>'O \UTI Rl' t!o...p~(\,... 0 ~ t:.. u ~.. ~~"" ~~ Fo11. vo'1'- Agenda Item No. Board Meeting D-3,,>-.~ ~4, 2015 REPORT TO THE JOINT RETIREMENT BOARDS August 18, 2015 FROM: SUBJECT: CITY OF FRESNO RETIREMENT BOARDS' DUE DILIGENCE COMMITTEE MICHAEL REID, Board Member PHILLIP HARDCASTLE, Board Member STANLEY MCDIVITT, Retirement Administrator DON STRACKE, Investment Consultant, NEPC APPROVE DIRECT LENDING MANAGER SEARCH RECOMMENDATIONS AND SOURCES OF FUNDING BACKGROUND: Direct Lending Search Process NEPC received 15 completed RFI's in response to our search for one or more direct lending managers. Each manager was scored on the following criteria: 1. Organization and Stability 2. Investment Style and Process 3. Relevant experience and performance 4. Fees The list was narrowed down to the highest six ranking firms. Two of those six were eliminated, either due to the fund closing prior to when CFRS could reasonably expect to make an investment or due to a focus on a less attractive part of the direct lending universe. The two finalists, Monroe and Crescent are both NEPC FPL managers. Staff and NEPC conducted conference calls with the remaining four firms narrowed it down to two firms as reported at the March meeting, and the Joint Boards interviewed these two firms at the April meeting. Legal Counsel has also now reviewed the contracting documents and prepared side letters for both Crescent and Monroe. The Due Diligence Committee composed of Michael Reid, Phillip Hardcastle, Stanley McDivitt and Don Strake who conducted on site due diligence visitations in Boston on August 11, 2015 at Crescent Capital and on August 12, 2015 in Chicago at Monroe Capital. BOARD ACTION: D APPROVED D laid OVER D REC REVIEW
MEETING DATE : August 24, 2015 PAGE 2 Monroe Capital At the Monroe Capital on-site visitation in Chicago, we met with the following individuals over a five-hour meeting at their office on 311 South Wacker Drive Suite 6400: Michael Egan, Managing Director, Chief Credit Officer Tom Aronson, Managing Director, Head of Originations Zia Uddin, Managing Director, Portfolio Manager Karina Stahl, Director of Finance & Operations Matthew Lane, Director, Underwriting & Portfolio Management Nathen Harrell, Vice President, Underwriting & Portfolio Management Sora Moon, Assistant Vice President, Investor Relations We initially reviewed their organization, their funds and terms; and their track record. Tom Aronson provided an in-depth review of the firm's origination process and information about the current lending environment. We reviewed their structuring, covenants and portfolio monitoring along with workout experience. They reviewed two actual case studies on recent loans. We then met with their Fund Accounting and Compliance teams. Discussions included valuations, reporting, legal, compliance and firm governance. As an overview, the Due Diligence Committee found Monroe Capital to have depth in staff and a strong conservative Direct Lending process that the Due Diligence Committee would recommend to the Joint Boards. Crescent Capital At the Crescent Capital on-site visitation, we met with the following individuals over a five-hour meeting at their office in Boston: John Bowman, Managing Director Scott Carpenter, Managing Director (Originations) Mike Rogers, Managing Director (Portfolio Manager) We initially reviewed their organization, their funds and terms along with their track record. Scott Carpenter provided an in-depth review of the firm's origination process and information about the sponsor lending environment. We reviewed their structuring, covenants and portfolio monitoring with Mike Rogers along with his workout experience. We discussed their Fund Accounting and Compliance operations which are located in their Santa Monica, California Headquarters office. We did not visit the Santa Monica office. Discussions included valuations, reporting, legal, compliance and firm governance.
