Ron Kantowitz – Direct Lending's Evolution and Invesco's Edge (EP.457)

23:56This was the other attractive dynamic as relates to our coming onto the Invesco platform. across the Invesco private credit platform, we have over$25 billion of capital invested in the portfolio companies of more than 200 private equity firms. There was already more than just name recognition, tremendous connectivity with a wide swath of private equity firms, many of whom crossed both broadly syndicated and what we were doing in the middle market. In many cases, the name partner at these private equity firms was an associate when we were associates 25 years ago. So there's history there. And as long as you treat these relationships like partnerships and understand their needs and can address those, you should have an annuity of opportunities across a fairly wide base of them.

24:41What does a typical diligence process on a deal look like? It's deep and extensive. It starts with our simple premise, relentance in your debt, you should not lose money. The way we think about it, everything we do needs to be primary diligence. If we were to get a call from another direct lender who said, hey, we've closed the deal. We're long$50 million. We'll send you our IC memo. Would you guys want to buy it? Not for any reason other than that's just not how we conduct business. We would gracefully say thanks, but no thanks. For us, everything needs to be primary. We fly down to the company.

25:12We want to look management in the eye. We're going to do our own forensic diligence around the accounting. We're going to go deep in the quality of earnings. We're going to engage our own third-party sector experts to make sure we understand all the subtleties around the business. It's a very, very extensive process. It's not just similar to what private equity are doing. One of the subtle delineations between what we do on the direct lending side and what's historically done on the syndication side is if you're in the banking market and you're syndicating, you're doing your diligence, but your intent is to sell the business.

25:42If you do it right, you're risked off pretty quickly. We're going to be in this deal for three, four, five years. The amount of analysis and diligence we're going to do is pretty extensive, and we're going to want to drive documentation. You can find the best business in the world, but you can blow the investment on the documentation. Think about a leverage covenant. The definition of EBITDA in a credit agreement is two pages long. If you get that definition wrong, the covenant may be toothless. Everything from start to finish for us is hands-on, primary. A typical deal will take us anywhere from two to three months from start to finish to get it done.

26:13What are some examples of things that you thought were going to be a deal you're going to be happy to lend to and you found something that had it fall away? Typically, when you start a process, you'll get a SIM, a document that sells you on the deal. It's written by a sell-side banker, so it's generally pretty positive. You'll look at this business and you'll see, you know, revenue grew nicely and EBITDA grew nicely and the ask on leverage is pretty conservative. And you start out thinking this could be a really nice business. Most often, where we walk away from something, there's this thing called quality of earnings, which is there are all sorts of adjustments that go into EBITDA.

26:48I'll pick the gym business as an example. If a sponsor is buying a gym, they will ask when we first break ground on a box, we spend money on it. We may want pro forma adjustments to reflect the EBITDA of that box when it becomes mature. And we say, well, that's great, but today it's doing zero. As we go through our diligence process and we go through the quality of earnings, you start looking at all the adjustments. This is what they're telling you, EBITDA, is what was EBITDA? And then it's always a primary discussion for us in any of our credit meetings, what do the adjustments look like? And all too often, what you discover is the actually bidah is materially less than what's being portrayed.

27:25And sometimes those adjustments are legitimate, but other times they're not. Most often, we'll look at something and optically, it'll look great. But when we start digging through the numbers and we start understanding what's happening pretty quickly, we'll back away. And I think the trick to this business, you got to triage. You certainly can't spend time on 500 deals. You've got to be able to pretty quickly figure out which ones you're just going to let go and where are you going to spend time. When a sponsor that you have a relationship with is doing a new deal, you have this balance of you want to be accommodative, you want to be relationship.

27:57You also want to win the deal in a competitive market. How do you navigate that? Competition is a fact of life in our business. So much capital has come into the market, whether you're looking at the middle market, whether you're looking at the upper end of the market, there are a lot of participants and it's competitive. I think there's a subtle difference though between the competitive dynamics in the middle market relative to the upper end of the market. If you look at the middle market, the word you'll often hear used is clubby. With maybe the exception of one or two, on every deal we do, we will partner up with one or two other direct lenders.

