Middle Market Direct Lending

Transcription

1 August 2017 Middle Market Direct Lending

2 DI SCLOSURE This document represents the views and perspective of TwinBrook Capital Partners as of the date of publication. Nothing in this document is intended to be, nor should it be construed as, investment advice or investment recommendations. This presentation does not constitute an offer to sell, or a solicitation of an offer to buy the limited partnership interests or securities of any funds of Angelo, Gordon & Co. ("AG"). No such offer or solicitation will be made prior to the delivery of confidential offering memoranda and other materials relating to the matters described herein. Before making an investment decision with respect to any such interests or securities, potential investors are advised to read carefully the confidential offering memorandum, the limited partnership agreement, if any, and the related subscription document (collectively, the Offering Documents ), and to consult with their tax, legal and financial advisors. Data presented is as of the date hereof unless otherwise indicated. References to specific investments or strategies are for illustrative purposes and are not intended to be and should not be relied upon as a recommendation to purchase or sell particular investments or engage in particular strategies. There is no representation or guarantee regarding the reliability, accuracy or completeness of this material, and neither AG, its affiliates nor their respective members, officers or employees will be liable for any damages including loss of profits which result from reliance on this material. This presentation is being provided to a limited number of eligible investors on a confidential basis. document may not be reproduced in whole or in part without the prior written consent ofag. Accordingly, this 1

3 EXECUTIVE SUMMARY TABLE OF CONTENTS Executive Summary What Is Middle Market Direct Lending?. 3 Why Invest In Middle Market Direct Loans?.. 8 How Can Investors Differentiate Managers? 10 Experience Sourcing.. 15 Asset Selection 18 Appendix: Glossary of Terms Middle market direct lending is a large and growing component of the private debt market. The increasing importance of private capital to finance small to medium-sized businesses, coupled with investors interest in the asset class contribute to dynamics that set the stage for continued growth 1. This report defines middle market companies as those generating $50 million of EBITDA or less 2. While many portfolio managers seek to associate themselves with the middle market, not all strategies are created equal. Middle market direct lending portfolio managers exhibit varying degrees of experience, employ different sourcing strategies, and target different asset types. This report will inform the reader about: What is middle market direct lending? (Page 3); Why invest in middle market direct loans? (Page 8); How investors can differentiate between portfolio managers? (Page 10). WHAT IS? Bank and non-bank lenders provide debt capital to small to medium-sized businesses. WHY INVEST IN MIDDLE MARKET DIRECT LOANS? Middle market direct loans have the potential to provide investors with attractive risk adjusted returns, low volatility, and a hedge against rising interest rates. HOW CAN INVESTORS DIFFERENTIATE BETWEEN PORTFOLIO MANAGERS? Experience, sourcing, and asset selection Prequin Global Private Debt Report. 2 S&P. 2

4 WHAT IS? The Middle Market represents a growing, target-rich opportunity set. MIDDLE MARKET PROFILE 200,000+ Companies 33% Private Sector GDP DEFINING THE OPPORTUNITY The middle market is a large, diverse, and growing segment of the economy comprised of small to medium-sized businesses. There are 200,000+ middle market companies in the U.S. spanning a wide range of industries including manufacturing, distribution, healthcare, business and financial services, technology, consumer products, and retail 1. Estimates place the U.S. middle market as contributing 33% of private sector GDP, employing nearly 48 million Americans (1/3 of all US jobs), and combining to represent the third largest global economy 1. As such, the middle market represents a growing, target-rich opportunity set for investors. #3 48 million U.S. Jobs Rank in Global Economies Middle market companies are typically privately held and most commonly either family or founder owned (non-sponsored) or private equity owned (sponsored). Today there are over 5,300 middle market companies owned by private equity firms, up from 1,900 in 2004² (Figure 1). 6,000 5,000 5,310 4,000 FIGURE 1: U.S. Middle Market Private Equity Owned Companies U.S. Middle Market Private Equity Inventory Count by Year (Pitchbook) 3,000 2,000 1, , Middle market companies generally do not have access to public debt or equity markets due to their size. These businesses have traditionally relied on commercial banks, community banks, and finance companies to obtain debt financing. Persistent needs requiring debt capital include (but are not limited to): general corporate purposes, working capital, capital expenditures, acquisitions, refinancing of existing debt, and dividends. 1 National Center for the Middle Market, which defines middle market as companies with $10 million to $1 billion in sales. 2 Pitchbook. 3 P&I Senior Secured Loans Supplement (pionline.com). The sustained private equity activity in the space has been a significant driver of the corresponding increase in demand for debt financing. There are roughly 300 middle market private equity firms seeking debt financing to support their transactions³. As of June 30, 2016, total un-invested private equity capital seeking financing totaled approximately $552B². 3