PAGE 3 As an overview, the Due Diligence Committee found Crescent Capital to have a smaller team but significant lending experience. Given the years of experience of the three principal members on the team, there was some concern about the younger team members being qualified to replace any of the three primary team leaders. We did find the team leaders to be very experienced with a conservative Direct Lending process that we would recommend to the Joint Boards. They have experienced the 2008 market correction and skill with workouts. The Boards may want to consider a further on-site due diligence review of Crescent's back office operation in Santa Monica. MONROE CAPITAL (Summary as previously provided by NEPC) Executive Summary Monroe Capital Private Credit Fund II LP (the "Fund," "Fund II," or "Monroe II") seeks to provide investors with current income and long-term capital appreciation by directly originating senior secured loans in lower-middle market companies located in North America. The Fund will primarily invest in U.S. companies with less than $25 million in EBITDA that require financing to fund a corporate event such as a buyout, refinancing, recapitalization, ownership transfer, or acquisition. Fund II is targeting to invest in 25-30 companies over a four-year investment period. The General Partner is seeking aggregate capital commitments of $600 million for Fund II. The Fund is targeting a net internal rate of return, or IRR, of 8%-10% (unlevered), 12%-14% (levered). Firm/Organization Monroe Capital (the "Firm" or "Monroe") was formed in 2004 by three former Hilco executives, Ted Koenig, Mike Egan, and Tom Aronson. Monroe focuses on lending to middle and lower-middle market companies primarily located in the United States. The Firm's professionals have backgrounds from various middle market financial institutions including GE Capital, Capital Source, CIT Group, American National Bank, Van Kampen Asset Management and GMAC Finance. In addition to its investment staff, the Firm has a fully-integrated accounting/finance group, operations, back-office, and investor relations staff located at Monroe's Chicago headquarters. The Firm has additional offices in Atlanta, Boston, Charlotte, Los Angeles, Dallas, San Francisco and New York City for the purpose of originating transactions. The Firm currently has over 48 individuals on staff, of which 34 devote a material amount of time to the Fund (employees who dedicate >50% of their time to the Fund). Monroe has invested approximately $2.5 billion in over 500 middle market lending transactions across closed-end funds, managed accounts and a business development company. The
PAGE4 Firm has five other current funds: Monroe Capital Senior Secured Direct Loan Fund LP, Monroe Capital Partners Fund, L.P., Monroe Capital Partners Fund II LP (SBIC), publicly listed Monroe Capital Corporation (ticker MRCC) and Monroe FCM Direct Loan Fund LP. The investment objectives and parameters of each program vary and each program is governed by its own respective operating documents which may have different investment terms and conditions. Monroe is an independent, 100% employee-owned investment manager. The daily activities of the Firm are overseen by Ted Koenig, who serves as the President and CEO, as well as Michael Egan, Chief Credit Officer, Thomas Aronson, Head or Originations, and Jeremy VanDerMeid, Portfolio Manager (the four "Partners"). The Firm has 5 owners including the four Partners and one senior underwriter. As of December 31, 2014, Monroe had approximate $1.9 billion of total assets under management. Portfolio Management Team As stated earlier, the Firm has 34 investment professionals dedicated to Fund II. Excluding the four partners dedicated to the Fund, the remaining thirty one investment professionals consist of the origination team (13 members) and underwriting and portfolio management team (17 members). Investment Strategy The Fund will directly originate senior secured direct loans in middle market companies primarily located in the United States. The Fund will leverage Monroe Capital's sourcing and underwriting platform that has been operating since 2004. It aims to protect invested capital and generate high single digit to low teen net IRRs by focusing on the senior position in the capital structure and accessing transactions that require a heavy origination effort. Monroe expects the following debt/equity concentration in the portfolio: Security...IJ!,.._e Senior Secured - 1 st Lien Unitranche Opportunistic Private Credit Equity Upside (Warrants) Debt/E_!luity Percentage of Invested Capital 50%+ 0-40% 0-25% 5% 95/1000/o/0-5% The Fund will target senior secured direct lending investments in a wide range of industries. The Fund will also seek diversity in terms of investment size, company type, industry, geography, and asset type. The Fund is targeting investments in middle market companies with EBITDA of $3-$25 million and revenues of $25-$250 million. Monroe is staffed to pursue deals alongside private equity sponsors as well as non-sponsored transactions. Historically, the Firm has pursued an approximated 50%/50% mix in sponsored and non-sponsored transactions. The Fund will seek companies with stable