28:30I like doing that for a variety of reasons. We know most of the other middle market direct lenders because we've all been in the business so long. In many cases, we worked together earlier in our careers at banks. But equally, it's never a bad thing to have more eyes looking at the same transaction and looking at it each with your own unique vantage point as a means to make sure you mitigate risk. But the point on competition is one where you're not really incented to be too aggressive where it comes to things like rates. Because at the end of the day, what I want to do is lead every deal I can.

29:00If you think about your private equity clients, they may have two or three direct lenders that are their core relationships. So they're going to rotate you. Invesco, you're going to lead this deal. You're not going to lead the next deal, but we still want you in the deal. None of us are really incented to go in there with aggressive pricing because even if you win, you lose. We're all going to be in the deal regardless. You compete on things like relationship. You compete on things like sector expertise. You compete by trying to bring them ideas, value add. But generally speaking, we're all fairly regimented when it comes to thinking about things like leverage and pricing.

29:35I find it to be much more of a collaborative market relative to the upper end of the market. I don't mean any way to disparage the upper end of the market, but it's just much more intense. You have huge players all vying for really, really significant positions, competing not only with each other, but also with banks. In the middle market, it is much more collaborative. I mean, most of our competitors are our friends. You treat everybody with integrity, you be transparent with them. And over the long term, it tends to work out. If we win a lead, we'll invite a couple of lenders in and they'll reciprocate when they win a lead.

30:06You're not really incented to do silly things to win business. There are always going to be exceptions. And when we see those, we walk. We have a bit of a life's too short philosophy. Once you're in a loan of a company and a sponsor, you think about two different scenarios. One is everything's going fine. Maybe you have to monitor it. And the other is something's not going well. I'd love to get a better understanding of what you're doing in each of those two scenarios. One of the nice things about the middle market is you get tremendous transparency in terms of performance. In almost every deal, we get monthly reporting, we get quarterly reporting.

30:40Because we have covenants, we get compliance certificates, we get annual budgets. Because these are small deals, we know the management team, we know the sponsor. Every month, our analysts take those monthly numbers and they spread them. And if anything doesn't seem right, they'll raise it to the deal captain and we'll look at it and usually it's nothing, but if there's something we don't understand, we'll pick up the phone, call the sponsor, call the CEO. On a quarterly basis, the whole team goes offsite for a day, and we do a fulsome quarterly review of the entire portfolio. And then post that, we sit with investment committee, and we walk them through any names that we think need to be highlighted for them.

31:14And it's a fairly extensive rating system we go through, all of which to say, it is rare if ever that we're going to be caught off guard or surprised by something really bad. If something's going wrong, if there's a trend, we should see it coming real early and we should be on top of it and we should be aware of it. If something goes wrong, you need to have restructuring capability and resources or you're going to find yourselves in trouble. On my team, we have workout resources. One of my partners ran restructuring during the GFC at the bank he was working at. On any deal we do, we immediately drop him in and he becomes captain if we have a problem at a credit.

31:48But I think more important than that, across our private credit platform, we have significant resources. We have a distressed team that does something all day, but focus on challenge credits, loan to own. There's a wealth of resources at our disposal, such that if we find ourselves in a situation, you want to make sure you've got proper resources available to be able to address it. How do you use all of the data that comes from all these reports from companies across both your portfolio and thinking about what's going on in the markets and opportunities? We do a fair amount of analytics and sensitivities across our portfolios.

32:22on a quarterly basis, we run all sorts of sensitivities. We look at what's going to happen if interest rates go up, what's going to happen if margins go down. We look at it on a name-by-name basis. We look at it systemically across the portfolio. We also look at all sorts of analytics. What's happening at the top line across the portfolio? What's happening at the margin? When we sit in front of investors, everybody's got the sound bites of what's going on on the market. We can tell them what we think is happening vis-a-vis our access to the middle market. In many cases, we can sort of front end what we're going to ultimately hear.

