The private equity industry and the asset-based lending industry have shared a working relationship for a long time, but newer capital providers, particularly those in the direct lending segment, are changing how private equity firms seek out financing for their portfolio companies. Dwayne L. Hyzak, CEO of Main Street Capital, a capital provider to the lower middle market, spoke with ABF Journal about how the relationship between private equity, asset-based lending and direct lending is evolving and changing commercial lending.
Historically, how has the private equity world interacted with the asset-based lending industry?
Dwayne L. Hyzak: I think the private equity industry has historically had a strong, active relationship with the asset-based lending industry. These relationships have been particularly strong with private equity firms that employ a strategy of investing in industries with asset-intensive business models. The large asset bases of these businesses can be utilized to support an ABL facility, which frequently can represent a substantial portion of the portfolio company’s overall capital structure.
How has that relationship evolved over the years and how would you describe it currently?
Hyzak: Partly as a result of the private equity industry’s focus over the last decade shifting to businesses and industries that are less capital intensive and more people or intangible asset focused — subscription-based software and technology companies are great examples — I believe that the use of ABL financing by private equity has decreased as a percentage of overall private equity transactions that include debt financing as part of the transaction capital structures.
In addition, the growth of the direct lending industry, where both publicly-traded and private debt capital investment firms have experienced significant growth and are very active in providing cash flow and enterprise value term loans, has taken a significant portion of the market share for first lien debt facilities in private equity-backed transactions.
As a result, in today’s market, the majority of ABL facilities for private equity-backed businesses are centered around two cases: 1) companies with significant assets and 2) ABL facilities for working capital. Examples for the first case would include transportation or heavy equipment companies which have a significant amount of fungible assets that maintain long-term value and are therefore ideal for asset-based lending. In the other scenario, you will see ABL facilities that are focused on supporting businesses with significant amounts of accounts receivable and inventory financing for the working capital needs of these companies.
Private equity firms have usually been referral sources for asset-based lenders, but are some firms that may do some private equity in addition to other investing cutting out the ABL ‘middle man’ and providing secured financing themselves?
Hyzak: I don’t think that traditional private equity firms have moved to providing secured financing for their portfolio companies. Most traditional private equity firms are very focused on a specific type of investing and typically have a mandate included in their fundraising documents and agreements with their limited partner investors that would cause them to focus on equity-only investments and, typically, control equity investments. These agreements would typically restrict them from providing debt capital or secured financing for their portfolio companies.
I do think that more investment firms have been emerging over the last couple of years with more flexible investment strategies and mandates — similar to our lower middle-market
investment strategy that we’ve been executing here at Main Street for the last two decades — that allow for combined debt and equity investment strategies. However, I wouldn’t characterize those investment strategies as strategies that are eliminating opportunities for asset-based lenders.
Why are more of these firms providing combined debt and equity investment strategies entering the marketplace?
Hyzak: As I mentioned earlier, I think that there has been growth in the number of firms with these types of flexible strategies over the last couple of years and I expect that the industry will see that growth continue going forward. I think that there are two primary reasons for the growth.
First, the competitive nature of the market for investments in private companies has increased significantly over the last decade and the ability to provide a combined and flexible debt and equity solution can be one way for investment firms to distinguish themselves from their competition.
The second is a recent acknowledgement by some firms that the private owners of many businesses do not always want to sell either 100% or even a controlling interest in their companies. A combined debt and equity strategy can be a very attractive solution for these types of companies. We’ve employed this strategy and approach in our lower middle-market investment strategy for the last two decades. As a result, our experience has been that providing a combination of debt and equity solutions to our portfolio companies, their owners and management teams has been very well received by those companies that are trying to solve a financing need but do not want to give up control of the company to a third party.
What are some other forms of financing PE firms look to for their portfolio companies? What type of financing would you say is most attractive to these firms?
Hyzak: The direct lending solutions that I mentioned earlier [are] likely the most significant development in the financing options for the private equity industry over the last decade. These solutions have grown significantly over the last few years and we expect that growth to continue for the foreseeable future.
I think the growth of these direct lending solutions is the result of a combination of the private equity industry’s desire for a cash flow-based debt solution that provides significant flexibility in terms of both a long-dated maturity and limited or, in certain situations, no required principal amortization. These solutions provide the private equity firms with the flexibility to focus on growing their portfolio companies and utilizing the resulting free cash flow of these businesses to fund some or all of that growth. Before the emergence of these direct lending solutions, in most situations, this same growth would have required either one or a combination of additional equity investments by the private equity firm and/or a new debt facility. The limited principal repayments requirements can be very attractive in these situations.
The desires of the private equity firms have been met by a growing industry of direct lending funds that welcome the opportunity to provide these flexible debt solutions to well-known, high performing private equity firms that have a proven track record of supporting their portfolio companies.
How do you expect the PE/ABL relationship to develop coming out of the COVID-19 pandemic as well as over the long-term?
Hyzak: I think the relationship between private equity and asset-based lenders will always have a healthy existence, particularly in the types of asset heavy companies and industries that I mentioned earlier. In the near-term, I think there could be some additional opportunities for ABL in certain other industries as the trailing historical revenues and EBITDA in these industries continue to rebound and improve from the impacts of the pandemic.
Longer term, I believe you’ll continue to see the direct lending strategies take an increasing role in private equity transactions.
Dwayne Hyzak is CEO of Main Street Capital and a member of its board of directors. Previously, Hyzak served as president, COO, CFO and senior managing director. He served in other senior executive positions at Main Street since before its IPO in 2007. Beginning in 2002, Hyzak also served as a senior managing director and in other executive positions of several Main Street predecessor funds and entities, which are now subsidiaries of the company.