Keeping Capital Deployment Consistent in Challenging Markets

When the M&A market is muted or volatile, maintaining a consistent capital deployment strategy can be a challenge. Drew Guyette, senior partner and co-chief credit officer at TPG Twin Brook, joins the podcast to discuss the prevailing tailwinds in the lower-middle market, how his firm is putting capital to work right now and what he sees on the horizon in 2025.

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 your host, Katie Maloney. Today I’m talking with Drew Guyette, senior partner and co-chief credit officer at TPG Twin Brook, to dig into how to maintain a consistent capital deployment approach during times when the M&A market is muted or volatile. We’ll also look ahead and discuss what 2025 might hold. Drew, welcome back to the podcast.

Drew Guyette: Thanks, Katie.

MMG: So, Drew, I was hoping we could start the conversation by hearing your perspective on what the current tailwinds are that are driving growth in the lower middle market today.

DG: Sure. When we look at 2024, what this market currently feels like, the characteristics that are driving deal flow, I think you have to acknowledge some of the performance and some of the volume of the last two years, maybe even three years in a slightly muted M&A market, slightly muted add-on market, it’s certainly been more pronounced in the last 12 months. So as we look at what deal activity looks like right now, you are seeing some of that thawing play out. So you’re seeing an increase in absolute observations of companies looking to transact. You’re seeing private equity firms getting more involved in terms of what growth strategies are available to these companies, what fragmented marketplaces exist and, as a result, what add-on opportunities exist. And so when you think about some of those tailwinds, you could look at it as there was a little bit of a backlog getting us to this point in time. And so now we’re kind of starting to work through that. Companies that had to rehabilitate their management teams or their P&Ls, get their house in order maybe is another way to say it, and be ready to bring it to market: We’re in that moment of time right now. I think certainly the observations around some of the interest rate cuts, some of the forward-looking guidance the Fed has provided in terms of where that individual variable will sit over the course of the next 15 to 18 months. That spurs growth, that spurs it both on an organic basis but also on an add-on basis. But generally speaking, as you look at the subsegments of industries, there’s still a lot of very healthy sectors in the U.S. and so it’s those businesses operating in those sectors that are really drawing everyone’s eye right now on an M&A basis.

MMG: And I want to get into to some of those sectors a little bit later, but first, you mentioned the slowdown this year and also the muted add-on environment. I’m curious whether you’ve seen a decline in add-on activity throughout the lower middle market or whether you are still seeing companies pursue add-ons as a path to growth?

DG: It’s a good question. We have to take this on a relative basis lens, and so have we seen a slowdown by comparison of the last two years? Absolutely. Is this market producing volume that is akin to, let’s compare it to 2017 or 2019 as a vintage, it’s probably within an acceptable tolerance or range of those vintages. So, I like to frame that because it’s not binary, it’s not zero to a hundred, right? We’re somewhere in a range bound of what is available, but have we seen a slowdown? Yes. I think maybe I would describe the slowdown though more along the lines of the exercise, the modeling, the analytical part of pursuing that add-on acquisition, it just means more right now in a higher interest rate environment. You have to get it right, you have to really understand what are the post-close investments, and whether that’s on a human capital level or that’s an infrastructure level or there’s a cost to acquire the synergies of those add-ons. So yes, you are seeing a little bit of a slowdown still play out on the add-on side. It’s not zero. There is an acceptable amount of add-ons for those good performing platforms that have the capital and the resources and certainly the lender support. I think the other piece of it though, when you look at the diligence streams, what is producing the slowdown? I think it’s taking a longer time right now to really work through the diligence, work through the analytics. Certainly on the underwriting side as a lender, we’re seeing that too: elongated timeframes to really make sure you’re getting it right. Now the translation to that though is what is actually being done? What is being executed arguably comes with a higher standard or a higher quality of underwrite and diligence if we were also putting that in a relative framework.

MMG: And outside of add-ons, can you talk about how else you’re seeing companies using debt financing right now?

DG: You’re still seeing a little bit of it take place on the infrastructure and the organic side. Admittedly, the private equity model over the last 10 to 20 years has really skewed more towards add-ons than organic initiatives. And part of the reason for that is the cost, whether that be on-balance sheet cost or the use of debt proceeds to fuel those organic initiatives and the timeframe that it would take to execute on them. So still a lesser amount going. The used debt for organic purposes, you’re seeing more of it beyond the add-on side in this moment in time. When you think about the drive to recover capital, when I’m thinking about a GP-LP relationship at the private equity level, you are seeing private equity firms evaluate those better balance sheets and think about dividend recaps as a source of using debt to fuel some other transaction moment. Admittedly, in the lower middle market, you’re not going to see the percentages of dividend recaps. And it’s not to say it’s zero, but it’s a smaller percentage than maybe what the overall direct lending market thinks about when they talk about dividend recaps. It’s just certainly less pronounced in the lower middle market. So TPG Twin Brook probably is seeing a very small percentage of our opportunity set on the pipeline be a dividend recap, more of where we are seeing those opportunities on existing platforms still skews to add-ons, still skews to organic growth initiatives where it makes sense to apply debt to the situation.