32:54If something's going to go wrong, we're going to see it earlier, and perhaps we're going to see it across the broader market. The key thing for me on the portfolio management side is you just don't want to get caught by surprises. If you can get out in front of problems, if you can understand where things are going, you have a far better chance of fixing them, putting yourself in a position for a successful outcome. It's been a long time since we had a real default cycle. You've been through a few. We'd just love to get your sense of how you're thinking about the current environment in light of what you've seen in the past.

33:26I've lived through credit cycles, market dislocations, Great Recession. Every time you have a credit cycle, it's different. Every time you have one, nobody predicted it, or certainly nobody predicted why it happened. Today, we're living in a really unique environment, and we have been for the last couple of years. Since 2022, we've been living in this rising interest rate environment where we were worried about inflation. We were worried about recession. We had all these geopolitical conflicts. A lot of things to worry about. In fact, it actually has had a pretty significant impact on M &A volumes and deal flow.

33:58But we live with an eye towards the glasses half empty. On every deal we do, we run recession scenarios and we're very, very selective about the types of businesses that we're going to invest in. We've been living in a higher for longer interest rate environment. We're staring in the face of some type of tariffs. Nobody actually knows where we're going to end up. but ultimately they're going to have some type of impact on the economy. We are trying to figure out, are we going into a recession? Are we looking at stagflation? Are things going to settle out? What's the Fed going to do? You can look at all these macro dynamics in the market.

34:32You can handicap them. But at the end of the day, in all those scenarios, where do you want to be in the cap structure? We want to be senior security. We want to be at the top of the capital structure. We want to have lots of capital beneath us. We want to have full collateral in all the assets of the businesses we lend to. And we're going to be really selective about the types of businesses we lend to. If we think we're going into a recession, we're going to stay away from highly cyclical businesses. We focus a lot on the health of the consumer. We're not leaning in on discretionary consumer products these days.

35:03We're thinking about all the things that could possibly go wrong. We're doing our best to either mitigate those and make the investment or not make the investment. I don't mean to sound draconian here because I do believe at some point we're going to find our way to the other side of this. The markets at some point will stabilize. And what's going to be really unique about this opportunity set then, because of all the uncertainty we've been living in for the last two to three years, you've got private equity investors that are really long assets, need to sell them but haven't been able to because buyers and sellers just haven't been able to acquiesce around valuation.

35:36But when we get to that point where markets start to stabilize, there's going to be a huge backlog of opportunities that are going to come to market. Today, we're being really selective. We're keeping our powder dry. We're watching. We're all over the portfolio, but we're also waiting because we do believe there's going to be a pretty significant opportunity come down the bike. Are there any signposts that you're seeing in structures of risk that you've seen in the past or things that you're staying away from, even if you are fine with the sector that it's in? The two things that most simplistically are telltale signs for are you going to get in trouble or not are leverage and covenants.

36:12If you start to see leverage creep up, you got to start worrying. If you start to see deals coming without covenants, you should start worrying. There is another red flag in the market and it's something you're hearing more and more about these days. And this is the advent of bringing pick into your transactions, payment in kind. Our deals are all done cash pay. That's the way you're supposed to do see your debt deals. And if you look at a portfolio, it should be all cash. There are going to be times when you structure a deal day one, where for company specific reasons, maybe you're going to have a pick opponent.

36:45Perhaps the company's got some significant capital expenditures they need to make over the next two years. So you'll put some pick in there just to give them a little bit of additional free cash flow relief. But you're doing that knowing why you're doing it. If there's a red flag or a canary in the coal mine in the markets today, is if you start to see portfolios that were structured with all cash starting to suddenly show up with PIC components. If you're restructuring your deals where you're converting some of your current cash into PIC, there's only one reason you're doing it. You're doing it because the company doesn't have the free cash flow to service your loans.

