We look at their history. We actually will vet the PE sponsor as well. There's a ton of stuff that goes into our underwriting mix. However, at the end of the day, diversification is steady, boring. I always say to people, we invest in the non-sexy backbone of our community. Maybe those companies won't love that description, but we're generally not going to have a page full of logos that people are really going to recognize.

Michael Hainsworth:

Tell me about the deal activity at Monroe right now. Where are you seeing opportunities in the US private debt market to take advantage of that lender friendly environment for that lower middle market in which you operate?

Dayna Kleinman:

I would say deal flow is starting to pick back up. I think the industry as a whole did see a little bit of a pause in Q1. Obviously absorbing all those rate hikes from 2022 in the beginning part of this year. It does take a little time. If rates go up, it could be 30 to 90 days before that works into a floating loan. There was definitely a little sense of pause, a little sense of where the PE sponsors going to continue to pay multiples, and all that has to shake out. A little quietness or more quiet than we've seen in Q1, but I would say that's picking back up.

We are really seeing it. For us, we're in a lot of different sectors. Again, they are not necessarily cyclical sectors, so we see a lot in the software and technology with recurring revenue. We still see a lot in the healthcare services, as well as business services and feel like those are very steady ongoing needs around our environments.

Michael Hainsworth:

So then what timeframes are we talking about when it comes to the opportunities provided by today's market? Are there specific indicators that you're monitoring for signs of change and it's time to change tact?

Dayna Kleinman:

Well, I think some of that might get driven by the private equity side of the business. They almost have to come to terms on their own. We were paying 12 times multiples, maybe we're down to 10 times multiples. Are these companies... Because we've got dry powder to put to work. If you think about how the equation comes together, if a private equity company decides to buy a company for their fund, let's say they're buying it for $250 million, it could be a $25 million EBITDA firm, they're paying a 10 times multiple, they're probably putting up $150 million of that equity and we're financing $100 million of that.

That ratio is going to be somewhat dictated by the private equity side figuring out, is there a new happy medium of what kind of multiples we should be paying? Because that will also determine if I'm the business owner, am I going to go to a PE sponsor, or am I going to go direct to a lender? I mean, heck, if I can get a 10 times multiple, guess where I'm going? Our opportunities get a little dictated by that. But again, that's why we work with a wide range of sponsors, as well as with the companies directly. For us, the trigger points of what we might see, so that might be an indicator if you see multiples change, obviously if we see the interest rate cycle take pause or eventually reverse.

I think the fears of recession have dampened a little bit. I would say six months ago, that felt like every other headline. I think today it's out there. We're living with it. It's either there or not happening. Again, I think the drama of it is a little bit removed. I would say it's not going to be some sharp dissension or sharp 90 degree angle. I think we're just going to slowly see some things shift a little bit back to norm, if you will.

Michael Hainsworth:

You mentioned dry powder. How much cash do you have sitting on the sidelines to deploy, and how has that changed over the last year?

Dayna Kleinman:

Generally, the ratio though, if you looked at the private credit market as a whole and not just Monroe relative to private equity, it's about 20% of whatever they have. How I interpret that is that there is a lot of dry powder for the PE shops to put to work. Now, that might have come down a little bit finally, but that means there's plenty of opportunities for us. And then you have to look at the balancing act, right? Capital raising, raising money and deploying it. You want that nice balance of as we bring in money, we can quickly deploy it. No manager wants to create cash drag, right?

It's a constant balancing act, to be honest, we know we're bringing in flows on a regular basis and we deploy on a regular basis. Last year we did about 50 new deals and maybe 50 add-ons from existing borrowers. That's, again, when we look at over 2,000 deals a year, that's our normal pace. It's just that ratio maybe between add-ons versus brand new deals.

Michael Hainsworth:

In Canada, investor allocation to private debt has been slower than in the United States, but there is growing interest globally. Have you noticed a shift in the adoption of private debt as an asset class for investors?

Dayna Kleinman:

I would say globally, yes. I think you're absolutely right. Canada has had some headline issues that maybe had folks take a pause. I think that's been absorbed and acknowledged and folks have been able to move on from that. I think it's really proven itself as an asset class across the board that has low correlation to traditional assets. And that is such a huge value add, right? When you look at an environment in 2022 where both equities and bonds were down, I mean, any of us that have been around multiple decades would tell you that was never in our textbooks.

That wasn't supposed to happen. When that does happen, all of a sudden, that reminder of why you want something with low correlation really comes through and to be able to find an asset class that can provide a lot of the benefits of what you go into, for example, traditional fixed income for without taking on that correlation and that can be relatively boring. I think that's really welcome to any portfolio manager.

Michael Hainsworth:

What's the most important takeaway for the listener of our conversation today as you see it?

Dayna Kleinman:

If you haven't looked at private credit, you're not too late. That will definitely be one message. I don't want to scare anyone from saying you've missed the sweet spot as the stars have aligned. I think if you haven't looked, now's the time. We have floating interest rates on our loans, and we're at a base rate of five, with spreads about 7%. We're earning about 12% from our borrowers. We pass majority of that onto our investors. There is yield to be earned. There is income to be earned. There is stability in pricing. You're not tied to daily markets. It is a growing industry. It's a growing asset class, and that is going to continue to happen.

You hate to use that cliche, if you're not showing it to your clients or you're not thinking about it, someone else is, but there is a truth to that. This is going to become a bigger and bigger part of our economy. The expectation of how large private credit can get, I want to say is in the trillions over the next few years. There's a lot of good managers out there. I would also say another takeaway is not all managers are created equal. I just said there's a lot of good managers out there. It's understanding what makes a manager unique, what part of the marketplace they work in. Just like you would buy a small cap or large cap, you want to look at lower middle market, upper middle market, traditional.

Different managers focus on different sectors. There's a way to look at private credit managers and build a portfolio and an allocation around that in a really thoughtful way. There is a lot of really, really, really strong opportunities out there and some really smart people doing some good stuff. Now is definitely the time.

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Part of Ninepoint’s Alt Thinking Podcast Series. Available at Google, Apple, and Spotify Podcasts.