MMG: And I guess expanding on that, can you talk about how TPG Twin Brook has continued to source deals and grow its platform despite the slowdown that we’ve seen this year? I think you made a really good point earlier in contextualizing the slowdown is really just relative to the past few years, but I still think it’s an interesting question as far as what you guys are doing to maintain sourcing activities and whether you’ve changed your strategy or approach at all.

DG: Yeah, the short answer is we haven’t changed our approach, but the obvious critical rebuttal to that would be, but in a slower M&A market with fewer add-ons, how are you able to not change your approach and still successfully deploy risk-adjusted capital? And I think part of the answer really lies that TPG Twin Brook is one of the few market leaders of the lower middle market. I think a lot of that has to do when you translate scale into flexibility, I think that translates into…our scale lends itself to experience when we see different businesses, different companies operating and sub-segments of sub-segments. So chances are we’ve already observed these platforms and therefore that gives us a leg up on the diligence side. So as a result, we’ve actually had a pretty successful 2024 in terms of both new LBOs, but then also complimenting that with add-ons. And Katie, one of your questions was, how do you control the risk? How do you do something that’s not unique or something that’s not different? And because of our market leadership and scale, we will see a fairly reasonable percentage, somewhere between 25% to maybe even as high as 45%, of our deployment comes from add-on acquisition financing with the install base of platform companies that we have. And with our dominant administrative agent role in 98-plus percent of these businesses, we are the ones that are able to choose where that new capital is deployed, how it’s structured, how it is documented and ultimately who’s the recipient of it. So TPG Twin Brook’s able to deploy a decent amount of capital every single year because of the size of that scale. I like to sometimes describe it as we have a little bit of selective indifference when it comes to the new originations. We’re a little agnostic to whether it’s a new LBO or an add-on, and the consistency of the private equity model in our marketplace of what we target and how we support these private equity firms as a valued debt partner allows us to continue to deploy that capital in the add-ons in a nice risk-adjusted fashion.

MMG: Back in the spring, I spoke with your colleague Pete Notter who told me that borrowers at the time were facing the challenge of controlling costs while at the same time trying not to compromise their top-line growth. And I wondered if you could talk about how you strike the right balance between those two priorities when working with borrowers. A theme of past TPG Twin Brook conversations has really been the relationship-based approach that you all take. So I’m very curious to hear how you’re approaching that tension between those two priorities.

DG: Yeah, and it’s important to get it right. That might sound naive, but how do you get it right and how do you stay on top of it because you want to encourage these companies to grow. We all understand the basic business models that you have to be able to invest in human capital or you have to be able to invest in systems to produce that growth. As a senior lender, you’re constantly looking at where the margins of the business are, where is the sustainable cash flow to support the debt load that the company has taken on. I think one of the ways that we’re able to do that in partnership and strike that equilibrium, get the right balance of our interests as well as the private equity firm’s interest, it really lies in our portfolio management style. And so when you think about differentiators to the TPG Twin Brook strategy versus other direct lenders, number one, we hold the revolving line of credit in every single one of our borrowers. We don’t farm that out to a bank, we don’t create some sort of synthetic strip that is outside of our ecosystem. We have dollar one exposure through the revolvers. At a business level what that means though is that we’re dialoguing with these CEOs and these CFOs daily and weekly regarding their working capital needs, their payroll needs, all the inflows and outflows of their liquidity position. That will then translate into dialogues with the private equity firms. And so that certainly is probably the most frequent touchpoint we have with these companies to make sure that we’re both lined up. Expectations are met and constantly monitored. You can think about the monthly financial statements that we receive on these borrowers as another checkpoint into the dialogue of, are we tracking to a forecast we all agree on? Are we tracking to that budget? Where are the variances and where those misses? I do like to think about some of the best relationships that we all have in our lives, whether it’s professionally or personally, and chances are those are rooted in constant, frequent conversations and interactions with each other. So best way to stay on top of that and make sure nothing ever gets askew is likely in that monitoring side of the world.

I think the second piece though goes to a little bit of the philosophy of TPG Twin Brook. One of the defining characteristics of our portfolios are 100% private equity-backed borrowers. And so when you think about the why behind that, sometimes that lies in the fact that they have the capital support to bring to these businesses. So if you want to pursue a growth strategy that requires, as you point out, Katie, the desire to invest in operating expenses, to build costs into the business, to put margin pressure on it, you have the ability then to turn to the private equity firm and say, infuse capital support, let’s maintain where the senior debt profile should be, let’s maintain that cushion to the financial covenants and bring in equity to actually fuel what is otherwise equity growth.