5 H '17 Total Loan Volume ($bn) ($bn) WHAT IS? Private Debt assets have grown considerably over the past decade due to favorable supply & demand dynamics. SIZING THE MARKET Since 2006, the private debt market has been characterized by sustained growth, with assets under management having quadrupled since 2006 reaching $595B at June (Figure 2). Within private debt, many private investors have been drawn to the attractive dynamics of middle market direct lending, resulting in increased allocations to the asset class. FIGURE 2: Total Private Debt Assets Under Management Prequin $600 $500 $400 $595 $300 $200 $156 $100 $ Jun16 Dry Powder Unrealized Value In conjunction with the growth of the asset class, middle market sponsored loan volume has steadily increased as well (Figure 3). FIGURE 3: Middle Market Annual Sponsored Issuance Thomson Reuters $80 $70 $60 $50 $40 $30 $20 $10 $0 As indicated earlier, there have been several reasons for increasing middle market loan issuance: A sustainable and target-rich opportunity set; The prevalence of middle market private equity capital and activity; and Traditional commercial banks being supplanted by private capital. The exodus of commercial banks from the middle market has been the result of both ongoing consolidation and the increased regulatory burden following the 2008 financial crisis. 1 Prequin. 4

6 Q1 '17 WHAT IS? Given recent consolidation, there are far fewer community banks. Per Figure 4, the number of commercial banks has steadily declined since At the same time, large national banks have shifted their focus to cater to larger corporate clients (exceeding $50 million of EBITDA) that may present attractive treasury or fee-related opportunities. FIGURE 4: Total Number of Commercial Banks and Savings Institutions Federal Deposit Insurance Corporation 17,000 15,162 15,000 13,000 11,000 9,000 7,000 5,000 5,856 Stringent regulatory requirements have also caused banks to pare back middle market lending activity. Noteworthy guidelines affecting the market are new FDIC, OCC, and Fed guidelines on bank leveraged lending, Dodd-Frank, Volcker Rule, and Basel III. KEY TERMINOLOGY A direct loan is one that is negotiated directly between a non-bank lender or a small group of lenders and a borrower. KEY CHARACTERISTICS OF MIDDLE MARKET DIRECT LOANS SIZE LENDER GROUP INTEREST RATE SECURITY Loan sizes are typically $20 million to $200 million vs. > $250 million in the broadly syndicated loan market. With directly originated loans, bank groups are frequently comprised of a sole lender or clubs of two to three lenders vs. large corporate transactions which are broadly syndicated (five or more lenders). Interest rates are floating and computed based on a spread over LIBOR (London Interbank Offered Rate, which re-sets at periodic intervals, usually every one to three months). Typically, will include a LIBOR floor (guarantees lender will be paid a certain rate regardless of stated LIBOR rate). Loans can be secured by a borrower s assets and stock. Priority of repayment is dependent on the security characteristics of the loan. 5

7 WHAT IS? KEY DIFFERENCES: Middle Market Loan vs. Broadly Syndicated Loan (BSL) Market Size of Lender Group Large corporate transactions are broadly syndicated, often to dozens of institutions, including asset managers and hedge funds. Transaction Size Generally above $200MM and in some cases over $1 billion. TERM COVENANTS AMORTIZATION Stated maturities generally range from five to seven years with an average life of approximately four years. Transactions typically include enhanced lender protections in the form of covenants. Two to three financial covenants govern financial performance, while negative covenants prohibit borrowers from taking actions to adversely impact lenders such as incurring additional debt or making distributions. Loans will include required, scheduled principal amortization (as well as mandatory prepayments under certain scenarios). The amortization amount will depend on type of loan, size of company, and cash flow profile. Liquidity Broadly syndicated loans can be actively traded. Covenants Broadly syndicated loans are often covenant lite or have no covenants. LEVERAGE Direct loan investments are predicated upon the borrower s ability to repay debt through its operating cash flow and ongoing business prospects. Debt is provided to a business based on a multiple of its EBITDA this is referred to as leverage, or the ratio of debt to EBITDA. The sustainability of a borrower s EBITDA (proxy for cash flow) will impact what multiple of EBITDA a lender will provide in the form ofdebt. LOAN-TO-VALUE (LTV) LTV is the loan amount divided by the total value of the business and represents the cushion a lender has between its debt and the total value of the business. In addition to fundamental cash flow dynamics, lenders are also underwriting to the enterprise value of the business, both at the close of the transaction and in a downside scenario. As such, loan-to-value analysis is a critical component of the investment thesis. RISKS Other major risks considered by investors include the following which will be discussed in greater detail: CREDIT RISK: The potential for a business to default on its required principal and interest payments. STRUCTURING RISK: The potential for poor loan structures or unfavorable documentation. ILLIQUIDITY RISK: These loans are not actively traded; direct lending is generally oriented toward a buy & hold strategy. As such, an illiquidity premium is paid relative to broadly syndicated or large corporate loans. 6

