The Silver Lining to Rising Rates with Ted Koening of Monroe Capital

October 2022

Interest rates are expected to continue to soar in 2023.

So...how can investors turn rising rates to their advantage?

In this latest edition of the Alt Thinking Podcast, Monroe Capital’s Chairman and CEO Ted Koenig discusses with Michael Hainsworth how Private Debt is ideally positioned to deliver reliable income and improved risk adjusted returns – even as rates rise and the global economy advances towards a potential recession in 2023.

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

 

Michael Hainsworth:

Equities have taken a hit as central banks worldwide try to tame inflation through accelerated interest rate increases. And despite the unprecedented hikes we’ve seen so far, more are on the way. Ninepoint’s Eric Nuttall likes to say he smiles every time he suffers a pinch at the gas pumps – because he’s hedging away that inflationary cost through energy sector investments. So how do we do the same every time the mortgage rate rises and economic growth falls? Ted Koenig of Munroe Capital tells me private debt is one solution. So I began our conversation by getting his interest rate outlook. And if you’ve got a variable rate mortgage, you’re going to want to be sitting down for his answer.

Ted Koenig:

Well, the US Fed has indicated that their target is 4.4. I think it'll get to 4.5 or somewhere close to that. We're currently at 3.2. So we're looking at least another 120 basis points of increased interest rates, probably 75 basis points here in October, and another 25 basis points in each of November and December, is my bet.

Michael Hainsworth:

So what does that current rising rate environment mean for private credit?

Ted Koenig:

Well, private credit is all floating rate, which is the good thing. So every time there's an increase in interest rates, private credit absolute returns go up. So this year alone, we've seen about a 200 basis point increase in our interest rates for our investors, with the increase in the Fed rates. The spreads tend to remain relatively similar, around 5 to 550 to 600 basis points. But the real upside for private credit investors has been the increase in interest rates, which is, as I said, about 200 basis points this year.

Michael Hainsworth:

So then let me sort of barbell that with your recession outlook for 2023, because we've got the good. Is this the bad or the ugly?

Ted Koenig:

Well, the challenge, and I will tell you, we've been doing this 20 years, so I can tell you what happened during the .com crisis. I can tell you what happened during the great financial crisis, three recessions in between, COVID, and now this high inflationary period. As long as interest rates don't get too high, and what I'm talking about is not 4.4%, but 7, 8, 9%. As long as we don't get interest rates too high, most companies that we're lending to in private credit are cash flow generating companies. They're not venture capital companies. They're not money losing companies.

Those cash flow generating companies generate anywhere from two to four times debt service coverage, meaning that they generate enough income to pay their interests. And as long as that income level is generated, interest rates get paid and private credit investors get paid. And that's what's happened over the last 12 to 15 years, and that's why private credit's been such a hot place to be for fixed income investors.

Michael Hainsworth:

So then tell me about that cashflow that's coming in. In a recessionary environment in Canada, in the United States, how does that impact the companies to whom you lend when it comes to their incoming cash?

Ted Koenig:

Good question. There's about 350,000 middle market companies in the United States and Canada. And of those companies, most all, from a transactional standpoint, used private credit. And they don't really use bank financing, because after the great financial crisis, the regulators came down on banks for doing leverage lending. So they change the capital requirement rules. So this market is now a private credit market, private debt market. And private debt lenders like ourselves, Monroe, we've been through this, as I said, almost 20 years. We focus on companies that are non-cyclical industries, defensive in nature, healthcare, software, technology companies, companies where we can identify and project cash flow with some certainty recurring revenue.

And if you can underwrite recurring revenue companies, business to business services companies, you can make your way through a recession or through a financial crisis or through COVID. We did the same thing after the GFC back in '08, and we focus on high quality companies. And those companies have a reason to exist. Someone's buying software, someone's paying to keep the lights on for those businesses. And those are the companies we want to finance. And we've generated double digit returns doing this now for almost 20 years.

Michael Hainsworth:

What's the risk to the investment thesis?

Ted Koenig:

Risk is a meltdown, an overall economic meltdown. Our funds have between a 100 and 150 companies in each fund. Each position's probably 2 to 3% of our overall fund. So diversity is your friend when it comes to credit. The ultimate risk is an overall market meltdown and creating companies filing for bankruptcy and default. Now, we've seen that happen after the great financial crisis in the large cap market, where large cap companies with heavily debt leverage ratios, filed bankruptcy to restructure the debt, and then debt gets converted to equity.

