Closing a deal requires a lot of give and take, and in times of uncertainty, the right sponsors will have your back. 

On this episode of The Capital Corner, McGuireWoods' Geoff Cockrell joins Andy Silverman, Managing Director at Parkway Capital, to discuss the trends, deal structures and challenges that an SBIC may see in the market right now.

Geoff and Andy explore topics related to investment and underwriting, including the significance of independent sponsors in Parkway Capital’s deal flow. Andy notes that being a long-tenured capital partner of independent sponsors allows his firm to make informed decisions on which deals to pursue, with eight of their current nine portfolio company deals being independent sponsor-led deals. 

The evolving market has affected how EBITDA multiples are considered for mezzanine debt. Compared to previous years, there have been lower prices and a decrease in total funded debt requested by sponsors due to a decline in values and rising interest rates. 

The current underwriting environment has also presented new challenges, with companies experiencing pandemic-related benefits performing better than they would have otherwise. This can make it difficult to determine the baseline performance for the company, particularly with younger companies that were founded around 2020.

The senior cash flow lending market has also tightened up, with credit officers declining deals they would have previously approved.  

Despite these challenges, it’s important to keep the deals coming. “We continue to try and fill the pipeline because it really is a numbers game. You need to have X number of deals in order to put out Y LOIs to close Z deals,” Andy says. 

Featured Guest

Name: Andy Silverman

What he does: Andy is the Managing Director at Parkway Capital, the mezzanine credit affiliate of Calvert Street Capital Partners. He helps manage the mezzanine investment business. Prior to Calvert Street / Parkway Capital, Andy was a partner at Capital Resource Partners (CRP), a long-standing private investment firm. 

Organization: Parkway Capital

Connect: LinkedIn

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This podcast was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this podcast, you acknowledge that McGuireWoods makes no warranty, guarantee, or representation as to the accuracy or sufficiency of the information featured in the podcast. The views, information, or opinions expressed during this podcast series are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This podcast should not be used as a substitute for competent legal advice from a licensed professional attorney in your state and should not be construed as an offer to make or consider any investment or course of action.

This is the Capital Corner, a McGuire Woods podcast, exploring investment strategies, capital structures, and topics relevant in today's middle market private equity. Join McGuire Woods partner Geoff Cockrell as he and specialists share practical insights to inform your deal work.

Thank you for joining another episode of the Corner series. I'm your host, Geoff Cockrell, a partner at McGuire Woods. Here at the Corner series, we try to bring together deal makers and thought leaders on investing in a number of different topics. Today we're thrilled to be joined by Andy Silverman, managing director at Parkway Capital. Andy, before we jump into a few questions, maybe give a quick introduction of yourself and Parkway Capital.

Sure. I've been at this now for 20 years. I started my career at Capital Resource Partners, which is a Boston-based mezz fund, and I joined Parkway about three years ago now. Parkway is a 25-year-old Baltimore based mezz fund and we had been investing off of the balance sheet of a Baltimore based family office, did 45 some odd deals basically with an LP base of one. And then about three or four years ago, we started to organize ourselves around raising a more traditional pool of capital. We went out and began the licensing process with get our SBIC license, went through that, went through it successfully. Certainly there was a lot of heartache and a little bit of hair pulling along the way, but got the license, raised the capital, and so we're currently investing out of $125 million vehicle.

Part of our process in launching the SPIC fund was joining forces with Calvert Street Capital Partners, who like Parkway, Baltimore based, similar lineage, and has been around for a similar amount of time, and we found that combining with them would provide us unique amount of insight into the market. They are an equity focused shop with a very thesis driven approach to life and we are a SBIC mezz fund, and so being able to come together, we don't co-invest, we don't share staff, but it allows us to have a broader sense of what's going on in the market and we think that makes us more educated investors, and if we're lucky, then hopefully better investors as well.

Andy, I know you're more of a generalist. I spend most of my time in healthcare investing and in the middle market and lower middle market, a healthy amount of the deals that we see and end up working on are sourced by independent sponsors, which is a little bit of a nuanced area of the market. And that's often the type of deal where I would see an SBIC participating in. How much of your book of business is related to independent sponsor led deals and how do you think about backing an independent sponsor?

Yeah, that's a great question. We just looked at the stats the other day in preparation for our annual meeting and about two-thirds of our deal flow is from the independent sponsor community, so it's very important from what goes into the funnel and then it's equally important and perhaps more so, in terms of what comes out. We currently have nine portfolio companies, Parkway 2, and eight of those nine are independent sponsored lend deals.

I think that's a function of a couple things. One, when we started investing out of the fund, senior debt was effectively free, and so the funded equity sponsors, I want to say they wouldn't take our phone call, but we were just a less relevant conversation for them. Whereas the unfunded or independent sponsors, they needed the debt and they needed the equity co-investment. In Parkway, we target to invest about 20 to 30% of our fund in the form of an equity co-investment alongside of our debt, so the ability to provide a one stop solution to a sponsor, especially one that needs to raise a lot of capital to get a deal done, has and will continue to be pretty relevant. I think that's how, in part, we build up our portfolio and certainly now that debt, senior debt, that is, has risen to the pricing that currently, it just made us more relevant, so that's part of the answer.