8 WHAT IS? Covenants allow for early lender intervention prior to a payment default / nonperforming status. CREDIT RISK MANAGEMENT For all types of loans issued, it is important for investors to understand the performing status of the loans, which is indicative ofthe risk profile. PERFORMING LOANS are characterized by stable financing performance, compliance with financial covenants, and payment of principal and interest obligations when due. COVENANT DEFAULT is indicative of non-compliance with the financial governors negotiated at the onset of a transaction (typically maximum debt / EBITDA, fixed charge coverage ratio, and capital expenditure limitation). Although a covenant default is indicative of a deterioration in financial performance, this situation often allows for a constructive solution to be implemented between lenders and the borrower while a significant portion of enterprise value remains. Additionally, economics can be reset to compensate lenders for the greater risk profile. NON-PERFORMING LOANS are characterized by non-payment of required principal or interest; these situations tend to be of greater concern, as they are reflective of liquidity challenges and a risk of the loan not being repaid. Performance Spectrum Covenant Default Under this scenario, the company is in violation of provisions outlined in legal documents (negative or affirmative covenants) that protect lenders. Although a breach is evidence of a heightened risk profile, it provides a window for lenders to adjust economics and determine a course of action where adequate enterprise value still remains. Payment Default This is a circumstance that can be prompted by a number of events such as non-payment of loan obligations, bankruptcy or insolvency, or others. This allows lenders to undertake actions toward recouping value owed to them; relative to covenant default, this scenario is deemed to pose a greater risk to full recovery. FINANCIAL PERFORMING COVENANT DEFAULT NON-PERFORMING PROFILE Stable Declining Risk of loss COVENANT Compliance Default Default PAYMENT Compliance Compliance Default While direct lending strategies can target financing opportunities across this spectrum, significant attention is often placed onperforming loans due to: Exhibiting a more consistent and stable originations pipeline in comparison to the lumpiness of troubled credits. Exposure to a broad range of industries, whereas troubled credits can experience heavy sector concentrations (e.g. energy). Consistent deal flow in and out of cycles, whereas non-performing investing tends to be more opportunistic or counter-cyclical in nature. Investor-focused skill sets, whereas non-performing loans can be more operationally focused. Relationship oriented, relative to strategies or tactics (loan to own, etc.) employed by distressed investors that may put their interests at odds with sponsors or equity holders. 7

9 Q-17 Equity Contribution Q-17 EBITDA Multiple Spread (bps) WHY INVEST IN MIDDLE MARKET DIRECT LOANS? Relative to large corporate loans, middle market loans typically provide higher yields, lower volatility, and higher recovery rates. POSITIVE ATTRIBUTES OF THE ASSET CLASS POTENTIAL FOR ATTRACTIVE RISK ADJUSTED RETURNS Directly originated middle market senior secured floating rate debt typically offers a higher yield and lower debt / EBITDA profile than large corporate or Broadly Syndicated Loans ( BSL ). MIDDLE MARKET VS LARGE CORPORATES Compared to large corporate loans, middle market loan spreads were 155 basis points higher from 2010 to March 2017, leverage was 1.0x lower from 2010 to June 2017, and equity contributions were 5% to 10% higher over the same period. (Figures 5-7). Middle Market Large Corporates FIGURE 5: Leveraged Loan Average Spread S&P Capital IQ LCD bps higher FIGURE 6: LBO Debt to EBITDA 7.0x 1.0x lower Thomson Reuters 6.0x 5.0x 4.0x 3.0x FIGURE 7: Average Equity Contribution for LBO 50% 45% 5-10% higher Thomson Reuters 40% 35% 30% 25% 8