Those are companies that had 7, 8, 9, 10 times leverage. In the middle market, lower middle market where we play, we're looking at leverage rates of 4, 4.5, 4.25 times leverage. We don't have that same highly leveraged situation. So companies in our space don't tend to file bankruptcy and Canadian companies and US based companies don't tend to file bankruptcy from a restructuring standpoint, because they're not trying to get out of their debt. They file bankruptcy to restructure their operations, but they continue to pay their debt.

Debt doesn't get converted to equity. So from a debt standpoint, a lender standpoint, it's a very friendly situation where a lot of these companies are privately held, second generation, third generation. And those companies tend to navigate their way through recessions as opposed to liquidating.

Michael Hainsworth:

Well, let's step back then and talk about what the key differences are, and the nature of a loan to a lower middle market, a traditional middle market, and an upper middle market borrower.

Ted Koenig:

Well, first you have to define what you mean by each those terms. A lower middle market firm tends to be EBITDA, earnings before interest, taxes, and depreciation, which is a net income determination, 35 million and below. Traditional middle market tends to be 35 to 75 million of EBITDA. And a large company, large middle market tends to be over 75 million to about 150 million of EBITDA. But so now with those three distinctions in mind, the large middle market companies, those over 75 million and above, historically, have had to compete for financing with the syndicated bank lending market.

And that's the high yield market. And there's no covenants in those deals. Very, very high leverage, loose documentation, and relatively low interest rates. Because of the run up in the economy over the last several years, the traditional middle market today has no real covenants and loose default rates and bad documentation also. So the one place that's held from a covenants default documentation stage is the lower middle market, that 35 million and under EBITDA size company, which is virtually the entire Canadian market, and probably two thirds of the US middle market.

And the reason why it's held up is because those companies tend to be owner, family owned, private equity firm owned. They don't tend to be publicly traded to businesses. And in a recession, they can pivot, they can cut off capital expenditures, they can cut expenses, they can do things that large cap companies can't do to protect themselves. That's why we like that market. The Wall Street firms don't tend to play there, because the deals are too small. So there's a lot less competition. The market's much more highly fragmented, and we can be much more selective and making loans into that space.

Michael Hainsworth:

So this is why you prefer to focus on the lower middle market space? There's more room to maneuver.

Ted Koenig:

Yeah, clearly more room to maneuver. Lower leverage, higher pricing, better loan documents. Those are the primary reasons.

Michael Hainsworth:

So tell me about your lending criteria.

Ted Koenig:

Well, as a firm, we have 25 origination professionals that are out in the market chasing transactions full time. And they're calling on private equity firms, investment banking firms, banks, attorneys, accountants, brokers. They generate about 2000 transaction opportunities a year for us. In any given year, we'll invest in 50 to 60 of those 2000. So somewhere between 2% and 2.5% of the deals, transactions that we see, we invest in. Once we identify a transaction that we're interested in, we bring one of our underwriting professionals on, and we've got about 40 underwriting professionals. And that underwriting professional basically structures and does the diligence, third party diligence, valuation diligence, earnings, EBITDA diligence, all kinds of supplier customer diligence calls.

And we'll come up with an investment thesis of why this company is important in its industry, why it's important to it's customers, what are the ways that we get out, whether it's a refinance, a sale. We'll do an underwriting based on valuation. And then if we can find ourselves to lend somewhere 50% or less of what we believe is enterprise value, that's a transaction that we'll go forward with. We always want to be 50% or less loan to value in our transactions, because that gives us a lot of room to maneuver if there's a non-performance or an under-performance. Because whoever has that other 50%, whether it's a private equity firm, a family, an owner, they've got a heck of an incentive to make sure we're taken care of before we come in and try and move against the company and hire an investment banking firm to sell the company.

Michael Hainsworth:

You mentioned that the waiting at any given fund of an individual firm that you've lent to is no more than 3.5 some odd percent. Why is that the magic number for you? And does that waiting evolve or change depending on the environment in which we operate?

