A True Alternative: Long/Short Allocations to Health Care
Health care offers unique opportunities for skilled active managers to generate alpha — both long and short — across multiple health-care industries.
Direct lending has grown dramatically over the last 10 years and we believe will likely continue. With evolving bank regulation and because of their size, middle-market companies generally don't have access to the same depth of capital market solutions as larger companies. So, there is a plentiful opportunity set.
With the GFC and Dodd-Frank reform, enhanced rules and regulatory requirements decreased banks’ ability and willingness to issue loans to middle-market companies. Their participation in leveraged loans is less than half of what it was 20 years ago. That share has been taken by non-bank lenders that have a longer-term, more asset-driven approach to underwriting this risk. Subsequently, not only is the middle-market company opportunity set very deep, the relative market share for direct lending and non-bank investors is increasing over time.
With more opportunity comes growing competition. Competition in the direct lending market has increased as we see larger amounts of capital being deployed, especially in bigger deals. Years ago, a direct lending financing of $250–$300 million would have been considered the upper end, yet now, “mega” unitranche deals of up to $2–$3 billion of financing size are completing regularly. However, those deals have come with spread compression and more aggressive terms, which collectively dilute the investor benefits to the asset class versus broadly syndicated loans and high-yield bonds.
But given the vast majority of recent fundraising capital is directed at upper mid-market deals and those that substitute for larger traditional syndicated loans, we believe we still see substantial value in the “true middle market,” where natural inefficiencies and smaller, but still established, companies offer compelling returns in contrast with larger issuers. The scope of direct lending managers has evolved to address all facets of the asset class, with some playing broadly across private credit and others focusing on specific niches.
What do we consider the true middle market? Middle market typically is defined as either $500 million or less in revenues or $200 million of EBITDA or less. We consider true middle market to be companies with around $50 million in EBITDA and lower middle market about $5 million to $25 million in EBITDA. These are oftentimes companies experiencing significant growth benefitting from secular changes in the economy and across their industry, but not yet so large to issue debt efficiently in the capital markets or in the so-called “mega” unitranche deals. This is especially true with non-sponsored issuers, whose family or individual owners tend to prefer discretion and relationship orientation.
In terms of sponsored versus non-sponsored, there are pros and cons to lending in both. At a high level, sponsored versus non-sponsored is simply the profile of ownership. Sponsored can be a financial investor, commonly a private equity fund. Non-sponsored can be a family owner or management team, even a publicly listed company that has more permanent ownership.
Generally, the agenda of the company, the strategy, the timeline to achieve that strategy, and the financial leverage to help achieve it, are driven by the ownership. Sponsored private equity funds have a more finite horizon with a return over a three to five-year period. Therefore, financial leverage is very important to generating the return expectations over that period, and non-sponsored owned companies have a more permanent or longer-term horizon.
In 2021, PGIM Private Capital (PPC) closed a joint sponsored deal with the Sydney corporate finance team for ZircoDATA, a provider of off-site secured document storage and management. The company re-evaluated its capital raising and chose to partner with PPC as the sole lender on a direct basis because of the relationship we had developed, responsiveness, and our knowledge of the sector. We were able to underwrite a A$75 million senior secured term loan, committed A$15 million to a revolving credit facility, and committed A$10 million to a delayed draw term loan facility to support the company’s growth objectives. PPC was well-positioned to provide this financing, given its cross-border office relationships in San Francisco with the sponsor and in Sydney with the issuer. The flexibility of capital commitment with local currency, as well as committed but unfunded options, well-suited the company’s needs.
PPC also completed a non-sponsored deal with Ameritex in 2021, a provider of reinforced concrete pipe and box culverts. We had a pre-existing portfolio relationship with the company and had supported growth and recaps over many years which culminated in this deal. We were able to underwrite a $165 million senior secured term loan, committed $30 million to a revolving credit facility, and committed $65 million to a delayed draw term loan. PPC’s ability to provide a large issue size and flexibility demonstrates the depth of the direct lending market for growing companies such as Ameritex.
Our regional office network of nearly 200 investment professionals across 15 global offices enables it to source unique and proprietary deal flow, allowing for the flexibility to offer transactions cross-border or in any one domestic market. This broad origination platform enables greater investment selectivity and grants PPC access to less-trafficked, non-sponsored deal flow, creating greater portfolio diversification for investors.
"Ultimately, in private credit, origination is the biggest scarce asset, and we have origination capacity as deep as anyone in the world," said Matthew Harvey, Managing Partner, Direct Lending, at PGIM Private Capital. "When you think about selectivity of investments, you accomplish that by not being a price taker, but by finding your own deals through your relationships.”