10 WHY INVEST IN MIDDLE MARKET DIRECT LOANS? HIGHER RECOVERY RATES Middle market loans have historically experienced higher recovery rates and lower loss-given-default rates than the large corporate loan market (Figure 8) due to enhanced structural protections. In addition, to the extent a loan is first lien senior secured, it is secured by a borrower s assets and stock. As such, the loan is positioned to be repaid before other stakeholders receive any proceeds. FIGURE 8: Average Recovery Rates ( ) 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 85% 81% Middle Market Loans (<$100MM) Large Corporate Loans (>$200MM) 78% Senior Secured Bonds 57% Senior Unsecured Bonds 33% Senior Subordinated Bonds First lien senior secured loans provided to middle market borrowers typically have two to three financial covenants and smaller, more manageable lender groups. These dynamics create an opportunity to intervene early on if a borrower is not performing, resulting in lower credit losses and maximized recovery rates. LOWER VOLATILITY RECAP: Why Invest in Middle Market Direct Loans? Attractive risk adjusted returns Higher recovery rates Lower volatility Protection against rising interest rates Middle market loans have exhibited less correlation to, and lower volatility than, the broader capital markets due to lack ofactive trading¹. Middle market direct lenders invest based on borrower and industry fundamentals, not based upon short-term technicals or fund flows. PROTECTION AGAINST RISING INTEREST RATES First lien senior secured loans are floating-rate instruments with coupons structured based on a spread over LIBOR, which is typically adjusted every three months. Floating rate debt can provide a hedge against rising interest rates and inflation. 1 P&I Senior Secured Loans Supplement (pionline.com). 9

11 HOW CAN INVESTORS DIFFERENTIATE MANAGERS? Manager B s profile appeals to investors seeking sustainable returns with low volatility. INVESTOR SCORECARD Investors should evaluate potential lending strategies based on direct experience, sourcing strategy, and asset selection. Manager Differentiation Scorecard EXPERIENCE SOURCING ASSET SELECTION SCORECARD EXPERIENCE SOURCING ASSET SELECTION Track Record & Cycle Experience Diligence Process MANAGER A Limited direct experience lending within middle market Limited experience through cycles with significant losses, and/or smaller portfolios Reliance on agent s diligence or limited third party diligence performed vs MANAGER B Extensive experience within middle market Experience taking large loan portfolios through multiple credit cycles with limited losses Robust credit process and significant third party diligence performed Ownership Target non-sponsored companies Target sponsored companies Origination Strategy & Role Size & Profile Security Asset Type Source from I-Banks or participate in other lenders transactions Act as participant in a majority of transactions Target large corporates with larger lender groups, covenantlite, or excessive cushions Prevalence of last-out structures (first lien behind revolving lender) or unsecured positions Non-Performing, opportunistic, or special situations Direct origination from sponsors Act as agent in a majority of transactions Target lower middle market with manageable lender groups and two to three covenants First lien senior secured with revolver capabilities Performing 10

12 HOW CAN I NVESTORS DI FFERENTI ATE MANAGERS? Not all strategies are created equal - risk and return will be determined by strategy selection. Q&A: What is the most common misconception among investors? It is a common misconception that smaller companies pose greater credit risk. Historically, the middle market has exhibited a more favorable risk profile relative to large corporate loans (Refer to Figures 5, 6, and 7). KNOWING WHERE TO FOCUS There are three primary factors through which to assess middle market direct lending strategies: EXPERIENCE: Experience is the foundation of a successful manager this can be manifested in the form of one s track record, cycle experience, and internal credit process. A manager should have a thorough and consistent diligence process, lengthy middle market experience and have worked through multiple credit cycles, preferably with limited losses. SOURCING: Investors should consider the manner in which transactions are sourced and whether they lead to a sustainable set of quality investment opportunities. Managers may pursue a direct or indirect sourcing strategy. ASSET SELECTION: Risk can be derived from a number of different sources, most notably from the manner in which a security is structured or the profile of the borrower. Lender protections can be favorably influenced by company size, performance characteristics, and security types. Furthermore, it is important for investors to understand the trade-offs that may exist when evaluating managers. Underpinned by manager experience, a helpful framework to better segment the market is through the following categories: (1) size; (2) ownership type; (3) security; and (4) sourcing. Portfolio Manager Experience Framework Middle Market (Size) Direct Origination (Sourcing) PORTFOLIO MANAGER EXPERIENCE Sponsored (Ownership) First Lien (Security) The pages that follow will serve to further examine the implications of each one of the segments and expand upon considerations and questions to further explore when assessing investment opportunities in middle market direct lending. 11