Ted Koenig:

Eh, there's no magic to this. It's more of an art than a science. We've been doing this 20 years, and what we've learned is that when you get too concentrated a portfolio with too few names, one name can affect overall investor returns. Or if we get too heavily invested in a particular industry, let's say we're too heavily invested in healthcare and either the Canadian government or the US government decides to change reimbursement rates on certain procedures like they did years ago with radiology, or on drug testing, or on blood testing, for example, and change reimbursement rates. If you're too heavily invested in companies that do that, you can find yourselves sideways in a relatively short period of time. So for us, over the years, we tend to like this 2 to 3% because no one, two, or three companies, if they default, can have a material effect on the overall fund performance.

Michael Hainsworth:

Is there a particular sector that you like more than another, or is that also an equal weighting for you?

Ted Koenig:

Well, it depends on the economic environment.

Michael Hainsworth:

This environment.

Ted Koenig:

Coming out of a recession is much different than going into what we think is a potential recession. So today we're very much focused on defensive industries. I've made no secret in speeches that I've given around the US and internationally, that we like companies that generate cash flow, consisted, stable, repeatable cash flow. These are business to business services companies. These are software companies, technology companies. These are companies that are important from a customer standpoint.

Unlike companies that we're staying away from, which tend to be more cyclical. Today autos, home building, anything relating to home improvements that results from transactions of new home purchases like furniture, furnishings, carpeting, appliances, consumer discretionary spending, high priced consumer goods. We're tending to stay away from right now, apparel, things that consumers buy when the economy is good. We don't like right now. We like things that consumers and businesses have to buy and pay for, irrespective of the economy.

Michael Hainsworth:

I don't feel like I nailed you down on this. What's your recession outlook for 2023?

Ted Koenig:

Well, it depends. And it depends all on what the Fed does and the Bank of Canada and the other major bank, Bank of England, Bank of Japan. We're looking at this, and the US unfortunately, has been leading the market in interest rate increases. And the reason why the US has been leading the market, is because of inflation. They've made a determination that number one issue is going to be inflation. We're going to at tame inflation and for good reason. I mean we're seeing butters up 39%, eggs are up 30%, wheat grain are up 23, 24% year over year. Wages are up.

So the whole idea is to tame inflation. The challenge with taming inflation is a single purpose is you raise interest rates, that slows an economy. Slowing an economy slows demand. Slowing demand slows profits and earnings. Slowing profits and earnings slows stock prices. And you end up in a recession. The rest of the world has been trying to keep up with the US, but can't. The US is pretty much energy independent, as is Canada. So US and Canada have a distinct advantage when it comes to the ability to raise interest rates to combat inflation.

The rest of the world can't raise interest rates at the same rate that the US and Canada can raise interest rates. So therefore, they tend to raise interest rates less, meaning inflation tends to be worse, and it tends to make their economies much more recession prone to the US and Canada. If the US and Canada can stop raising interest rates in the first quarter, which is my hope at that 4.4 level, I think we may escape a recession in the US and Canada.

However, if they continue to raise interest rates, we're going to be in trouble. Unfortunately, Europe, Asia, the Middle East, they don't have that luxury. They'll be in a recession in 2023. They can't raise interest rates enough. Inflation's not going to be tamed. And remember, the world buys oil, gas, commodities in dollars. The world tends to repay credit in dollars. So as those dollars strengthen, which has happened across the board, the US dollar is strengthened tremendously across the currencies, Euros, UK, Asian, Korea, they're repaying debt at higher values with deflated currencies. They're buying fuel power in dollars with higher dollar costs, with deflated currencies. That's going to push people in other countries into a recession, unfortunately.

Michael Hainsworth:

So then what role does private debt play in weathering a recession and fueling economic growth over the course of the next year?

Ted Koenig:

Well, private credit and private debt is a currency for transactions. That's what you have to remember. Private credit fuels transactions. We've had the highest M&A volume 2021, 2020 was a down year because of COVID. But 2019 was another very hot year. And '22 actually has been a good year. So all this M&A volume in the US, Canada, North America, Europe, the rest of the world, that's been fueled by private credit. The syndicated bank loan market has lost share. The first time ever, private credit has overtaken syndicated bank loans for transactional finance, and that's because private credit provides certainty.

The syndicated bank loan market is all best efforts. Banks underwrite a loan, but they'll distribute that loan to other investors. Private credit is a committed, certain, reliable way to finance transactions. That's why private equity firms and the corporate world has been drawn to it. So private credit has grown at about a 12 to 13% CAGR, compound annual growth rate for the last 12 years. It's projected to grow at about a 17% CAGR for the next five years. So it's been the fastest growing asset class in alternative assets over the last 12 years, since the great financial crisis.

