Capital Gets Creative in a Higher-for-Longer World

Chris Moynihan: 

Welcome to Solomon Connects. I’m Chris Moynihan, a director in the M&A group, and today I’m joined by Vinod Chandiramani. Vinod, welcome to the podcast. 

Vinod Chandiramani: 

Thanks for having me, Chris. 

Chris Moynihan: 

Vinod is the head of our Capital Advisory Group, and he joined a little over a year and a half ago. Vinod, do you want to talk about the group that you formed and the people you’ve added to your team? 

Vinod Chandiramani: 

Sure. I’m very excited about the group and where we are today. It’s been a long road, but we’ve managed to compile a group of professionals who I think are representative of the culture and pillars of Solomon. It’s experts, good people who care and have a depth of experience. I’m very proud of the team that we’ve compiled. We lead by looking for the ways in which we could add value for both our clients and our partners. 

Chris Moynihan: 

And you bring a unique perspective and opportunity to our client base. Can you talk a little bit about the opportunity you see in the market in capital advisory, and where you all are focused right now? 

Vinod Chandiramani: 

A key component of the opportunity here at Solomon was to expand the product offering and the ways in which we could engage with our existing client base, as well as take Solomon’s leading industry content and monetize it in a different market. So, how have we done that? We started by building out a creditor advisory practice, which has given us an opportunity to introduce many of our bankers to investors in the leveraged-loan and high-yield markets, as well as many investors in the private credit and direct-lending markets. Then, we started scaling a financing business to expand the product offerings from more asset-based financing for consumer and retail companies – and we would do certain other financing in the middle-market space – to really focusing on capital solutions and hybrid capital. I define them as high loan-to-value investments that are effectively MOIC-driven. And then hybrid capital is more junior capital that is not cash pay – limited governance rights – but can be used to facilitate growth, facilitate a change of control over a period of time, and then also facilitate distributions to shareholders who may be facing DPI constraints. 

So, I think the unique opportunity about building what we’re building here at Solomon, it was a whiteboard and we weren’t burdened with any…what I would call legacy tech. And with that, we were able to form a group of folks who are purely focused on adding value for our industry partners and the clients they serve. 

Chris Moynihan: 

So, I want to focus on one specific point you said about those middle-market opportunities. And you’ve said in the past that showing up first to the smaller – call it sub-300 million capital structure – opportunities is often preferable to headlining the mega credits. What’s driving that dynamic? Why are you focused on that opportunity set? 

Vinod Chandiramani: 

I don’t know if it’s more attractive than focusing on the mega cap. I think it’s an arena where there’s an opportunity for us to add value and increase the market penetration of the firm. My objective is always to make sure that we’re in a position to add value, and I think that’s the area where we have the highest right to win. And I don’t necessarily define it as less than 300. I think about it in the context of market access. So, when an issuer has greater than – call it $50 to $70 million of EBITDA, probably $70 million of EBITDA – they have access to multiple markets, whether it’s high yield, whether it’s syndicated leveraged loans, whether it’s the direct-lending market. Once you get a little bit smaller down the size spectrum, the pockets of capital are more limited. So, you have less liquidity for companies to access. 

And then when you think about those companies and what you said – $300 million, as an example – the composition of those companies generally leads them to have a higher probability of issuer-specific credit risk. What I mean by that is a smaller company has a higher likelihood of having customer concentration. A smaller company has a higher likelihood of being dependent on a single facility. A smaller company has a higher likelihood of having less diverse revenue. You put those credit components together in an environment where you have uncertainty, in an environment where you have inflation, that creates frankly more opportunities for folks like us to come up with creative capital solutions. 

Chris Moynihan: 

And so looking at the other side of the table, if you’re one of these clients, you’re a sponsor that owns an asset or you are at the company themselves, what are those early warning signs where they should start to proactively reach out to you and say, “Hey, we’d love to get you in here to think about all these different alternatives available.” 

Vinod Chandiramani: 

Our number-one approach when we speak to clients and when we advise clients is you always want to be on the offensive. You always want to be in a position where you are driving the outcome. In order to do that, you have to maximize the duration you have to a specific decision point. And frankly, the shorter that duration gets – just basic option theory – the lower your optionality is. And so, we encourage clients to be proactive and to think about the next step because at the end of the day, hoping that the markets get better, hoping that this inflationary impact rolls off doesn’t necessarily lead itself to the best strategy. And so, if you ask me to talk to a client and say, “What should I be on the lookout for to evaluate whether I should think about something non-traditional from a capitalization perspective?” I would think about it in the context of: Do I have access to enough capital to invest in my business today to grow into the capital structure I have? 

As an equity owner, do I have the ability to deploy capital to realize my thesis in a manner that is optimal from a cost-to-capital perspective? Are there structural issues with my ownership base that I might not necessarily be the best steward of that asset? Is it going to take longer to realize the initial thesis? Has the initial thesis changed? If any of those factors or anything remotely close to that has occurred and you are looking at a capitalization structure that you need to reevaluate within 24 to…call it 30 months…you should be reaching out to folks like us. 

Chris Moynihan: 

For the past however many years when we’re in the low-rate environment, it always seemed like that default response for these companies was an amend and extend – so, thinking about just pushing out your maturities and hoping to find a solution down the road – but now it seems like companies or maybe lenders are much more interested in comprehensive solutions. Can you talk a little bit about that changing dynamic? Is it in part driven by the high-rate environment and a little bit more difficulty of just getting the same terms from the same lenders, or what’s really pushing that factor? 

