Asking The Right Questions

As direct lending attracts more potential customers, lenders are tapping vertical industry experts to help them efficiently assess opportunities. Michael Ferrari, head of new client development at Guidepoint, explores the trend.

Direct lending continues to be identified as one of the most promising opportunities among private debt investors with 65 percent of these investors planning to make commitments to direct lending funds in the next year. Unsurprisingly, the number of funds in the market is growing: at the start of Q3 2015, nearly half of the 233 private debt funds in the market were categorized as direct lending, up 3 percent from the prior quarter. This trending shift in the mid-market to alternative non-bank lenders coupled with attractive returns has made, in some cases, direct lending irresistible to fund managers.

“THE SERIES OF CONSULTATIONS WITH THE EXPERT ENABLED THE DIRECT LENDER TO PINPOINT RISKS. THROUGH PROBING, THE DEAL TEAM FOUND THAT THE LEGACY BUSINESS WAS UNRAVELING AT A FASTER PACE THAN INITIALLY THOUGHT.” – FERRARI

MINIMIZING RISKS

Historically, institutional investors have been the primary client base of expert network firms. These investors frequently call on the networks to connect them to professionals with experience and deep insights in particular industry segments. Sometimes these connections can happen within hours, allowing firm analysts to spend their limited time evaluating investment opportunities and risks. But over the last year, an increasing number of direct lenders are also turning to Guidepoint, looking to leverage expert knowledge and expand their resources for underwriting and due diligence. Time is short. Lenders often say they only have a week or two to express interest in a deal and sign a letter of intent. And as information on these specialized companies is usually limited or non-existent, quickly gaining a full understanding of the company, its competitors, the company’s place in the market, strengths, weaknesses, regulatory environment, management style, and more, can be hard to do.

In one case, a direct lender was presented with a packet of information from a sponsor about a business services company looking to refinance bank loans and pursue new market opportunities. The lender spent a week conducting top-level research before signing the term sheet and starting in-depth due diligence. While the firm’s fresh business idea seemed compelling, the lending team needed deeper industry knowledge to understand market dynamics and how quickly the new business could scale. “We know we are being sold to,” said the lender’s senior vice president. “So we need impartial sources.” After being presented with a number of experts to choose from, the direct lender consulted with an industry veteran with more than 15 years of experience in business services. The expert advised the deal team members and equipped them with the right questions to ask in order to obtain detailed information about the competition, the management team, the state of the legacy business, and the probability of success for future opportunities. The series of consultations with the expert enabled the direct lender to pinpoint risks.

Through probing, the deal team found that the legacy business was unraveling at a faster pace than initially thought. But what sealed the deal — or in this case, didn’t — was the revelation that the company’s competitors were so far ahead that the new technology and business idea would not gain traction. The firm decided to pass on the deal and did not extend credit to the business services company.

TRENDS

Clients in the US and UK are the predominant direct lending users of Guidepoint’s expert network services, matching PDI Research & Analytics data which shows that 89 percent of private debt funds are focused in North America and Europe. However, in-line with industry experts, Guidepoint expects other regions of the world to ramp up on direct lending; a popular advantage of private lending is its usual protection from market volatility. “There are certainly plenty of things that can influence the successful outcome of a direct lending transaction,” John Howe, chief executive officer of direct lender Old Hill Partners said recently. “But Greece’s future in the euro and the Chinese stock market rollercoaster are not among them. ”Some of the largest direct lenders are tapping Guidepoint to quickly gain a broad yet deep perspective on an industry or company. Guidepoint is seeing a variety of requests — from sectors such as industrials and mining, food products, and business services to more niche industries like pharmaceutical packaging, beverage package, e-commerce technology, and hospital software.

And clients are only hunting for the highly specialised. Armed with specific requirements, they are looking to speak to former employees of the target company, current customers, suppliers, and others who are insightful about recent industry trends, market size, purchase drivers, the competitive landscape, regulatory developments, and other information essential to due diligence.

To connect with these experts, direct lenders often first send Guidepoint screening criteria, such as job titles, industries, target companies, and years of experience. Through technology and other resources, Guidepoint’s staff then recruit potential experts based on the lender’s conditions and present them for approval. Most consultations take the form of phone calls, although some users opt for a face-to-face connection or survey product. Some lenders are also using expert networks after the deal has been signed to periodically check on a company’s market progress.

LOOKING TO THE FUTURE

A question that often arises is, “Will the banks be back?” People also wonder whether the banks will eventually want their share back in the mid-market. But another question to think about is whether mid-market borrowers will want to work with the banks again. Time will tell. Many borrowers are learning to like the higher degree of certainty in closing, the faster execution delivered by many direct lenders, and working with lenders with a deeper understanding of the challenges faced by fast-growth companies. This bodes well for both private debt investors and funds, and Guidepoint agrees with the majority preference, expecting the direct lending market to continue its uptick. As the number of deals and the speed at which lending teams must sign a letter of intent increases, lenders will need to gain strong knowledge of these industries quickly. For some, tapping experts is proving to be an efficacious way to do so.