I think the other part of the answer is because Parkway's been at this for 25 some odd years, we're not new to the independent sponsor party. The first deal that we did at Parkway in 2000 was an independent sponsor led deal. Now, we didn't call that as such, but that's ultimately what it was, and so we've been backing the asset class now for almost a quarter century and there's no way to prove this, but we might have the longest tenure as a junior capital partner in the independent sponsor segment. We're proud of that lineage and I think that is what helps us understand which deals to spend time on, which deals to move on from.

When I'm encountering an independent sponsor led transaction like one that you might be backing, one of the variables that either the selling company is thinking about or the banker might be thinking about, if it's a banked deal, or a competing bid might be thinking about as it relates to you and your independent sponsor is execution risk. In that context, how would you describe the execution risk that an independent sponsor led deal would have compared to just a fully funded equity fund?

I think for the independent sponsors who haven't done a deal yet and don't have a trophy on the mantle to point to, that's hard because then it is more of a leap of faith, but what we are seeing increasingly, especially in this market environment where the deal velocity is still relatively high, not at all time highs, but still relatively high, is a lot of pre-LOI work that we're doing in conjunction with independent sponsors. Deals come in, even though the sponsor doesn't have them signed up, we are still spending time to assist them in terms of leverage reads, support letters, thinking about growth avenues, thinking about potential covenant levels, and the ability to demonstrate some level of work to the seller and the seller's representatives, I think helps ameliorate that a bit. And certainly also a trial record of, "Hey, yeah, we don't have a committed fund, but here are five deals of five exits or some number to point to," that certainly helps.

And are you usually forward facing with the seller and the seller's advisors or a little bit behind the screen, because that also ties to ameliorating the execution risk.

Yeah. Well, an important point of delineation for us at Parkway is we're not trying to be the sponsor. My background at CRP, that fund was, we were basically sponsorless mezz. We were the front seat in the movie theater, so to speak. Here, we're way at the back, not way at the back, but we expect a sponsor to be the deal quarterback, lead the deal due diligence, lead the negotiations, and certainly lead the deal post closed. We're hopping to walk shoulder to shoulder with him or her, but if we are stepping in front of the sponsor, that probably means we're backing a very weak sponsor, and then that means we might be entering into the wrong relationship. We can play that role, but I think the better situations that we like to get involved in are ones where the sponsor says, "Look, hold the microphone, I got this because I've done this before."

Are you usually speaking for all of the mezz debt and the equity or some combination along with other maybe similar SBICs? How do you think of that?

Yeah. Well, so on the junior capital side, our check size alone out of this fund is 3 to 12 million. 12 would be our max hold, so a good entry point for us is anywhere from 6 to 9 and that 6 to 9 million can be usually as a match of debt and equity, so that's generally not enough to get a good sized lower middle market deal done. And the SBIC community is certainly clubby and collegial and thinking of the nine port coasts that we have, we've clubbed up on seven of that. That's by design because we don't think we're the only ones who have experience in this regard and we like every other points of view and other sets of deal and investing experience, and so we want to club up with folks and when we do, we certainly have the capacity to speak for all of the debt and in some deals, the lion's share of the equity.

Now, we can theoretically speak for all of the equity between ourselves and another deal partner, but one of the core tenets of our investing thesis, especially dealing with independent sponsors, is alignment of interest, and so we really try and avoid what I would describe as negative equity deals. Those are situations where the sponsor is showing up, not rolling a deal fee and not putting in equity, and so they're money good from the data close, and so that's not an alignment of interest. An alignment of interest for us would be rolling some or all of the deal fee and writing a hard dollar check, so that it's a meaningful amount to that sponsor or that sponsor's network of friends and family, and if it went missing, people would notice. It wouldn't just be change in the couch cushions.

Coming back to something you mentioned earlier, for a long time, there was a ton of daylight between the rate of return that you'd be underwriting for and the rate of return that a senior lender would be underwriting for. The market is definitely different now, and those two interest rates, at least, are much closer. How has that changed some of the dynamics in the market?

Yeah. Well, it allows me to be cheeky and say to the sponsors who ask about pricing, that I can say without blushing, that on a relative basis our debt's gotten cheaper, but then I say in all seriousness, "Look, mezz pricing really has not changed since I've been doing this." It's always been in the 12 to 14% range, plus or minus. And there was a period certainly three years ago where the mezz world was getting pushed down to 10%, sometimes a little bit below, but I would say really, all the deals that we are looking at and all the pricing discussions we're having are back in that 12 to 14, sometimes even higher range. That's just our experience. Others may be having a different one, but we think we've got a pretty good feel on the market, and so that backs you into an IRR in the mid to high teens and sometimes higher, with if you get warrants and if your equity co-investment works out.