13 EXPERIENCE Differentiated middle market investing experience is accumulated over a long time horizon and multiple cycles. TRACK RECORD AND CYCLE EXPERIENCE The primary risks of any middle market direct lending strategy are: (1) credit risk; (2) structuring risk; and (3) illiquidity risk. Effective risk mitigation is directly tied to the strength, depth, and capability of the portfolio manager(s) and investment professionals. Experience is the common thread that distinguishes managers, notably in the areas of track record, cycle experience, and diligence. Middle Market Direct Lending Risk and Manager Experience CREDIT TRACK RECORD STRUCTURING ILLIQUIDITY CYCLE DILIGENCE RISK EXPERIENCE RISKS CREDIT RISK The potential of a business to default on its required principal and interest payments. STRUCTURING RISK Poor loan structures or unfavorable documentation. ILLIQUIDITY RISK Loans are not actively traded; have 5-7 year maturities. Mitigated by in-depth, up-front due diligence of an experienced portfolio manager with a long track record of successfully investing directly in the middle market through multiple credit cycles. Mitigated by a portfolio manager with significant middle market loan structuring and documentation experience. Focus on prudent Loan-to-Values ( LTVs ), reasonable leverage profiles, and two to three financial covenants. Highly selective investment approach born out of detailed up-front diligence mitigates this risk and ensures principal protection, along with an appropriate premium to compensate for illiquidity. 12

14 EXPERI ENCE EXPERIENCE TRACK RECORD Nature and scope of experience investing in middle market direct loans. CYCLE EXPERIENCE Experience managing large portfolios through multiple credit cycles. DUE DILIGENCE Internal credit process for evaluating loans and nature of third party due diligence. Number of years of direct lending experience in the middle market Number of years of underwriting experience across the team Historical return profile, recovery rates, and payment default rates Size of portfolio managed through the cycle Loss experience through the cycle How quickly the majority of the portfolio returned to performing status coming out of the cycle Incidence of payment defaults vs. covenant defaults Robust, well-defined internal credit process Selectivity and hit ratio number of transactions closed vs. reviewed Lender ability to have input in scope of diligence Detailed up-front diligence (on-site management visits, industry reviews, and customer and supplier calls) Detailed third party diligence commissioned by sponsor (financial, industry, tax, etc.) 13

15 EXPERI ENCE Middle market direct lending diligence should be a lengthy, comprehensive process anchored by independent third party reviews. DILIGENCE PROCESS Each firm establishes its own unique internal diligence process. Although credit approvals and milestones may vary across institutions, they commonly include the following elements: (1) sourcing a transaction; (2) initial screening; (3) underwriting & due diligence; (4) legal documentation & closing; and (5) portfolio management. The general characteristics below reflect the hallmarks of a robust diligence process. DILIGENCE PROCESS SOURCING A TRANSACTION INITIAL SCREENING UNDERWRITING & DUE DILIGENCE LEGAL DOCUMENTATION & CLOSING PORTFOLIO MANAGEMENT Private equity sponsors, investment banks, and other third parties provide a steady stream of deal flow. Originators primarily interface with sponsors or business owners to source opportunities. The originators subsequently work with their lending institutions to determine if the transaction is worthy of pursuing based on the firm s strategy and investment parameters. If a transaction meets the necessary criteria, the next step would typically involve the formation of a deal team by the lender to perform an initial credit and valuation analysis. Loan structure, terms, and pricing are initially set at this stage. Initial terms may be presented to an investment committee for approval; upon acceptance of those terms by the borrower, the deal team moves to detailed diligence to complete the underwriting. The diligence process is a comprehensive review that comprises the bulk of the entire deal timeline and consists of a range of company-specific and industryfocused reviews that may include: (1) on-site company visits and management meetings; (2) detailed financial reviews and business Q&A with both management and the sponsor; and (3) independent third party reviews engaged by the sponsor in key areas such as industry, accounting / tax, insurance / benefits, environmental, IT, and management background checks. Investors should prefer a lengthier, more thorough process to a shorter one. External legal counsel is engaged by the agent on behalf of lenders to draft a credit agreement, security agreement, and other ancillary collateral and loan documents. Loans are funded once diligence is completed and documentation is fully negotiated. Firms adopt a range of approaches, however, in the views of some, best practice is for the deal team to maintain responsibility for ongoing portfolio management of a company post-close. Continuity is important to maximize value of the knowledge base built throughout the diligence process. Portfolio management is high touch, with the portfolio manager communicating with company management monthly at a minimum to assess performance. Typically, middle market companies looking to grow will require incremental financing to make acquisitions or support growth capital expenditures, which may require reopening the structure and documentation to provide additional debt. 14

16 H '17 ($bn) SOURCING Key benefits of sponsored loans are professionalization, third party diligence, and committed capital. OWNERSHIP: SPONSORED VS. NON-SPONSORED Middle market direct lending investments can be bifurcated between: SPONSORED LOANS NON-SPONSORED LOANS Which are provided to companies that are majority owned and / or board controlled by one or multiple private equity firms. Which are provided to companies that are privately held typically by founder owners-operators. Thomson Reuters estimates that volume for the sponsored loan market ($50B+) is roughly half of the non-sponsored loan market ($100B+). This gap has narrowed in recent years due to increased private equity capital (Figure 9). FIGURE 9: Sponsored vs. Non- Sponsored Loan Volume Thomson Reuters $140 $120 $100 $80 $60 $40 $20 $0 Non-Sponsored Sponsored Sponsored transactions are viewed by market participants as being highly selective, attractive assets backed by the investment community. While there are attractive non-sponsored companies, it is incumbent on lenders to select the right ones; sponsored loans often benefit from a sponsor s commitment to longer-term relationships and leverage its extensive industry, cycle, and transaction experience. Effective origination with sponsors helps to create a consistent and repeatable source of deal flow, which acts as a meaningful barrier to competition. 15