PAGE 5 and consistent cash flow generation and will not engage in distressed transactions with companies that have negative earnings. The Fund's strategy is designed to provide Limited Partners with access to a transparent and diversified portfolio of otherwise hard to access secured private loan investments. The following are core elements of the Fund's strategy: Strong Current Income: The Fund's investments will target a consistent and sustainable current income distribution of 7-10%. Protection of Capital: The Fund's focus will be on the safety and protection of invested capital. Loans will be well-collateralized and typically have a lien on a borrower's tangible assets and intangible assets, and a pledge of company stock. Covenants will be structured to provide the ability for early intervention in the event of deteriorating financial performance of a borrower. Conservative Structure: Loans are expected to have low leverage ratios, conservative loan-to-value and significant equity capital support and a repayment schedule which is based on a conservative estimate of the borrowers' predictable free cash-flow generation capability. Agented by Monroe: The Fund is targeting-75% of transactions to be agented by Monroe. This increases return and reduces risk for each investment. As Agent, the Fund will receive optimal interest and fees. Additionally, the Fund will be in the position to structure covenants and protect its capital. Predictable Exits: In addition to the Fund's conservative approach to structuring and emphasis on protection of capital, the Fund will seek a predictable exit. The Fund's investments are not expected to be dependent on event-driven or purely market-driven exit strategies, such as robust merger and acquisition markets or a fully functioning IPO market. Return Enhancement: Additional yield generation will come through PIK interest, warrants and success fees. The Fund is targeting total gross investment returns of 12%-14% per annum. Portfolio Diversification: A broad array of industries will be targeted to produce a balanced and relatively non-correlated portfolio of investments. The portfolio will be structured to have the downside protection inherent in a collateralized pool of assets.
PAGE 6 NEPCPros: Loan Experience - Has invested over multiple economic cycles with a low loss rate Broad origination network and resources Slightly lower fees versus Crescent NEPCCons: Higher turnover within the team versus peers CRESCENT CAPITAL (As Provided by NEPC) Executive Summary The Crescent Direct Lending Fund, LP and Crescent Direct Lending Levered Fund, LP ("the Unlevered Fund" and "the Levered Fund", respectively, and collectively the "Funds") seek to generate high current income while focusing on preservation of capital by originating senior secured loans for lower middle-market companies. Deals will primarily focus on US-based companies held by private equity sponsors. The Unlevered and Levered Funds seek to raise $300 million and $250 million, respectively, in capital commitments. The Unlevered Fund is targeting a net IRR of 7.5% to-10.0% and a net multiple on invested capital of 1.2x-l.3x. The Levered Fund is targeting a net IRR of 11.0%-to-12.0% and a net multiple of 1.3x-1.4x. Crescent Capital Group (the "Firm" or "Crescent") is also launching a Direct Lending SBIC Fund. Firm Overview Crescent Capital Group was formed in 2011 following a spinout from Trust Company of the West ("TCW"). The history of the Firm dates back to 1991 when Crescent Capital Corporation was formed to focus on opportunities in the sub investment-grade debt markets by investing in bank loans, high-yield, mezzanine and distressed debt. In 1995, Crescent Capital Corporation joined TCW to expand its fixed-income capabilities and was renamed TCW Leveraged Finance Group. In 2010, the founders of Crescent decided to spin off from TCW and, by January 2011, Crescent Capital Group began operating as an independent, employee-owned asset manager. The founders and Managing Partners of Crescent Capital, Jean-Marc Chapus and Mark Attanasio, collectively own the majority of Crescent Capital's equity. Allied World Assurance Company (a publicly traded reinsurance company) formed a strategic partnership with Crescent in December 2012 in which Allied acquired a minority ownership interest in Crescent. The Firm is divided into four product groups: Capital Markets, Mezzanine, Special Situations and Direct Lending.
