Shannan Simmons

Hello, everyone. I'm Shannan Simmons, PineBridge’s Global Head of Consultant Relations and I am delighted to be joined by members of PineBridge’s Alternatives Platform, including Joe Taylor from Private Credit, Justin Pollack from our Private Equity Team and Joseph De Leo from the PineBridge Benson Elliot European Real Estate Team.

We're pleased to have you back for another instalment in our Alternative series to discuss your collective focus on the middle market space and lessons learned post-crisis. Welcome back, Joseph, Joe and Justin. Thanks, again, for being here today. Middle market focus is a common thread across PineBridge Alternative Strategies. Why focus on this particular segment? Joe, why don't we start with you on private credit?

Joe Taylor

Thank you, Shannan. The fact is that this is a niche specialization. And it really is very difficult to be a jack of all trades, right. So, from an investment perspective, the ability to take years of experience, take lessons learns and the fact is, it's a risk-taking business. So, there will be lessons learned and there will be areas of an investment sector types of transactions, types of management teams, as well as curating who your partners are on both sides of the equation, are factors that need to be developed over years of focused niche specialization.

And so, in the middle market, so core and lower-middle market, the fact is, which I think is lost on a lot of participants and investors in the space, in the US equates out to the equivalent of the third or fourth largest GDP in the world. And it houses over 200,000 companies, they're ever evolving in this particular market here in the US. So, with that, you know, you as an investor, are financing companies, which naturally are a little bit smaller, and thereby require a highly specialized and experienced investment thesis that has been proven, time tested over the years in order to be successful.

And so with that, the fact is that the segmentation that we're focused on, that we're talking about the core and lower end of the mid-market, is not a commodity. It has not been a commodity in the past. It's not today, and it will not be tomorrow. Because this really comes down to a bilateral type of a relationship where you as a lender, in private credit, are taking a relatively large risk profile as a lender to a company, which by its very nature is a private company that really only has access to your capital.

And from a liquidity perspective, from a business continuity perspective, and from a relationship perspective, the manager should be as informed as the owners of the business are, in regard to the investment. And whether it's a private equity or a non-sponsor transaction, that niche specialization can only be developed with years of experience. And therefore, being a, we like to call a tourist in the segmentation, where you're kind of chasing the latest, greatest sector that seems to be in vogue, typically will not lead to good outcomes on a longer term basis for those particular managers and thereby their investors.

Justin Pollack

Joe, I’d agree. You talk about the size of the middle market, I think one of the other elements is the breadth of the middle market. We see, there's a huge opportunity set among middle market companies, and in the private equity firms that invest in them, but one of the difficulties investors tend to have is to compare on the large end of the market, you can find almost all of the large cap private equity managers who are managing multibillion dollar type funds, up and down Park Avenue in New York, or in Mayfair in London. And that will capture almost every manager headquartered there. You can go visit them, hear about all the companies they own wherever, they happen to be. But it's really concentrated.

When you start looking at the middle market, you actually need to go out elsewhere. So, you have to travel to Detroit and St. Louis and Chicago and Hamburg. And that's where a lot of these middle market managers are, closer to the businesses that they actually own. And what that leads to is, there's a huge opportunity set in middle market businesses, because it's literally hundreds of 1000’s of businesses that are potential to be bought, to be taken over by a private equity firm. And it's a huge number of opportunities.

But from an investor standpoint, the opportunity set that you need to start by looking at, the quantum of capital they can invest. A large cap and the middle market are roughly equal in size, with respect to private equity in terms of how much capital they are putting to work every year.

So, the ease of use is to put a lot of money to work in the managers, you can find in two cities. If you really want to put a lot of money to work, a similar amount in the middle market, you have to have a lot more conversations with a lot more managers who are doing a lot more transactions. And that's the challenge. And that's something that we focus on is we have a lot of those conversations, we're meeting hundreds of managers a year across dozens of cities, many different countries. And what it leads to is, you get a more bespoke portfolio filled with interesting underlying companies, rather than somewhat frankly more generic portfolios in the larger end.