17 SOURCI NG SPONSORED (Sponsor Orientation) vs NON-SPONSORED (Management Orientation) RELATIONSHIP CAPITAL SUPPORT DILIGENCE BEST PRACTICES MANAGEMENT Lenders maintain a direct relationship with sponsors and management Most sponsors operate with a committed pool of capital to weather liquidity challenges or invest in turnaround initiatives Sponsors share independent third party diligence for market, accounting, environmental, insurance/benefits, IT, etc. Sponsors seek to implement best practices incl. standardizing metrics, industry knowledge, systems and reporting Lenders underwrite to sponsors who control the board and can upgrade / replace management Lenders typically interface directly with management teams and owneroperators Downside protection is limited to the personal balance sheet of an entrepreneur or private owners Third party work may be engaged, with management teams serving as primary source of business diligence Best practices can vary and are dependent on entrepreneur / management team Lenders underwrite to management who often have board control and can be difficult to replace Direct lending creates a competitive barrier that may also enable greater influence on terms and outcomes. ORIGINATION STRATEGY & ROLE: DIRECT VS. INDIRECT Middle market direct lending can be classified according to the manner in which transactions are originated, namely direct or indirect origination. Middle Market Lending Continuum DIRECT DIRECT LENDING is characterized by transactions where the lender sources deal flow directly from private equity firms or borrowers. CONTINUUM INDIRECT INDIRECT LENDING is exhibited where the lender is a participant in another lender s directly originated facility. The lender relies in large part upon the direct institution or other intermediary for deal flow, diligence, structuring, and documentation. 16

18 SOURCI NG Q&A: What does an effective direct lending model look like? CRITERIA DIRECT INDIRECT Role Agent Participant Relationship Sponsor Lenders Fee Income High Low Deal Flow Consistent Episodic Repeat Deals High Low Selectivity High Low Few organizations are likely to characterize their sourcing strategy as indirect, and it is important to note that this dynamic is often not binary. Rather, lenders may exhibit characteristics of both sourcing strategies. Some of the hallmarks of an effective direct lending strategy are: DEAL FLOW: Effective origination platforms are able to cast a wide net to consistently source transactions, which serves to enhance selectivity. Efficacy can be demonstrated by the number of unique transactions reviewed and the number of unique sponsor relationships (diversity). COMPETITIVE BARRIERS: Direct origination models may benefit from proprietary and institutionalized relationships, which create a real barrier to competition and act as a source of repeat deal flow in a range of scenarios including portfolio company trades, add-on acquisitions, and others. INFLUENCE: Direct lenders generally have a greater voice in structuring transactions to favorably influence terms and outcomes. This is most pronounced where a lender serves as administrative agent. With increased access to both management and sponsors, acting as administrative agent of a middle market loan offers: (1) greater control over the diligence process; (2) input over loan structuring; and (3) increased fee economics. The following chart (Figure 10) illustrates the differential in economics for an agent relative to a participant for a representative transaction: FIGURE 10: Agent vs. Participant Illustration $60,000 Facility ($ in 000s) Agent Participant Commitment $30,000 $30,000 Administrative Agent Title of lead lender in a multilender credit facility. Commitment Fee (@ 1.50%) $450 $450 Arrangement Fee (@ 0.50%) $300 $0 Administrative Agency Fee 1 $60 $0 1 Paid annually, each year during the life of the loan. 2 Only contemplates year one fees. Agents often receive additional fees for amendments and acquisitions. Total Fees 2 $810 $450 % of Commitment 2.70% 1.50% For illustrative purposes only. Fees may vary. 17