37:18That's a key red flag. If I were speaking to an investor and they said, well, how do I assess this direct lender versus that direct lender or this portfolio versus that one? One of the things I would say to them is look into the portfolios. Look at what opening leverage was, look at what current leverage is today. Look at what percentage of the deals started out all cash and what percentage of the deals today have a pick component. If those things have moved in the wrong direction, those should be red flags. You better dig in a little deeper. It feels like in the private equity market, there's a little bit of the bottleneck of capital because you haven't had the liquidity.

37:50And yet on the credit side, it feels like there's almost insatiable to me. What have you seen as those two come together? There's a couple of dynamics here. Private equity have raised record sums of capital, and it's a challenge for them because we spend about half our time talking to investors and the other half our time talking to our private equity clients. And thematically, what we've heard from them is it's slow. They keep waiting for deal volumes to pick up. So they're sitting on cash. Problematically for them, they're not able to sell these businesses. You think about the cycle for a private equity investor of raising money, investing in companies, improving those companies exiting, distributing capital back to their investors and doing it again.

38:29To your point, there is a bit of a bottleneck there. And we hear it from investors all the time. We're telling us we're just not getting distributions back at the pace we had hoped. So then you pivot to the credit side. Why is that asset class just continuing to raise more and more capital? It's a function of the fact that it's a pretty attractive asset class in the environment we're living in today. You look at these equity markets, it's hard to see our equity markets growing 10, 15 % from here in the near term, given all the vol in the markets. But if you choose to invest in this asset class and you can deploy, you're going to be sitting there generating low double digit returns, hopefully without a whole lot of risk to the portfolio.

39:09As more capital comes in, it absolutely does create more competitive pressures. We have seen spreads come in 50, 75 basis points. But the reason you're still seeing so much capital coming into the market is on a relative basis, it's still an incredibly attractive asset class. We are consistently generating low to mid double digit returns across the cycle. That's a pretty good place to be in almost any environment. You've built out this business over the last bunch of years. How do you think about growth where if you raise too much money, you'd almost take yourself out of the mid market where you like playing?

39:41It's a huge challenge. Throughout my career, it's always been the dynamic. The more successful you are, the more capital you raise, the harder it is to continue within your strategy. Now that said, we have a lot of private equity investors that have been doing this for 25 years and they have consistently said, look, we could raise more, but we like this segment. We're sticking to the middle market. This is where we've been successful and this is where we're going to stay. We have a similar philosophy. I don't aspire to go bang heads with the entities that are deploying five, 10 billion a quarter.

40:13It is a different market. It's not where my expertise lies. It's not where we have fun. It's not where our clients are. We're just going to be really careful and measured about the capital we raise, the capital we deploy. Maybe someday it becomes a problem. I guess it's a high-class problem if it happens, but it's not something we're trying to do. One of the terms you'll often hear, when you get to a certain size, you become an asset gatherer versus an asset investor. We want to be investors. We like investing. We'd have to raise a whole lot of money before that would be a problem for us. We've got a long road ahead of us in terms of making hay within the middle market.

40:46How do you think about capital solutions for the middle market businesses? On the larger end, you see all different types of financing structures and the large alternative asset managers. You're just focused on the senior secured piece. How's the team thought about, oh, there should be a different risk reward opportunity below that into the equity? So we talk a lot about it. Earlier in my career with my partners, we ran mezzanine funds. We did a lot of aggressive equity co-investing. It was somewhat a function of the market. The path we've set ourselves on at Invesco for now certainly is to stick at the top of the cap stack.

41:23We look at our investors and we say in the context of your overall portfolio of investments, you should think about us as that very safe, secure, low double digit opportunity. You can tuck it away. You're going to get quarterly distributions from us. you're going to sleep well at night with respect to what we're doing for you. And we like doing that. Is there an opportunity down the road to play in different parts of the cap stack? Maybe. I think it would really be more a function of what the market opportunity looks like. For example, if we went into a significant recession and you saw valuation start to plummet, maybe there'd be a better opportunity to play at some of the junior capital and take more of the equity upside.