I think it'll continue to be the fastest growing asset class, because it generates current stable return. Remember, insurance companies need current return to pay out insurance contracts, annuities. Pension funds need current income to pay health, welfare, and retirement benefits. You can't get that with the liquid assets like real estate, private equity, and other similar type assets. Private credit generates quarterly payments of interest and fees. That's the magic of why private credit has been such an important asset class.

In the last three to four years, high net worth investors have come to realize the same thing that institutional investors have learned. High net worth investors now are looking for current income. They've seen fixed income bonds go down 20% this year, stock market down 30%. There's been no place to hide. The only place in the market to hide has been in private debt, where we've paid out a 10% or better current return this year, last year, during COVID, and each of the last 20 years. So it's been a really good place for institutional investors and now high net worth investors and RIA firms to jump into.

Michael Hainsworth:

I can imagine though that for some of our listeners, because private debt isn't generally as liquid as an equity investment, the question would be, why invest in private debt now during this time of great economic uncertainty? What if I'm going to need that cash?

Ted Koenig:

Good question. You're right. It is not liquid. Private credit is not a liquid investment. The idea that institutional investors have come to understand over the years, is you're getting paid extra dollars for that illiquidity. So by investing in private credit, we've generated a 10% return this year, last year. The traditional bond market, interest rates have been 1%, less than 1%. So for those investors that can afford illiquidity, they should invest some portion of their allocation, whether it's 8, 10, 20% of their investment allocation into private credit.

What we're seeing more of, and Monroe is actually one of the firms that's leading the pack on this, is we've created a fund for high net worth investors that provides liquidity. So after one year, investors can get liquidity on a quarterly basis. And it's a pretty interesting product. A number of other firms have done it as well, because the high net worth market tends to be a little more liquidity focused than the institutional markets. So what we've tried to do is create a product that meets the needs of the high net worth investors for high yield stable income, yet still provides some level of liquidity after a fixed period of time, which in our case is a year to get the funds invested.

Michael Hainsworth:

You mentioned that for high net worth individuals, that a percentage of one's overall portfolio could be 8%, it could be 20% private debt. Knowing that you can't provide advice without knowing each listener's individual investment criteria, generally speaking, for whom is 8% an appropriate allocation for whom is 20% an appropriate allocation?

Ted Koenig:

It's all dependent, as you said, on individual circumstances. All I can tell you is what we're seeing in a general basis. Registered investment advisor firms, RIAs, have now made private credit a fundamental asset class in construction of high net worth portfolios, just like it is for institutions. So historically, institutions did between 4, to 5, to 8%. Today we're seeing an average of 15 to 20% allocation for institutional investors. I think we're going to see a similar increase in allocations for high net worth individual investors, because the nice thing, particular for people on fixed income are those over 50 years old, let's say. It's nice to have a consistent set amount of income that you can count on irrespective of what happens in Europe, or Asia, or the Middle East, or the US.

And private credit does that. You know you're going to get an interest and fee payment every quarter, because private credit is just a basket of loans to companies that pay current interests. So each individual investor should think about what their needs are from a lifestyle standpoint, what their fixed expenses are, and private credit is a really good way to cover fixed expenses and lifestyle needs and let investors invest in more of the volatile, risky assets to generate growth.

Michael Hainsworth:

Ted, this has been a fascinating conversation. If there was one takeaway for the listener, what would you want it to be?

Ted Koenig:

Risk return. That is what most listeners, particularly high net worth people, don't understand and don't really think through as carefully as institutional investors are. People say, "Lock up my money. Invest in something I want three times my money. I want 4X my money. I want a stock to go from 10 to 50." The challenge with that is there's a fair amount of risk associated with that. So the right thinking, the right balance for investors should be, "What's my risk tolerance? And what is my return need? And if my risk tolerance is low, and my return tolerance is a higher need, then I need to match those two items together."

And private credit tends to be lower on the risk curve. Real estate is a little higher on the risk curve, but it doesn't tend to generate the current return. Equities tend to generate no current return and tend to generate more return over time, but very high in the risk curve. So it just depends on what an individual investor's needs are. But very often I've seen high net worth individuals, particularly sophisticated individuals, not really think through the risk return dynamic that's appropriate for them.

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

 

 

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