19 ASSET SELECTION Smaller transactions typically exhibit lender protections that contribute toward a more favorable risk adjusted return profile. SIZE & PROFILE: MIDDLE MARKET VS. BSL While it is common for portfolio managers to characterize themselves as lending to the middle market, the parameters that define its scope can vary widely. EBITDA is most suitable (vs. revenue) in delineating the market, given its use as a proxy for cash flow and basis as the metric used in determining debt capacity and company valuations. For simplicity, S&P defines the middle market as including issuers with no more than $50 million of EBITDA, while the large corporate market is characterized by issuers exceeding $50million ofebitda. Market Segment By EBITDA EBITDA SIZE SEGMENT OVER $50 MM LARGE CORPORATE / BSL $25 MM -$50 MM UPPER MIDDLE MARKET LESS THAN $25 MM LOWER MIDDLE MARKET Important differences between the two markets include: LEGAL DOCUMENTATION: Lower middle market documents tend to be substantially more lender friendly with tighter borrower restrictions. COVENANTS: Large corporate transactions can be covenant-lite or have limited covenants governing borrowers, whereas middle market transactions typically include a minimum of two to three financial covenants that create the opportunity for early involvement during distressed situations. LENDER GROUPS: The middle market commonly exhibits smaller, more manageable lender groups with a relationship orientation. Rather than trading out of a struggling credit, lenders tend to take a long-term approach in working toward a solution, improving recovery rates. PORTFOLIO MANAGEMENT: The middle market provides for more direct and frequent access to management teams (can be daily, at a minimum, monthly) compared to limited regular communications with quarterly performance updates in the large corporate market. 18

20 Yield (3 Year Term) Total Debt To EBITDA (Leverage) ASSET SELECTI ON Intuitively many investors believe that smaller credits reflect increased credit risk; however, the data has generally shown the inverse with middle market transactions utilizing more conservative capital structures, receiving higher pricing, and achieving greater recovery rates (Figures 5-8). 9% 5.0x FIGURE 11: Yield and Leverage for Middle Market Companies 8% 4.5x Thomson Reuters 7% 6% 4.0x 5% < $5MM $5-$15MM $15-$25MM $25-$40MM > $40MM Yield Leverage 3.5x Other factors that differentiate the middle market vs. large corporate include: LIQUIDITY: Large corporates are predominantly actively traded, whereas the middle market is typically characterized bya buy and hold mentality. SOURCING: Large corporates can be indirectly sourced via syndications given transaction size, while the middle market sees more direct origination among top tier lenders. PRICING: Large corporate pricing is impacted by external market dynamics (energy, etc.), whereas pricing is linked to borrower or deal-specific factors in the middle market. SECURITY: FIRST LIEN SENIOR SECURED VS. UNSECURED Middle market direct loans may include structures that consist of any one of a combination of the loan types referenced in the table below (Figure 12). FIGURE 12: Middle Market Loan Structures Type Security* LTV Leverage Amortization Pricing Revolving Line of Credit First lien 40-55% x N/A L LIBOR floor Senior Term Loan First lien 40-55% x 1-5% 50-75% ECF L LIBOR floor Unitranche Term Loan First lien / Second lien 55-65% x 1-5% 50-75% ECF L LIBOR floor Second Lien Term Loan Second lien 55-65% x N/A Mezzanine Term Loan N/A 55-70% x N/A L LIBOR floor 12%-15% (cash / PIK) For illustrative purposes only. Fees may vary. 19

21 PRIORITY ASSET SELECTI ON In addition to first lien senior secured structures, investors should consider LTV, leverage, and amortization to assess risk. Within first lien, key features that distinguish risk profiles are as follows: SECURITY: The security interest represents a lender s lien position with respect to the borrower s assets and stock and right of payment in the waterfall. In the event of a liquidation or bankruptcy, a first lien senior secured lender will first be repaid in full, followed by junior lenders, other unsecured creditors, and lastly equity holders (referred to as the payment waterfall). Debt provided lower in the waterfall typically receives a higher interest rate. LOAN-TO-VALUE: All first lien term loans do not have the same risk profile. A first lien senior secured term loan provided at 60% LTV is riskier than one at 40% LTV, despite having the same liens and protections. LEVERAGE: The leverage through which a first lien facility is provided can vary, and depending on the leverage relative to the total enterprise value, can represent a different risk profile. Greater leverage is often indicative of more risk. AMORTIZATION: In a senior secured position, the lender will typically require scheduled amortization on the term loan and an excess cash flow recapture. Higher scheduled amortization reduces the loan balance more rapidly and in turn the risk exposure of the lender. Junior debt will typically have no scheduled amortization, with a balloon payment at maturity. Capital Structure FIRST LIEN 40-55% LTV Q&A: Why is first out important? If the first lien term loan lender does not provide the revolving line of credit, they are not necessarily first out. The bank or lender providing the revolver will be paid first and will have a true first lien on all assets. SECOND LIEN 55-65% LTV SUBORDINATED 55-70% LTV EQUITY 100% LTV RISK LEVEL 20