42:01But I think in the current environment, sticking to our mandate, which is orienting around capital preservation, being great stewards of our investors' capital is where we're going to focus. What's been your favorite deal that you've worked on? I did a deal a handful of years ago. It was a gym business. The sponsor was somebody I'd known for probably 10 or 15 years. We got in a van with the management team and we literally drove for two days from site to site and we'd get out and you'd just watch the interaction. These guys were just incredible. You'd get out and he'd look at that. You got to clean the window there.

42:34He'd hug the lead trainer. I hadn't done a gym deal prior to that. And they are really unique animals. The thing about gym businesses, on average, you lose 40 to 50 % of your clients every year. What business in the world would you lend to or invest in where half your clients quit every year? But notwithstanding that, when you look at the macro dynamics in the US, gym membership grows every year. These guys were just incredible operators. And from start to finish, I was in that business for 10 years through three financings, through multiple sponsors and including COVID, which was for a gym business, not a great environment, but it came through the other side of it perfectly.

43:12We actually just exited the business last year. It was sad to see it go, but it went to a large cap direct lending strategy without a covenant. For us, that was sadly the point where we shook hands and we said goodbye, but it was a real fun opportunity. As you go through credit by credit, how do you put your portfolios together? To be most conservative, you got to really focus on diversification. We look at diversification on a single name basis, diversification on a sector basis, diversification on a sponsor basis. On average, our typical investments will represent somewhere in the 1 % to 3 % position.

43:45So across a portfolio, I'm expecting to have 40 to 50 investments. The reason for that, you think you're doing great credits. More often than not, if you're going to have a problem, it may not be the credit you thought was going to give you a problem. But as long as you diversify the portfolio enough, as long as there's no single name that can actually do any damage, Even if you have something that goes sideways, it's not going to impact the overall performance of the portfolio. When we think about construction, it's very much focused on making sure we build a very diversified book of business across all of our funds.

44:14How have you thought about leverage on the funds? Leverage is a really interesting element in the direct lending space. To some extent, it's driven by investor risk tolerance. We have some investors that very early on said, we don't want leverage on the vehicles. And part of the thinking was you're in the double digits. That's all we need. We don't want to take the incremental risk associated with adding leverage on top of these vehicles. And then we have other vehicles and other investors that have asked for leverage across all of our vehicles, even where we have leverage. We tend to be more conservative.

44:45We won't put more than a turn of leverage on a vehicle. And you will see some direct lenders go as high as two turns of leverage on their vehicles. And I don't think it's a bad strategy. A turn of leverage will generally afford you somewhere in the neighborhood of 300 basis points plus of incremental yield. So it's not inconsequential. Of course, the problem with leverage is the obvious one. If things go wrong, you've leveraged the negative. We look to our investors. Some want it and we're happy to provide it and many don't. I don't worry about it in the context of our portfolios because I know what's in those portfolios.

45:18I know how we're selecting those assets, but the investor drives that decision and will accommodate them either way, whether they want it or not. I'm going to circle back to bank involvement. Big part of this market moving in the hands of asset managers was banks not wanting to be involved. Now you have banks willing to apply leverage to you and also getting interested again in this business. How do you see the banks playing into the competitive landscape and the risk of banks even lending to direct lending funds going forward? If I were working at a bank, I would be pulling my hair out saying, why is it okay for us to leverage these lever deals, but we can't actually do these lever deals.

45:52But I think it's treated as an asset-backed risk, and it's all in the Basel III regs. I wouldn't even pretend to be able to articulate to you why they're able to do that, but not traditional stuff. Banks are very sophisticated. I think they've been struggling over the last handful of years as this asset class has grown, and they are trying to come up with solutions. We've met with a lot of the large-cap banks. They're each thinking about it slightly differently. they have significant competitive advantages in that they have tremendous corporate relationships. They have historically great private equity relationships.

46:26The challenge for banks is to figure out how to navigate within the regs. You're seeing some start to partner up with other direct lenders. You're seeing some start to raise third-party capital. I wouldn't count the banks out. They should and they will find a way to get involved in this business, but it's hard. They're not really able to take these assets on their own balance sheet. All the issues that we all lived through during the GFC, they're muted today, but they still resonate with banks. And I think they've just got to figure out how to manage those dynamics, but they'll be back. I don't doubt it for a second.