But the goal here is to have a differentiated portfolio. What can you do with a smaller company versus a larger company. Our view is, if you have a good quality middle market, private equity fund manager, they can look at a smaller business and have a different package of opportunities that they're going to use to create value in a company, than a large cap manager who's competing with other large cap managers for a very limited number of opportunities on very high quality businesses, that the opportunity set is just very different because these are already high profile businesses under a lot of scrutiny.

There’s opportunity in the middle market to find something that maybe’s a little more rough around the edges, maybe founder owned, that has different opportunity sets ahead of it and that's why we like focusing there, it takes a lot more work. But we think the opportunity set is a lot more interesting.

Joe Taylor

Yeah, that's right. Quite frankly, to put it in the simplest terms, it's really old school private equity. This is where you're getting into a business, you're working with a naturally thinner management team to build that up, to add additional infrastructure, to do things like six sigma on manufacturing processes, to improve good based businesses, to make them better and to have them be able to optimize on their opportunity set.

What we find on private credit, also in this particular segmentation is, there is not a focus on financial optimization to any degree and certainly not to the degree that you see at the upper end of the market, BSL and large private credit, which essentially, has become not only commoditized, but the activity in that particular segmentation is heavily driven in regard to the financial optimization, the refinance activity, the switching back and forth from different types of financial lenders, which be it BSL, CLO, large banks and/or private credit. I think you would find, certainly, in the core, in the lower end of the mid-market, refinance activity is pretty rare.

It typically is partners teaming up, as Justin mentioned earlier, doing a lot of old school, due diligence, and having relationship value, which, at the end of the day is really the primary drivers of success for both private credit and private equity firms that operate in this particular segmentation.

Justin

Yeah, and Joe, I'd say old school is probably the right way to frame it. And I think that what gets missed is that old school approach was very successful, obviously for creating returns for investors over the last three decades, but the message has gotten through, particularly in the larger end of the market, where private equity tactics are now adopted by publicly traded companies. And the classic case study that we always see, it's still taught in MBA classes is RJR Nabisco, which was bought out by KKR in 1988.

It led to a bestselling book, it led to a movie, it's a really interesting business profile. But that story was all about how a publicly traded company that had lazy management, that had 10 private jets that they’d fly around the world and go to golf tournaments, that a private equity firm could come in and sell the jets, bring in more motivated managers who would go to work and could find a lot of hidden value, lying in what was really in plain sight, because there's just basic operating things that can be done to fix a business and improve it.

And that was the model that a lot of private equity firms used throughout the last three decades. But public companies now do those things, because there's a lot more scrutiny on public companies, you see activist investors, there's a lot more attention paid to expenses for these kinds of companies. You can't get away with that anymore, a company with $25 billion in size like RJR Nabisco, that simply wouldn't happen in the same way.

So, the large end of the private equity market can't follow those same tactics. And we sort of say that what they're doing is, it's like they're taking over businesses so larger, like an aircraft carrier, very complicated. And if you know what you're doing, you can do a lot of interesting things with it. But you can't turn it around very quickly. It's such an enormous, complicated thing. That's what these large companies are. They're very sophisticated engineering, you know, aircraft carrier, as well as in a large company.

But for a company that's mostly financial engineering, and that's very clever. But what are you going to do with it, once you own it that hasn't already been done, whatever way it's drifting, it's going to continue that way until you steer it. And that's going to take a long time to correct whatever course it is on.

But in the middle market, the old lessons still apply, because you frequently find companies that really only have one or two executives to the extent you can even call them that, who manage a business and if they're owners, it's whoever was good yesterday was probably good today, because I don't want to mess up my golden goose. But when they start getting towards generational transfer, and they don't have kids that are going to take over the business, or maybe it's an orphan asset inside of a bigger business, and management can't get anyone to pay attention to them.

You can apply those old lessons of fixing basic things. Maybe some simple business planning, because these smaller companies don't have access to the top consultants and all kinds of executives on the board helping them. So, what we find is the middle market is very old school in a way that you can approach it, in a way that you can't on the large end of the market in private equity. So, choosing where you're playing becomes really important. If your goal is to try to generate an opportunity set that we've seen in the past. If it's going forward, it's in our view, it really has to be the middle market.