22 APPENDI X: GLOSSARY OF TERMS ADMINISTRATIVE AGENT ( AGENT ): COVENANTS: EBITDA: MIDDLE MARKET DIRECT LOAN: FIRST LIEN SENIOR SECURED LOAN: LARGE CORPORATE LOAN: Title given to lead lender in a multi-lender credit facility. This role often includes: (1) control over the diligence process; (2) control over loan structuring; (3) increased fee economics; and (4) increased access to both management and the sponsor. Lender protections negotiated in legal documentation, which include financial covenants (governing borrower financial performance), negative covenants (prohibiting borrower from taking certain actions), and affirmative covenants (requiring the borrower to perform certain actions). Earnings before interest, tax, depreciation and amortization. A proxy for cash flow used as a metric in determining debt capacity and firm valuations. A loan that is negotiated directly, without an intermediary, between a lender or a small group of lenders and a middle market borrower. A senior revolving loan or term loan secured by a first lien on all assets, cash flow and stock of the borrower. The lender is in a first priority position and will be repaid first in a liquidation or bankruptcy waterfall. Loan provided by several financial institutions to a company with more than $50 million of EBITDA (also referred to as Broadly Syndicated Loan ( BSL )). LEVERAGE: The ratio of Debt to EBITDA (often quoted as a multiple). The sustainability of a Borrower s EBITDA will impact the multiple of EBITDA a lender will provide in the form of funded debt. LOSS GIVEN DEFAULT: LOWER MIDDLE MARKET: MEZZANINE LOAN: MIDDLE MARKET: NON-PERFORMING LOAN: NON-SPONSORED LOAN: PARTICIPANT: PERFORMING LOAN: PRIVATE DEBT: SECOND LIEN LOAN: SPONSOR: SPONSORED LOAN: UNITRANCHE LOAN: Risk that measures the magnitude of the loss a lender would incur in the event of a default. Sub-segment of middle market comprised of companies generating less than $25 million of EBITDA. A term loan subordinated in right of payment to senior facilities (generally will not receive payment until payment in full of senior facilities) and, if secured, the liens are behind senior facilities. Companies generating $50million of EBITDA or less. Loan exhibiting risk of not being repaid (often caused by liquidity or cash flow challenges); may encounter non-payment of required principal or interest obligations when due. Loan made to a company that is not majority-owned and/or board-controlled by one or more private equity firms. Rather, borrowers are typically privately held or founder owned and operated. Lender in a multi-lender credit facility that is not the administrative agent. Loan exhibiting stable borrower financial performance, compliance with financial covenants, and payment of principal and interest obligations when due. Broad landscape of debt capital that is not traded on a public exchange and is provided by non-bank investors. A term loan secured by a second lien on all assets, cash flow and stock of the borrower. The lender ranks behind the first lien lender in terms of security and waterfall, but not necessarily in right of payment. Term that is synonymous with private equity firm. Loan made to a company that is majority-owned and/or board-controlled by one or more private equity firms. A term loan combining senior and subordinated tranches of debt into one facility with a blended interest rate. 21

23 TWIN BROOK CAPITAL PARTNERS is a finance company focused on providing cashflow based financing solutions for the middle market private equity community. The firm was founded and is managed by a group of highly experienced, dedicated professionals who have been successful working in the middle market. Much of the team has worked together throughout their careers at leading middle market lending institutions. The management team has successfully closed over 1,100 transactions with 200+ different middle market private equity firms. Twin Brook s flexible product suite allows for tailored financing solutions for leveraged buyouts, recapitalizations, add-on acquisitions, growth capital and other situations for companies that typically have EBITDA between $3 million and $50 million. 300 South Wacker Drive, Suite 3500 Chicago, IL (312) ANGELO, GORDON & CO. is a privately held firm specializing in global alternative (non-traditional) investments with an absolute return orientation. The Firm was founded in 1988 and as of June 30, 2017 manages approximately $28 billion. Angelo, Gordon has over 400 employees, including 150+ investment professionals. The Firm is headquartered in New York with associated offices in Chicago, Houston, Los Angeles, San Francisco, London, Amsterdam, Frankfurt, Hong Kong, Tokyo and Seoul. The firm manages capital across ten strategies: (i) distressed debt, (ii) non-investment grade corporate credit, (iii) middle market direct lending, (iv) energy direct lending, (v) real estate equity, (vi) real estate debt, (vii) net lease real estate, (viii) residential and consumer debt, (ix) private equity and (x) multi-strategy hedge funds. In each discipline, the firm seeks to generate absolute returns, in all market environments and with less volatility than the overall markets, by exploiting market inefficiencies and capitalizing on situations that are not in the mainstream of investment opportunities. The firm is an SEC registered investment adviser. 245 Park Avenue New York, NY (212)