46:59I want to make sure I get a chance to ask you a couple of closing questions. We started with your first paid job at EDS. What'd you learn from that job? When you join EDS, the first thing they do is they send you down to Texas for this EDS training program. It's 10 or 12 weeks of really intense training to develop your skills. But the model for that training program is to challenge you from a multitasking perspective, a resource constrained perspective. You'd go down there, there were 40 of us in the training program, and you'd have eight hours of classroom training. And then you'd have the equivalent of eight hours of project work to do.

47:33It was pretty intense. You'd come into class some mornings and a seat would be empty and the instructor would come up to the front of the room. And in very matter of faculty say, you know, so-and-so has been terminated for performance reasons. Over the course of those 10 or 12 weeks, 22 made it through the program. I was reasonably convinced if any day someone was going to tap me, I was going to be the next one out the door. But what it taught me was we all underestimate what we're capable of doing when put in challenging environments. To this day, that was probably the most difficult 10 or 12 weeks of my career.

48:05I so clearly remember how stressed I was and how difficult it was, you come out the other end of it, you feel pretty good about yourself and you can pretty much take on anything. I learned a lot about myself in that process and what I was capable of. What's your biggest investment pet peeve? As the market has changed, as so much capital has come in, deals move pretty quickly. What drives me nuts is when people try to cut corners or take things at face value. Everything in our business is a sale. Selling you this is a good company. I'm selling you should provide this kind of leverage. You can't take anything at face value, you got to do your work.

48:40And it's hard because things are moving at lightning speed and it's easy to sort of, well, you know, they like it at this leverage, so it must be okay. But nothing drives me crazy more than you got to do the work. Which two people have had the biggest impact on your professional life? When I joined the Royal Bank of Scotland, there were two individuals that brought me on. Their names were Leif Robertson and Ewan Hamilton, two Scots. I was just a deal guy. I had private equity relationships. I'd done a bunch of deals. and they gave me a white canvas at the fifth largest bank in the world to build a leveraged finance business in the U.S.

49:13The mentorship they provided, the guidance they provided, I will forever be grateful to them. That job changed the direction of my career. They were incredible bankers. They're still good friends today. And I can't say enough things about how grateful I am to them for giving me that opportunity. What's the best advice you ever received? My mom instilled in us, be kind to people. And don't be kind to people because you're looking for something back in return. Be kind to people because it's the right way to be. My wife and I have tried to instill this in our daughters. And I think in the world we're living in today, it's a pretty good ethos to live by.

49:49Last one. If the next five years are a chapter in your life, what's that chapter about? It's easy because it rolls off the last question you asked me. I've got two amazing daughters. They're teenagers. they're both going to be in college in the next handful of years. The next chapter of our life would probably be entitled Transition. We spent the last 17 years of our lives, my wife and I, worrying about them, supporting them, doing everything we possibly can for them. I'm a little bit wary of what our lives are going to look like when they leave the nest and we're looking at each other and our dog and trying to figure out what we're going to do next.

50:23How about on the business side the next five years? It's continue to grow the platform. I don't know that it's a new chapter. It's just going to be a continuation of what we've been doing. To build a business from start, there's this trajectory. It takes a while to get lift. We've just gotten to a place where we've got significant lift and significant inertia. If we start to see the market rebound in terms of M &A volumes, I think for us, maybe it'll be called explosive. We're going to see some pretty explosive growth in our platform over the next five years. Well, Ron, thanks for the steep dive into the senior security space.

50:54Thank you so much, Ted. It was great. Appreciate the time. Thanks for listening to this sponsored insight. Sponsored episodes are paid opportunities for another 12 managers a year to appear on the podcast. If you're interested in telling your story in front of the largest audience of investors in the industry, please email us at team at capital allocators.com to apply for one of the slots.

51:26Thank you.