Joseph De Leo

Turning to real estate, similar to Justin and Joe, we are as well a mid-market manager, here in Europe. The mid-market is a segment of the market that we are committed to. We've been in the mid-market space for over two decades since we founded the business. And we play in this segment of the market, because it suits the style of investing that we do. But more importantly, it's defined by certain characteristics that we think creates the environment for us, that allows us to find interesting investment opportunities. And the first characteristic of the mid-marker in the space we play in inefficiency.

It is an inefficient part of the market, meaning, information is opaque. It's not a part of the market that is driven by bankers, brokers, agents, it's very much a bilateral market. So, you need to have those long-standing relationships in order to source opportunities.

Secondly, it usually involves an enormous amount of complexity that needs to be resolved in a short period of time, because most of the situations we typically see in this part of the market is a large institutional investor, who's got a complicated asset, whether it needs a significant level of reinvestment to initiate a repositioning, maybe it's under managed, or it's got a broken capital structure, or in a lot of cases, it's in a complex wrapper, a complicated ownership structure, and you need to unravel that.

And the key to being a successful manager, in my opinion, in the mid-market is number one, you need the relationships in this part of the world. Europe is not homogenous. In my opinion, you can't send an Italian to go and do a transaction in Germany. So, you need to have the individual teams, you need an Italian team, you need a French team, you need a German team, you need a British team, and these teams must have the deep relationships in these markets.

And that's what we have, when you've been in business for over two decades in this part of the world. And then secondly, you are originating transactions on an off-market basis. That's where the inefficiency comes from and this is not a market that involves investment bankers, or real estate agents, or brokers. This is a bilateral market, or principal market. And you’re typically, when we get approached, or when we uncover opportunities, we're solving a problem from someone. And that problem usually has a time constraint. And you need to have the agility to be able to work in those tight time constraints.

And so, you've got to bring all the pieces together. You need those skill sets to be a successful mid-market investor. And this is why we focus on our knitting, this is what we know and we've been doing it for over twenty years and we're going to continue to do this going forward.

Shannan

I have another final question for you all. Having been in the industry for both the GFC and COVID, many managers always talk about lessons learned or enhancements to their processes, what lessons have you learned in recent years post COVID or perhaps, even further back during the financial crisis that have helped your teams’ investment process? Let’s start with Justin on the private credit side.

Justin

The financial crisis, it taught us a key lesson about liquidity and financial prudence. So, we saw general managers who manage private equity funds. The ones that reacted quickly figured out what can we cut, with the 401k match, no raises this year, try to manage their companies to tighten liquidity and make sure that they’re not spending money that they don't have to.

The problem though is that lesson was a lesson for a liquidity crisis and COVID was a medical crisis. And we saw a number of managers take the playbook out for the financial crisis and try to apply it to something totally different. There's no thinking, no reaction to how things were different this time around. And COVID was a very different situation. The key questions are, can we open our stores or our factories? Are employees likely to come to work? Is our supply chain going to get us the product or the supplies that we need?

And we saw sponsors who reacted very differently to identical situations. They're very similar companies and the anecdote we like to share is in the same week in May of 2020, during COVID, when lockdowns were really taking full effect. We talked in the beginning of the week with a sponsor who owned a mult-unit, very large franchise taco fast food restaurant, across multiple states, blue states and red states, which had different reactions to lockdowns. And they told us their tale of woe, people don't want to eat in our restaurants, they can only eat outside. And we mostly serve fish tacos. And if you take them home, it takes too long to get home, and then they're soggy.

So, our same store sales are down 50% versus the prior year, so what are we going to do? And then they tried to tell us how they cut the 401 (k) match. And there’s going to be no raises and a whole bunch of other things that they're following their playbook from 2008. And we sort of said”, “okay, that at least makes sense. It's disappointing to hear.”

Later that week, we talked to a totally different manager who coincidentally owned a multi-unit, taco restaurant across red states and blue states, whose principal product was fish tacos. And they told us in May of 2020, their same store sales comps were at 99% of the prior year, to which we were shocked. And it was sort of like - well, how did you do that? And they said: “well, you know, what we found was, people don't want to take fish tacos home, they get really soggy. So, we switched to chicken.”

