Private Chat — Doing the safety dance in the lower middle market

Recent headlines suggest the private credit market is beginning to crumble; however, the asset class isn't a monolith. Look further downmarket, and a far more resilient story emerges.

In this episode of Cloud 9fin, US private credit deputy editor Shubham Saharan is joined by Natalie Garcia, Deerpath's head of underwriting, as well as Reed Van Gorden, Deerpath’s head of origination, to discuss how the lower middle market is staying steady despite industry headwinds.

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Creators and Guests

Producer

Chase Collum

Head of Podcasts for 9fin Limited

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Shubham Saharan
Hi, everyone. This is Shubham Saharan. I'm the deputy editor for the U.S. private credit team here in New York at 9fin, and I'm joined today with a few members of the Deerpath team. I'll let them introduce themselves, and then we'll kick off into what is a great conversation about the lower middle market. Natalie, why don't we kick it off with you?

Natalie Garcia
Hi, Shubham. Thanks so much for having us on. I'm Natalie Garcia. I'm the Head of Underwriting at Deerpath and a permanent member of the Investment Committee. I'm based in our Florida office, and I've been with Deerpath for 10 years. During my time at Deerpath, I started off doing originations and underwriting, and over time became more specialized. And now I currently head the underwriting team, which today sits at 15 people, split throughout our various offices.

Reed Van Gorden
And then my name is Reed Van Gorden. I’m Head of Origination at Deerpath and a permanent member of the Investment Committee. I've been here 10 years. You'll notice a lot of commonalities here. I'm based in Chicago. Luckily, we avoided the big snowstorm that all of New York and the entire East Coast is getting. Similar to Natalie, I started off as a deal lead and over time have specialized as well, focusing on origination and leading a team now of eight. Natalie and I actually overlapped at J.P. Morgan, but we didn't know each other. We also overlapped in business school where we did know each other, but I think we got too distracted by overseas trips and living the life of business school students. So we didn't actually come together until Deerpath.

So it's worked out pretty well now for 10 years.

Natalie Garcia
Yeah, third time's a charm that we encounter each other.

Shubham Saharan
Third time’s a charm, and it's a decade-long relationship in underwriting.

Reed Van Gorden
I am now three months away from 11 years and Natalie is about the same.

Shubham Saharan
Wow. Okay, so everyone found exactly where they had to be then. I'm so glad that we're getting to chat. There's nothing like a good winter storm to set the backdrop for a good conversation on private credit. So let's hop right into it. First I want to give our audience an understanding of where exactly you all sit in the private credit market. When we’re thinking about Deerpath, can you set the scene a little bit for us? Where are we? Lower core, upper middle market?

Reed Van Gorden
Yeah, so Deerpath Capital was started in 2007 and we've stayed true to one space throughout, which is broadly speaking, the lower middle market. For us, that's defined as businesses with $100 million to $250 million of enterprise value. Additionally, we exclusively focus on sponsor-backed. Imagine a sponsor is buying a company, we're then coming in doing 40% of the capital structure, providing the debt, helping them do the industry consolidation, probably helping them grow from somewhere around $10 million of EBITDA up to $25 million or $30 million before they sell it to a bigger sponsor. At this point, Deerpath is over 100 people and we see over 2,000 deals per year.

Shubham Saharan
That's a pretty wide assortment of the lower middle market. So it seems like we're going to have some fun talking about what exactly the dynamics are. Let’s hop right into it. I want to start off by talking a little bit about the state of the lower middle market. We've seen a lot of term degradation in the upper middle market, and there's always conversations about how some of those terms are starting to come down market. Things like covenant-lite becoming more prevalent. Pricing's coming down across the board. Leverage might be going up. I want to ask you, what actually is going on? What are the themes that you're starting to see? Are you starting to see some of those terms that were once only for the leveraged loan market or the BSL space come down toward your end? Or are you staying pretty solid with your underwriting?

Reed Van Gorden
Maybe starting off, I'll talk a little bit about market and then we can go into trends. The nice thing about our market segment is it tends to be more stable than other market segments. It tends to be more stable in terms of number of transactions and dollars. Last year was a good year overall for us and for our segment of the market. There are so many deals in our market and we cover over 450 sponsors, so there just isn't that hyper competition you see up market that leads to a lot of degradation. Natalie, if you want to expand on that.

Natalie Garcia
That's right. I'll start off by saying that we still get the core protections that we look for in our loans. We get covenants in all of our loans. We get strong information rights, tight baskets limiting additional debt and collateral leakage. The biggest change we've noticed is what Reed mentioned—sponsors sometimes come down market and their lenders bring bigger terms from the core middle market into the lower middle market.

You can see this in the higher prevalence of term sheet grids presented to lenders rather than the more traditional version where a lender sends out its own term sheet. These grids can be long, where you're almost negotiating every basket and essentially negotiating a credit agreement upfront. Or you'll see a sponsor asking lenders to accept a precedent that is favorable to them and based on a larger deal. These are more core and upper middle market terms that occasionally come into our market when larger sponsors and their lenders come down market.