Vinod Chandiramani: 

I don’t know if the dynamic’s going to change. I believe it will change and I have a lot of conviction around that, but I think the reality of the situation is every issuer is facing very specific facts and those facts end up driving what is the right solution for them at the time, and the solution could be amend and extent. There are so many factors in the market today which will impact investors’ approach to amendment discussions, such that I think there’s a high likelihood that the traditional amend and extend – there’s just a higher bar. And the reason for that is the following: one, as you hit on, is base rates. So, base rates have just been higher for longer and they will stay higher, and the reality of that is businesses from a fixed-charge-ratio perspective are not where they need to be, and they’re not producing enough cash to invest in the business to grow in the manner that was originally underwritten. 

So, that’s point one. Then, point two is you have the fact that these smaller companies can absorb less pain, and absorbing less pain is in the form of risk of hard-asset inflation right now. You have energy prices up, you have potential concerns for certain discretionary consumer goods. All those things impact your margin profile and impact your top line, and margin profile being impacted then from a lender perspective impacts your loan-to-value, your LTV, and your value cushion. And so, as a result of that, just that dynamic in and of itself, a traditional lender in a credit that was issued at, call it, five and a half or six times thinking that they had 50% equity cushion, is probably looking at a business that may still be five and a half, six times, but the equity cushion is a lot lower and it’s not producing a sufficient free cash flow. 

That dynamic in my mind leads to investors demanding a de-risking event, which could be in the form of a paydown or a shift in the composition of the capitalization structure. And that shift in the composition of the capitalization structure could be a recap facilitated by a capital solutions provider or a hybrid capital provider. There’s lots of different ways to cut it. 

Chris Moynihan: 

And maybe one of the big structural differences in the market as well has been the advent of private credit. So, go back five, 10 years ago, private credit was a very small portion of the market and now it’s become a dominant force in everything from acquisition LBOs, dividend recaps, et cetera. How has that entrance into the market changed some of the conversations that you’re having? What are they like as participants and are they useful in this sort of tailored capital or providing capital solutions for the clients that you talk to? 

Vinod Chandiramani: 

So, in terms of changing the dynamics, we work with direct lenders every so often on recap situations and the dynamic there is – it’s very much a partnership with the owner and the company, and it’s a situation where they haven’t historically been quick to be overly aggressive. I think that that dynamic is going to change a little bit as they evaluate how to think about the sponsor and their strategic relationship with that sponsor on a go- forward basis. And I think it’s also going to shift to the extent that the private-credit direct lender needs to modify the composition of their portfolio to reduce exposure to certain sectors. But in terms of the broader market, it’s been frankly pretty positive outcome, because it’s given issuers a lot of different options to assess smaller middle-market companies that traditionally had very limited access to capital and now have a large pool of capital that they can get to. 

I just think that underwriting standards have to get modified and there’s a whole host of capital that was put to work in a very, very different environment, both from a base-raise perspective and, frankly, from a margin perspective that’s going to need to get worked through. How has it impacted our discussions from an advisory perspective? We’re actively building a practice to cover the private credit firms and fixed-income asset management firms. We want to help them with portfolio management, but then also educate them on other pools of capital that have been formed that facilitate some creative recaps like the capital solutions and the hybrid capital. 

Chris Moynihan: 

There continues to be all this capital at play. Default rates have continued to be relatively low, especially given the macroeconomic backdrop that you’re seeing with the tremendous amount of uncertainties. Do you think that’ll persist and that the kind of the default rates of 10% plus are something of the past, or will companies proactively use a more comprehensive restructuring to get to an outcome? 

Vinod Chandiramani: 

Honestly, I think default rates are tough to look at because the markets in which they’re being referenced they’re just a component of where we’re playing. The high-yield market is a very different market today than it used to be 10 years ago. It’s much higher-quality issuers, so the default rates there should be lower. The leveraged-loan market, if it’s single B-minus and triple C and below – the spreads are really wide there, relative to historic levels; but single B and up – the spreads are very tight. And then, in the private markets, it’s very hard to measure what a default actually is. My personal view is: I don’t look at default rates because there are a lot of recap opportunities and situations where our services are needed that may not hit the radar as a capital default, but it’s not regular way. 

Chris Moynihan: 

You work across all of our different teams on a variety of different sectors. Where are you seeing the most activity and opportunity? Because, I know, AI, for example, has posed challenge across a number of different sectors, but are there specific areas where you feel like there’s a great opportunity for your team to work together with the other industry teams? 

Vinod Chandiramani: 

Here at Solomon, we don’t have a lot of industry coverage exposure to the areas that will feel structural distress. So, the opportunities that we see within the portfolio are really around operational and execution issues associated with the underlying businesses. So, as an example, have you expanded too quickly and brought on some challenging contracts? Are you updating an ERP system that you have to reevaluate your margin profile? Is the investment going to take longer to realize the thesis, so you need to raise some financing to facilitate growth because the underlying owner can’t actually put new capital in because it’s in an old fund. So, where we’re seeing the opportunity is really a situation where it’s not the optimal time to sell the asset, but they need capital for some reason, but there’s also a clear path to demonstrate to the new investor that’s coming in that there is value cushion there. So, those are the opportunities we’re looking for. 

Chris Moynihan: 

Vinod, this was fantastic. Really appreciated your insights. To our listeners, thank you for tuning in, and we’ll be back soon with another conversation on Solomon Connects. Be sure to check out solomonpartners.com for more capital advisory trends and M&A insights.