MMG: Turning to a topic that’s maybe a little less harmonious, there have been a few recurring themes in 2024, one of which is lenders’ increased use of things like PIKs and LMEs, maintenance covenants and so on. So Drew, I’m interested to hear how you think about loan structuring and more specifically what your views are on some of these highly contested protections like PIKs and LMEs.

DG: Yeah, asking the chief credit officer about LMEs may open up Pandora’s box. So, we like the lower middle market for a variety of reasons. General statement would be the protections that you find in the credit documentation. You still see really good documentation principles in the lower middle market. You haven’t seen as much of that drift take place as the proliferation of private credit and direct lending have taken place over the last 10 to 15 years. The lower middle market, for the most part has been insulated from a lot of these concepts. At one point in time we were talking about financial covenants. Now liability management exercises are the new topic that are getting headlines. So, in the nature of the lower middle market, because of our scale, 50% of the time we’re the sole lender, which gives us a lot of strength. When you think about walling off some of those concepts and keeping those provisions outside of our credit agreement, the remaining portion of the transactions largely comprise of club executions. So again, very tight-knit small bank groups whereby the LME opportunities don’t really exist. So it’s something that we continue to monitor and it’s something that is getting more attention every day that goes by and you’re seeing these exercises play out. I do think it speaks a little bit to the maturation though of the private equity and private credit markets. As these markets expand, you open up opportunities for more flexible solutions to come into capital structures. You think about where first lien, second lien, unsecured, maybe as a traditional thought, those were concepts that all made sense and now at the equity level you’re starting to see some of that flexibility come in as well. And so LME is probably a byproduct of some of that flexible structuring taking place and some of the larger volume set of the private credit world allowing for it. So I don’t think LME exercises are going to spread to the majority of the private credit market.

On the PIKs side of the world, PIK also is a very interesting concept in these higher base rate environments. Unlike the last time we saw base rates this high, you haven’t seen a contraction of spread. So the all-in rate is unique and quite attractive up and down the spectrum for direct lending. Obviously makes a lot of sense how we’ve transitioned into some portion of PIK for more portfolio amendment-related activities. Some of these borrowers are carrying debt loads that were really defined and thought of and modeled in a lower interest rate environment. That doesn’t make them bad and it depends on how much PIK is being applied to the situation. Are you in zero to 2% or are you 3 to 5% of your all in interest rate is PIK or are you full PIK? And if you are full PIK, that might describe other vocabulary words that are synonyms, such as payment default and other concepts like that. So when I think about PIK on the portfolio side, it makes a lot of sense. It’s relevant. It’s probably one of the few definitions or one of the few concepts that we should all think about defining as a way to equalize and measure managers and the health of a book. I think that’s what PIK interest is kind of turning into, is this litmus test of the quality and the health of your book. On the new deal side, PIK is a little more difficult to really think about. And I do think you have to segment which part of the market you’re talking about. When you think about PIK on day one, TPG Twin Brook’s viewpoint is that if you need PIK on day one, you’ve probably applied too much debt to the situation. We are a senior debt cash flow lender, which means we are underwriting these sustainability of the cash flow into future periods of time. Every single one of our underwriting structures has to work in a flat growth case, meaning nothing changes for the borrower after day one into year five and the debt structure has to be self-sufficient in that flat growth case scenario. So as a result, PIK doesn’t make a lot of sense if that’s our philosophical credit underwriting approach. Where you see PIK start to come in, and you’ve seen more observations of it upmarket, you’ve seen concepts like synthetic pick get thrown around—certainly our vantage point we’re going to say that that implies you’ve put too much debt on this business and that you’re relying on a growth concept for that borrower ultimately to turn cashflow positive. Potentially you’re taking a little bit of equity risk as a senior debt provider, but from our vantage point, we’re going to continue to reserve the use of PIK for only those unique situations on the portfolio where we’re working with our partner private equity firms and we see a path forward and the borrower might need a little bit of cash flow relief, but it’s relatively speaking a very small portion of our portfolio that’s experiencing that.

MMG: Drew, your firm closed on $3.9 billion of capital commitments in August. Congratulations.

DG: Thank you.

MMG: Can you talk about how you’re planning to put that capital to work in the lower middle market and whether there are any specific sectors that you’re particularly bullish on? You alluded to some at the top of the conversation, so I’d love to hear more about what sectors you’re finding attractive these days.