And it's such a basic lesson, it doesn't necessarily take that much to shift priorities. But if you sit there and sort of say - well, we're following a playbook from the past that has to work and if it doesn't don't blame us - you're very likely to encounter some problems. To the extent you immediately react to what's in front of you and try to create some new ideas, you're much more likely to be resilient. And that's what we take into our conversations with managers now is, for a while we're just asking – “how did you respond to the financial crisis?” And many had good answers.

But now we're asking more broad questions about the smaller crises that happen along the way, not just COVID, but other things to see, are they flexible and resilient. Or are they the types that sort of say - don't blame me, something happened to us, as opposed to them reacting. Because that portends an inability to react to future things that we don't know what they're going to be. But you want to have someone who has that flexibility. So, it's something we look at pretty closely right now in conversation about how they've managed businesses for the last 15 years across a variety of situations.

Shannan

Thanks Justin. Joe, you alluded to COVID earlier in some of your comments and seeing these underlying portfolio companies go through it. As a team do you have any lessons learned that have contributed to enhancing your team’s process?

Joe

Yeah, that's a very good question. And it's something that should be on the top of every manager's list, right. And no matter how old you are, and how long you've been doing something, you should always be looking for lessons learned and the world changes. So, one of the things that certainly changed with COVID, which has become a critical aspect, for all of our diligence, at this juncture, is IT resiliency and operational efficiency. That really was a trial by fire in the COVID environment, right. It really came down to a tale of two worlds in regard to companies that were able to embrace the COVID environment, having their employees, having their operations, having to be remote to a certain extent, how they were going to manage that, how they were going to manage information flow with both their internal resources, their employees, as well as externally with their customer base, whether it's a commercial consumer account.

And with that, that resiliency, is a big factor that we found. With the companies and the management teams that could effectively transition very quickly, utilize and create quite frankly, a lot of new processes and new ways of doing business, are proving out to be some of the most resilient companies, even when you get post COVID and you had other issues with wage retention, logistical challenges, and obviously, a high inflationary environment.

So, we do think that that was, as I mentioned, a little bit of trial by fire. And for us that certainly is something that we've ingrained within core diligence is that IT resiliency, the contingency plans in how our management teams are being thoughtful and proactive in approaching disruptors within their business model. So, you know, that certainly was COVID specific, in regard to lessons learned.

You know, the other thing that we found coming out of the COVID environment, which is really something that is still I think being determined whether it's an intermediate impact, whether it's generational, is consumer preferences. So, if COVID we believe, had been a six-nine month, less than a year probably type of a lockdown environment, you probably would have had most people going back to, from a consumer perspective, their prior lives, right. From preferences, how they were deciding on discretionary, non-discretionary expenditures, how they were basically budgeting and spending, their earned income.

Post COVID, you know, we certainly have seen a change. And some of it was a little bit fleeting, with people being at home, and some expenditures and decisions that were made because of that environment. But even post, whether it's materialism, discretionary spending on experiential type of items, airfares, going to new locations, going and exploring, concert tickets, cruises, you know, visiting, and spending a lot more discretionary items on experiential versus what was in the past.

And, you know, we have certainly have seen over these multi years, a very high proportion of the spending for consumers going into that particular category, and how that impacts when things get a little bit tighter, where the consumer is going to decide to spend their lower pocketbook value, when we get into post this period of time, when you've gotten maybe a little tougher economic environment and less pent up savings that you accumulated through that COVID environment, which I think we're at this inflection point.

So, that is I think, something that we're still seeing how that evolves. But it certainly is, I think, an interesting dynamic that all managers need to be aware of and have on their radar screen, if they're going to be investing in some type of consumer-oriented sector.

The last item, which is absolutely a critical factor and differentiator, and certainly something that should be for every investor out there that's investing in a private credit manager is, is how that team is interacting with their investment portfolio companies’ management teams. In the core and the lower end of the market, you do have a benefit of a lot of transactions being bilateral. You may be as a core or lower mid-market lender, be the only lender in a financing or you may be in a small club. You're also typically doing longer due diligence periods, one-on-one with management teams.

