Finding Stability in an Uncertain Economic Environment

Finding stability is the name of the game as sponsors and lenders grapple with stubborn inflation. However, there are actions businesses can take now to spur growth. Betsy Booth, a partner at TPG Twin Brook Capital Partners, rejoins the podcast to discuss her approach in uncertain times, which industries are particularly good at weathering instability, trends in the lending market and more.

This episode is brought to you by TPG Twin Brook Capital Partners, a leading direct lending finance company focused on providing cash-flow based financing solutions for the middle market private equity community. To learn more about TPG Twin Brook, visit www.twincp.com. Read a transcript of the podcast below.

Middle Market Growth: Welcome to the Middle Market Growth Conversations podcast, an ACG production, I’m Carolyn Vallejo. “Uncertain” is a good word to describe the current economic climate as lower middle market firms cope with rapid shifts in policy and other challenges. Here to share her insights into how organizations can find stability in chaos is Betsy Booth, a partner at TPG Twin Brook. Betsy, welcome back to the podcast.

Betsy Booth: Thanks, Carolyn. Appreciate you having me.

MMG: Can you kick us off by telling us about TPG Twin Brook’s approach to market and your role there?

BB: Sure. So TPG Twin Brook is a direct lender supporting private equity-owned businesses in the lower middle market, so generally businesses that have less than $25 million of EBITDA. As an originator, I cover specific private equity sponsors across the country as they review opportunities to acquire businesses across a wide range of industries and work with them to provide a financing structure to support the initial investment along with their growth strategy.

MMG: Now, you were last on the Conversations podcast way back in the fall of 2023, which really isn’t that long ago, but it certainly feels like it. What are some of the trends and major developments that have shaped the lending market since then, and what are you keeping an eye on moving forward?

BB: As we look back on 2023, it was a retrenching year for a lot of our clients where sponsors doubled down on portfolio companies to further drive their value creation plans, just given the lighter new LBO market. Since then, it feels like a lot has happened. However, at the same time it seems like we’re still faced with similar challenges that are sticking around longer than expected. Some industries continue to experience a post-Covid hangover, including supply chain disruption, impact of inflation and lower demand overall, and this is all at a time when interest rates remained at heightened levels, leaving it unclear what the future holds for many companies.

MMG: There is a lot of macroeconomic uncertainty right now because of some of the factors that you just mentioned, specifically as inflation remains pretty sticky and policy questions continue to loom. So how is this uncertainty impacting the lower middle market?

BB: For one, it makes the budgeting process extremely difficult as management teams try to prepare and anticipate the upcoming needs of the business. We sit here today in February, and most businesses are going through board meetings and planning needs for the year. And so we find that sponsors and management teams are working to focus on what they can control and best position themselves to have cushion for the unexpected. More specific to some of the policy questions, you know, too soon to tell, right? And it could be a while before we see the effects of potential policy changes, but we do expect businesses are going to experience varying degrees of impact, mostly dependent on their industry. For example, businesses that rely on a lower wage labor force, they’ll likely need to be prepared to weather potentially higher labor costs and/or lower supply of workers. Conversely, you know, a financial services business with a white collar employee base and domestic operations likely won’t be affected to the same degree.

MMG: Okay. Now, interest rates are also top of mind for borrowers. Rising rates seem to no longer be out of the question. How do you see the rate environment shaping up and affecting the middle market?

BB: This goes back to my comment around budgeting and priorities for the near term. With potentially higher for longer interest rates, cash flow is top of mind for management teams who will be faced with decisions around whether to reinvest in the business in the form of whether it’s Capex projects or an ERP implementation. And these are going to be tough decisions, especially for businesses that have already put off investments over the past year in things such as Capex, automation, et cetera, in hopes for a lower interest rate environment to come. Additionally, liquidity is also top of mind as businesses navigate near-term cash needs. We see a lot of businesses proactively preparing 13-week cash flow models, monitoring cash on a daily or weekly basis, and working to build in a buffer for the unknown.

MMG: Okay. So certainly there are things that businesses can do, but it always helps to have a strategic partner by one’s side. And we’ve talked about things like interest rates and inflation and how all of this uncertainty is impacting budgeting and other cash flow requirements for these businesses. So how does TPG Twin Brook work with these sponsors and borrowers that are facing so much uncertainty to navigate times like these?