Not only has the interest rates of senior debt changed recently, but also the EBITDA multiples that you can get on that in senior debt have changed. How has the evolving market impacted how you think about EBITDA multiples for mezzanine debt?

Yeah, we track this on a quarter by quarter basis, and then we share that information with the sponsors that we work with, the other mezz folks that we've co-invested with and certainly our LPs as well. And what we've noticed, and it's not going to surprise anybody, but we saw our big tick down in enterprise values over the last two quarters, almost a full turn. Again, mathematically that makes sense because interest rates have gone up, and so as I said, prices have to go down. And then because of that, of the higher interest rates, we saw a tick down of total funded debt through the mezz. And what we saw at the end of Q1 of this year, the average total funded debt asked from sponsors was three turns, and that was a half turn lower than it had been a year prior.

And that reduction, is that landing on lower turns by both the senior and the mezz or mostly in the senior, where your turns are staying pretty similar? Who's reducing?

Well, in many instances, the senior's gone away, which we like working with senior lenders. It's important to us, it's important to us to bring in good senior term debt partners either at the onset of the deal or once we're in the deal for a while. Certainly important to us to have strong senior lenders who provide lines of credit revolving facilities, but what we've seen is the senior cashflow lending market has tightened up on the lower end of the spectrum. And while the lending officers are trying to get money out the door, the credit officers are saying, "Oh, no, you don't," while SVB and First Republic and Signature are having their one sideways and the questions bound about some of the other smaller regional cashflow lending banks. That's all led to a situation where a number of senior lenders that were in the market are out of it, and so now we've been promoted, so to speak, where we are the only debt on the balance sheet. That has been one of the prevailing trends that we've seen over the last six months or so.

In conversations with senior lenders. One of the dynamics that they talk about is that their credit underwriting process has gotten stiffer. The tires get kicked a lot harder. What's been your experience in the mezz market on that topic?

Well, we were just talking about this the other day at one of our IC meetings. It's a really challenging underwriting environment right now because for some of these companies, some of them truly benefited from the pandemic. Some of them truly benefited from supply chain disruptions and the sustainability of that relatively new and relatively strong outperformance relative to their history has made trying to find what the true run rate EBITDA does a challenge for us. And look, maybe that's just us, but it's caused us to be more circumspect, really thinking through deals, that there's always the rest of the things are going to go down. We understand that, but nobody wants to buy at the peak of a company's operating history. And there's been a lot of deals that have crossed our desk, some get killed quickly, some we spend more time on, where performance from '20 to '22 has just been outstanding and you really need to dig into how sustainable that is. Yeah, we're spending more time on things and we're almost working hard. I guess I would say we're probably working harder to make sure we're avoiding things that, in retrospect, would look like a mistake.

And in the mezz market, can you describe what the capital deployment rate has been in 2023 thus far and what your anticipation is for either the next quarter or the next half of 2023? It's been a constrained environment and curious if that's been the same for you, given that you all have filled in some of the gap that has been left by senior lenders pulling back. I would love to hear what your experience has been on deal activity and what your pipeline and expectations are for the second half of the year.

Sure. Well, it's funny. You go to the industry conferences, you see a familiar face, and the first question always is, "Hey, keeping busy?" You are forced to respond yes and that is certainly the case. As I mentioned, we saw more deals in Q1 than we have since we launched the fund, but I think as I think back on the conversations I've had, everyone says, "Well, yes. Deal volume is up, either significantly or marginally. Deal quality is not indexed with that higher volume." And that, along with a fear, I guess, across the asset class of underwriting, COVID risk, COVID error risk, supply chain error risk, has made us and I think others that I talked to incrementally more conscious.

Now, how does that translate into a pipeline? I think we've got about four deals under LOI right now that we're all pushing forward on. Statistically, not all four will close or will close when we think they will, but I think that'll set us up to have a pretty robust year, knock on wood, but we continue to try and fill the pipeline because it really is a numbers game. You need to have X number of deals in to put out Y LOIs to close Z deals.

Andy, I think we'll call it a break there. We definitely see you guys in the market, in the lower middle market, very active investor. You all do great work. Thank you for spending a few minutes here at the Corner series.

Well, thank you very much. I really appreciate it.

Thank you for joining us on this installment of the Capital Corner. To learn more about today's discussion, please email host Geoff Cockrell at gcockrell@mcguirewoods.com. We look forward to hearing from you. This series was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this series, you acknowledge that McGuire Woods makes no warranty, guarantee, or representation as to the accuracy or sufficiency of the information featured in this installment. The views, information, or opinions expressed are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This series should not be used as a substitute for competent legal advice from a licensed professional attorney in your state and should not be construed as an offer to make or consider any investment or course of action.