You have to be able to utilize that and develop a relationship where you can get your CEOs, CFOs on the phone any day of the week, to discuss good things that's happening in the business, as well as be proactive in regard to challenges. It makes it a lot more difficult when you go to larger transactions where there are a lot of other folks sitting around the table, whether it be multi-parties from a private equity perspective who are owners of the business, management teams, which are multi-multi deep layered and who and the key decision makers and how do you develop those relationships.

And when you have a number of lenders,, sometimes dozens of lenders sitting around the table and really, at the end of the day, the prioritization of being able to be proactive and getting information that is relevant for you to make decisions on how to approach and we're talking about a challenge situation, how to approach a challenge situation, to make sure that you're preserving your investment value.

That, I think for private credit is one of the biggest differentiators in regard to the core lower mid-market segmentations, versus when you get into a little bit more of, the financial optimization and I'm going to call it “facelessness” of the larger end in the market, where you have CLO high yield, and multi seats around the table, even on private credit transactions.

Shannan

Joseph, your team has been investing in real estate for a long time, can you comment on lessons learned from both GFC As well as COVID?

Joseph

I would summarize, the main lesson learned that I experienced that I would say is relevant for all other managers, it's all about, liquidity, liquidity liquidity. Leading up to the GFC, real estate was a highly levered sector asset class. Pre 2008, your typical capital structure was 80-90% debt, and the remainder was equity and obviously a significant amount of financial engineering was incorporated to drive private equity returns. And when you're managing a closed end fund structure, you have a finite amount of capital. And pre-GFC most managers weren't thinking about how the world can turn overnight, and they were committing all of their capital to investment.

So, they were never thinking of a rainy day and the need for liquidity, for reserves was not on anybody's mind pre-GFC. Coming out of the GFC, that was the great lesson learned. These closed end funds, if you've committed all of your investors’ money, there is no more money. And when you've got a bust capital structure, the way you solve for a bust capital structure is by having some liquidity. And I remember numerous conversations, through 2007, through 2008, asking us or telling me, whatever you do, please do not call me and ask me for an incremental liquidity over and above my initial commitment to the fund.

That was the ultimate lesson learned, certainly from a real estate perspective, which was you run a closed end fund structure, do not commit all of your capital to investment, keep a reserve. Reserves matter, that's how you get through times of difficulty, you have the liquidity to pay down some debt, have a really tough conversation with a lender, you need to have the ability to walk away from the table, if you can't get terms that are favorable, you need to have that liquidity.

And all private equity managers should be thinking about maintaining a 10-15% reserve in their funds and not committing all of that capital. And that was for us was the biggest lesson learned.

And secondly, related to that was just keeping leverage levels down. In a prior experience, I went into the GFC with a 75% gearing level. Coming out of the GFC, we've been running our business, roughly on average around the 50% mark. We've been prudent users of leverage, we've maintained reserves, and fast forward 10 years and here we are, we're in another part of the cycle that's turned and we've been able to have very easy conversations with lenders to secure extensions where we can make de minimis pay downs on debt, if we've got a small cure, we've been able to cure because we've preserved all that liquidity

And a lot of that really got tested during COVID, for example. So, going into COVID, we didn't know what to expect. And so again, we went into overdrive, we put the machine to work and it became a weekly exercise of measuring liquidity. The teams were ensuring all of our revenue was being collected. We're rethinking about any capex programs, we were reviewing all of our loan facilities to make sure there were no holes in those, so that lenders couldn't pull unfunded commitments.

These types of exercises we were doing on a consistent basis. And most importantly, on a fortnightly basis, we were communicating to our investor base. I probably did in the first six months of 2020 two hundred phone calls, reassuring our investor base, that we had everything under control, we were maintaining an enormous amount of liquidity. We had the credit facilities in place, we still had unfunded commitments, we were ensuring we were using any cash flow at the investment level wisely.

These were the key lessons learned. They all go back to liquidity. And we got through that very easily. Now we're getting through, you know, the challenges of today's market quite easily.

Shannan

Thanks. It's clear, that middle market presents opportunity and relationships and experience matter agnostic of the asset class. Thank you, Joseph, Joe, and Justin, for your insights today on lessons learned and the distinct nuances and opportunities of the middle market. And thanks to our listeners, we hope you enjoyed the discussions and learn something from today's podcast. For more of our market and Investing Insights, please visit our website at www.pinebridge.com.

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