BB: So, TPG Twin Brook’s disciplined approach, long track record of working with borrowers across a range of sectors, and experience during multiple economic cycles has allowed us to help companies navigate these times of uncertainty. And when you look at the firm’s strategy over its history, we’ve consistently been present in the market and we have not deviated from supporting our core clients in the lower middle market. At $20 billion of AUM and over 260 borrowers, we benefit from a portfolio of scale and have built up that expertise over time to add value to borrowers and sponsors, especially during challenging times. In the lower middle market in particular, PE firms tend to be more relationship focused as opposed to just getting the cheapest deal done at close. And instead, these sponsors are looking for reliable lending partners that can scale as they execute on their growth strategy for these businesses and can also provide flexibility when needed. We spend a lot of time upfront from a diligence and underwriting perspective, and these are fundamentally solid businesses that may just need time and flexibility to weather the environment, work through challenges, and hopefully make it out the other side, oftentimes a stronger, more efficient company. And so as a result, TPG Twin Brook and its borrowers have effectively partnered to find stability amidst this uncertain economic environment.

MMG: Right, right. Direct lending has captured a lot of attention in the last year or so. What are the structural advantages that direct lending provides to lower middle market borrowers in this type of economic environment?

BB: So, there’s a number of benefits we see, particularly in the lower middle market of direct lending, including, number one, more conservative leverage structures at the onset of close; number two, tighter credit documentation such as limits on the amount of adjustments to earnings, cash leakage out of the business, limits on incremental debt on top of ours; and number three, better lender protections including covenants and more frequent financial reporting. In general, the lower middle market enjoys more touchpoints with management teams and sponsors and these touch points afford the sponsor, the borrower, and us as the lender adequate time to construct a solution ahead of material performance deterioration or a liquidity pinch.

MMG: It seems that every business and every industry is facing the pressures of a lot of the uncertainty and the headwinds that we’ve been talking about today, but there have to be some industries that are quite resilient in a time like this. Are there any sectors that you’re seeing perform particularly well in this climate?

BB: One that we’ve seen is the broader environmental services space. It’s held up relatively well. For example, a residential recycling and hauling operations business might not seem like the most exciting industry, but it’s one that we’ve tracked for quite a while and consistently experiences stable demand given they’re providing a critical service, benefits from recurring revenue streams and a highly diverse customer base. If you think about your local waste hauler, you’re likely on auto pay, and as long as they’re picking up your trash, it’s not a service that you’re thinking about switching.

MMG: Good point. You’re right, I wouldn’t really have thought of that industry, but some of those factors that you mentioned seem like they would be exciting for investors in particular. What are some of the qualities that companies have that you’ve seen that effectively navigate such market environments—what type of qualities do these companies typically possess?

BB: Yeah, so typically we’re looking for businesses in mature industries that demonstrate stable non-cyclical demand qualities. We tend to avoid lumpy or heavy project reliant business models that can fluctuate meaningfully either quarter over quarter, year over year, et cetera. Additionally, businesses that have prioritized diversity, whether it be by customer base, supplier base, product category, these types of diversity oftentimes don’t experience large swings. And then businesses that can effectively differentiate themselves typically generate higher margins and have more room to weather fluctuations in market conditions. Finally, it comes down to being thoughtful around structuring considerations when performance is stable which allows for that cushion. When economic cycles change, we run a series of modeling exercises to sensitize both top line and margins to show support for the proposed financing structure and an ability to navigate these times of uncertainty.

MMG: Knowledge is power, and of course, it’s so important for investors, sponsors, lower middle market companies to understand what’s going on. And a lot of the information that you’ve provided today is quite insightful for these listeners, but it’s really important for our listeners to also be able to know what to do with that information. If this kind of environment persists, what are some of the steps that companies can take to really move forward and to drive growth despite all of this uncertainty?

BB: So, if the business has stabilized performance, but the broader macro picture is leaving their industry and their customer base stalled, for lack of a better word, it really comes back to the people, the management team and the organizational structure. We’ve seen businesses who reassess their sales team function, how they’re compensated, what their new customer pipeline looks like, and ways the management team can support their salespeople to drive top line revenue from both expanded wallet share with existing customers and attracting new customers onto the platform. So that’s more on the revenue side—on the cost and margin improvement side, businesses that have the ability to reinvest in things like automation or Capex have seen the benefit from an efficiency, capacity and labor perspective. The last piece I’ll add is oftentimes competitors are feeling the same pain, and if you’re operating from a position of stability with the backing of a private equity firm, M&A can be another great way to grow through a soft economic cycle. And this is where sponsors can add a lot of value by surrounding their teams with resources, operating partners, best practices across their portfolio companies to help their management teams feel supported during these times of uncertainty.

MMG: Excellent. So these businesses don’t have to sit around and wait for market conditions to improve. There’s a lot of actual things that they can do now to drive value. Excellent. Betsy, thank you again so much for joining the podcast.

BB: Thanks for having me.

This transcript was prepared by a transcription service. This version may not be in its final form and may be updated.

The Middle Market Growth Conversations podcast is produced by the Association for Corporate Growth. To hear more interviews with middle-market influencers, subscribe to the Middle Market Growth Conversations podcast on Apple Podcasts, Spotify and Soundcloud.