DG: I think as an institution we’re not changing our perspective on the industries or the heat map that we target. We like to think about our firm as a generalist-oriented firm. So, think about U.S. GDP less what we define as our avoided industries and what’s remaining of U.S. GDP after that is really how we have targeted the lower middle market and the private equity community. When I think about the sectors that we find more attractive or less attractive, really that philosophy, that go-to-market strategy is rooted in over 20 years of experience of this senior team working together. Certainly when we founded TPG Twin Brook back in 2014, it was the same approach to the marketplace, that diversification, that all-weathered approach to these industries, avoiding the heavy cyclicals, avoiding the volatile industries, thinking about things in sectors that contain fad risk or certainly more consumer discretionary. Those principles and application to our underwriting process have allowed us not to really have to change. We don’t have to go into a new year and, Katie, to your point, raising a new fund and say, okay, because we have done X, we now have to position the firm Y. That’s not TPG Twin Brook’s approach. We really do think we’re that perennial strategy that regardless of what the interest rate environment is, whether we are in a pandemic or not, whether we are experiencing a hard or a soft landing, our approach to conservative senior debt deployment and how we think about LBOs and add-ons allows us to be, again, using that phrase selectively indifferent to what the market conditions are. That’s not to say that we can be naive about it. Sometimes our jobs feel a little harder than others. Sometimes you have to spend a little more time to my point of what the duration is of your underwriting process, but we’ll observe over 1,500 unique transactions every year and from there we will down select to the best 3% that we think are worth pursuing in executing on. And so that is the benefit of scale. So I think we are uniquely positioned in that manner. So whether it be the start of the funnel in our approach or whether it be the flexibility that scale has provided us, we’re really kind of doing the same thing year in and year out, quarter over quarter.

MMG: And I did want to ask you, Drew, about how you think about capital deployment without changing your risk profile, which I think you really just got at. I mean it sounds like the scale and consistency really plays into striking that balance.

DG: Absolutely. Our approach to senior debt and the type of private equity firms that we work with, we really want to understand what your growth strategy is and how you plan to execute on that. As the chief credit officer, I will always say that uncontrolled growth is just as risky as any downside scenario that you can model out. So we really have to stress our underwriting to understand how is this private equity firm, how is this management team going to execute on that growth strategy? So when you take that as a starting point, then you go to the risk question and you say, how do you underwrite this business? What’s an acceptable amount of capital to put on it? You think about a higher base rate environment, you think about a soft landing, you think about inflationary pressures, you have all of these different variables at play, sussing out to a very conservative amount of senior debt based on cashflow with good coverage ratios. Said differently, the private equity firms that we are working with are not financially engineering their balance sheets at the time of acquisition to thus create this static moment where they can’t execute on that growth because they over-levered the company. So it is a harmony that we’re striking with the private equity firm. We want to make sure that they’re able to model out a successful return. We want to make sure that it’s still conservatively structured where we don’t think there’s unique risk on it. Now you can go to the place of saying, whether it be the amount of options, the pipeline, our forward look into 90 days because of the number of private equity firms and borrowers we evaluate, or you could look at one of my prior comments that 40% of our deployments come from add-ons and those are performing credits and those are credits that we know the best. We know those management teams, we’ve lived with them for some period of time in that first five years of ownership by the private equity firm. And so that is what really allows us to be balanced in our thoughtfulness and not applying too much unique risk to a situation. We’re able to kind of take every single opportunity and not have to chase a lower volume market in order to ensure good deployment every quarter.

MMG: So, we are having this conversation in November. The end of the year is coming up fast. I was hoping to close this out, Drew, if you could share a little bit about your outlook for the lower middle-market space in 2025 and what you’re expecting to see next year.

DG: I think if the Fed stays on its path, that obviously is a tailwind. We’ve already talked about a lower base rate environment should spur some more transactional volume, generally speaking across direct lending. So specific to the lower middle market, yes, I think that that would be one of the beneficial factors as we close out this calendar and we go into the next year, that can only help in terms of how much volume’s taking place both on the new LBO side as well as the add-on acquisition side. I think as I think about that backlog of deals building, we’re observing it as well inside of TPG Twin Brook, in our just inside 275 active portfolio accounts. We’re looking at maturity dates, we’re dialoguing with our private equity firms about when they’re looking to transact, when they’re looking to have a change of control. We are dialoguing with them regarding continuation vehicles that the desire for private equity firms to stay with this investment that they have. So I do look at 2025 with the lens of optimism if growth and increased volume is where optimism is found. I think when you look at the core of the performance metrics inside of the portfolio, we would tell you 95 plus percent of our borrowers are starting to see those green shoots take place. And so the economy, the strategy, the value proposition they’re looking to deploy is gaining more and more traction, so that lends well to having attractive companies come to market next year. So generally speaking, we do think 2025 will be a superior year to 2024. I think even if on an organic level it is not superior, I do think you’re going to see increased volume in the sense of refinancing, and private equity firms looking to stay the owner of the business, but find a lender that can support them for the next leg, the next five years.

MMG: Alright, great. Well, we will wrap it up there, Drew. Thank you so much for joining me on the podcast.

DG: Thanks, Katie, appreciate it.

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

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