PAGE 7 As of December 2012, the Firm had over 100 employees and approximately $12 billion in assets under management. Of those assets, around $6.8 billion are private equity/debt assets and commitments. The Firm is headquartered in Los Angeles with offices in New York, Boston, London and Paris. The Direct Lending team, consisting of six dedicated professionals, operates out of Crescent's Boston office. The division provides cash flow and asset-based financing for US-based lower middle-market companies. The team was formerly part of HighPoint Capital ("HPC"), a joint venture between the Audax Group and the Kraft family. Two of the senior professionals, John Bowman and Scott Carpenter, have been working together since 2005. They were joined by Michael Rogers in 2008. From 2005 to 2012, HighPoint Capital invested approximately $225 million in senior secured loan commitments. Prior to HighPoint, the senior investment team members worked together at FleetBoston. The group will leverage their existing network and Crescent's nationwide network of sponsor, intermediary, and other referral relationships. This includes around 500 sponsors with 150 priority relationships. Crescent Direct Lending is in the process of launching three concurrent funds focused on direct lending. Investments will be allocated pro-rata on capital commitments (including leverage) across the three funds, except when an investment does not qualify for the SBIC Fund. To support the growth of the business, Crescent plans on hiring origination professionals and additional junior staff. Investment Strategy Crescent's Unlevered and Levered funds invest in senior loans provided to lower middlemarket companies sponsored by private equity firms. The portfolios are expected to comprise first lien loans, unitranche, and second lien positions. Crescent Direct Lending's business model is focused on the direct origination of loans through its extensive network of relationships. The Unlevered Fund's managers expect the following debt/equity concentration in the portfolio: Securi~pe Senior Secured - 1st Lien Stretch Senior /Unitranche Senior Secured - 2nd lien Equity Upside Debt/Eguity Percent~e of Invested Ca ital 50% 25% 25% 0% ~~~~~~~~~-100%J~O~o/i~o~~~~-
PAGE 8 The Unlevered Fund is targeting companies with $5 million-$25 million of EBITDA, but may pursue transactions in companies with up to $50 million in EBITDA if an attractive opportunity arises. The following terms are consistent with what Crescent sees in the current market environment on an unlevered basis: Senior debt transactions: LIBOR + 5.0%-7.0% Unitranche transactions: LIBOR + 7.0%-11.0% Second lien debt transactions: LIBOR + 8.0%-11 % The Levered Fund will seek to amplify these returns with a low cost, floating-rate leverage facility that will have a lien on the Levered Fund's assets. Aside from the leverage facility, the Levered Fund will maintain the strategy of the U nlevered Fund. Crescent Direct Lending intends to continue the strategy of HighPoint Capital, which is based on fundamental credit research and risk analysis. The Direct Lending team expects to target investments in companies with the following characteristics: Leading market positions and sustainable competitive advantages Operating in industries with barriers to entry Operating in industries with positive underlying fundamentals Cash flows that are dependable and predictable Management teams with demonstrated track records and economic incentives Domiciled primarily in the United States The Firm will invest in various industries such as business services, manufacturing, industrials and consumer-related products. The team expects to avoid companies primarily engaged in real estate or energy. NEPCPros: Proven track record (Predates Credit Crisis) Team has low turnover NEPCCons: Underwriting Capability not as strong as other candidates Team has been at Crescent less than 3 years Slightly higher leverage than Monroe
PAGE 9 Summary of Due Diligence Committee's Recommendations The Due Diligence Committee has completed our on-site due diligence visitations and the Due Diligence Committee is recommending that the Joint Boards consider retaining Monroe Capital and Crescent Capital as direct lending managers in their levered funds. We further recommend that a new asset allocation be established for Direct Lending at 4% (approximately $100 Million) with an equal allocation between Monroe Capital and Crescent Capital. Additionally, we recommend that Tom Hickey, our investment legal counsel be directed to complete side letter negotiations with both firms. The Due Diligence Committee will defer the discussion as to the source of funding for the two mandates to the Joint Boards and a recommendation from NEPC. It should be noted that there is some time sensitivity as Crescent is planning on the final close of the fund on September Sth. Monroe is planning their final close on September 3Qth.