Some notable changes we've seen and pushed back on include multiple additional debt layers both inside and outside of our credit agreement, slightly wider covenants, and longer EBITDA definitions. On EBITDA, for example, we've seen requests for generous add-backs like run-rate adjustments, add-backs for growth hires, and longer look-forward periods for cost savings initiatives.

Shubham Saharan
You hit on an important point about who’s driving term degradation—sponsors coming down market and seeing opportunity. How does that change things on your side? Reed, on origination, how does that affect the pool of people you’re talking to? Natalie, does it change how you’re underwriting?

Reed Van Gorden
I think our list has expanded over the last couple of years, both as more firms come down market and because valuations are up. Bigger companies can struggle to make the math work for returns, so they sometimes start smaller, especially if they have a thematic view. There continues to be new firm formation in our size range—new $300 million to $400 million funds. There are also firms that used to be in our market, went up market, and are now raising new lower middle market funds. So yes, it has expanded.
Some of it is relationships. Some of it is brand. The benefit Deerpath has is we've been in the same market since inception. People know us. If a bigger sponsor talks to someone who plays consistently in our market, our name will come up.

Natalie Garcia
With respect to underwriting, nothing's changed. We don't loosen underwriting based on where the market is. We look for good-quality businesses, long operating histories, defensible characteristics, revenue visibility, conservative capital structures, and strong protections.

We try to be competitive. We hold the line on covenants, information rights, LME language, proxy right notice periods, priming language, and other protections that have come up in hallmark cases. We're typically the sole lender or administrative agent, so we have influence. We're less inclined to do club deals where we give up protections.

Because of competition, we may adjust in certain areas—maybe a slightly wider covenant cushion at the onset, scaling back later. We may allow specific EBITDA adjustments that are important to a deal, but with strict caps and often individual caps within broader caps.

Reed Van Gorden
Being the lead lender or admin agent gives us protection because they can't do anything around us. Also, the number of deals in our market compared to how many we need to deploy means we can be selective. If something pushes the bounds and makes Natalie uncomfortable, we can say thank you and move on. There will be more deals next week. Sponsors will come back because there aren't many lenders in our market with big hold sizes.

Shubham Saharan
Are there sector-specific trends requiring adjustments right now?

Natalie Garcia
Nothing specific sector-wise. We’ve seen more activity in IT managed services and IT services. We don't do software businesses, but IT services with locked-in contracts and recurring revenue dynamics are attractive. They're conducive to roll-up strategies and sticky businesses. When there's strong revenue retention, sponsors may justify add-backs for new contracts.

Shubham Saharan
Is there a difference between first-time sponsor-owned businesses and second or third-time ones?

Reed Van Gorden
Yes, there is different diligence. You worry more about key personnel risk in first-time deals. That’s why we prefer diversified services businesses. In sponsor-to-sponsor deals, there's more institutionalization. Some low-hanging fruit may remain for the sponsor, which can be helpful.

Natalie Garcia
In sponsor-to-sponsor deals, companies have typically been through audits and QoEs. You often have longer operating histories and more robust management teams.

Shubham Saharan
How important is the relationship between lender and management?

Natalie Garcia
It’s very important, especially if management is staying on. Incentives matter. We put a lot of weight on the management team. Years ago, Reed and I walked away from a deal because the management bench wasn't aligned with the incoming CEO.

Reed Van Gorden
It can be hard to diligence, but you ask around, look at track record, and spend time with them. As lead agent, we interact regularly with management through reporting and revolver draws. That gives us a better sense of strengths and weaknesses.

Shubham Saharan
What happens when origination and underwriting disagree?

Reed Van Gorden
Our Investment Committee operates relatively unanimously. If someone has a real problem, we don't do the deal. We've worked together long enough that it’s not personal. We just discuss and figure it out.

Natalie Garcia
Every originator has been an underwriter. We understand each other’s roles. We don’t send term sheets without screening through Investment Committee. Most tension happens at staffing—what merits work. But we know our precedents and where we hold the line.

Shubham Saharan
What does it mean to originate with your credit hat on?

Reed Van Gorden
We've had long-tenured leadership—Head of Restructuring, Head of IR, Head of Treasury and CLOs. We're invested in the fund and compensated based on profitability. Incentives are aligned for long-term performance, not short-term bonuses.

Natalie Garcia
Originators live with their credits. If you push through a hairy deal, you'll deal with covenant issues and tough conversations. That makes you cautious.

Shubham Saharan
There's a lot of noise around private credit right now. How are you seeing through it?

Natalie Garcia
We have a safety-first strategy. It may not be the flashiest approach in good times, but when cracks appear, that’s where we shine. Our underwriting and documentation have always been shielded from what’s in the headlines.

Reed Van Gorden
Our strategy is simple to understand. We finance businesses that have been around 20-plus years—HVAC, nursery schools, ophthalmology businesses, fire life and safety, MSPs providing outsourced IT to mid-sized businesses.

We're top of the capital structure. We're not doing mezzanine or capital solutions. We'll never be the highest-returning fund in a given year, but we focus on downside protection. Over the long run, avoiding losses may produce the best outcomes.

Shubham Saharan
This was a great conversation. It certainly seems like you're in the eye of the storm rather than riding the winds. Thank you both so much.

Natalie Garcia
Thank you. It was fun.