Brightwood Capital Advisors has incorporated the social factor of ESG in its lending practices since its founding in 2010, long before institutional investors and corporates in the U.S. made it a priority to support minority-run firms. The minority-owned firm has been a signatory to the United Nations principles for responsible investing since 2014, says Sengal Selassie, its CEO and founder.
Brightwood’s middle-market borrowers are businesses that are either directly owned or private equity owned; they range in size from $10 million to $75 million in EBITDA, with an average EBITDA of $40 million. The direct lender, headquartered in Manhattan, manages $4 billion in assets and has issued six collateralized loan obligations since 2016. The latest, Brightwood Capital Fund 2021-2, was led by Capital One Securities and issued in October 2021, comprising $321 million in rated tranches and a $106.8 million unrated subordinated tranche, according to Finsight. The AAA-rated bonds priced at 165 basis points over three-month Libor.
Selassie previously held managing director positions at Cowen Capital Partners and Societe Generale, where he engaged in middle-market lending. He spoke with Asset Securitization Report about the challenges that middle-middle companies—Brightwood focuses primarily on health services, business services, technology and telecommunications, transportation and logistics, and franchising—and middle-market CLOs face today. The borrowers are spread fairly evenly across the U.S., with 5% to 10% in Canada.
What prompted you to launch Brightwood Capital?
SENGAL SELASSIE: Banks were exiting the direct lending space in the wake of the Great Financial Crisis, so we saw the opportunity. Several of our team members had worked with me at SocGen or had good relationships with borrowers, so we were able to pull together a team pretty seamlessly. Our first vehicle was a small-business investment company in partnership with the [Small Business Administration].
You describe Brighton as an impact firm. Can you elaborate on what that means?
We’re one of the largest minority-owned firms whose primary focus is U.S. senior direct lending, and it’s not just from a firm ownership and composition perspective. Our second fund, also an SBIC, is dedicated entirely to underserved communities, primarily minority-owned businesses per the SBA definition. We’re one of the few platforms with a fund dedicated to serving that community. We have six funds in all.
Do any of the other funds have targeted investment missions?
No, they’re more general investing funds, but given our network about a third of the companies we lend to are either owned or run by women or underrepresented minorities. That capital can often be critical for these businesses to unlock their growth potential.
About 80% of the businesses we lend to are fully in the U.S., meaning all their employees, customers and facilities are in the U.S., and some are in Canada.
And those loans also end up in Brightwood’s CLOs?
Yes, if they have sufficient scale and credit quality. We’ve been able to show that very good returns can be made while serving a broader borrower base. And we have other funds that provide more direct exposure to minority borrowers.
What trends are you seeing among middle-market borrowers?
Everybody is more cautious now. M&A activity is down a bit as people try to reset and figure out the right valuations levels. But some companies see opportunities and are playing offense in the current environment, so we’re seeing a bifurcation.
The Brightwood CLOs are a little different, in that we do a good mix of loans to directly owned businesses—which are typically less levered—in addition to lending to private-equity-backed companies. We try to be more conservative in terms of leverage, and most of our companies have about a 50% loan-to-value. We’re seeing interest from investors who are looking for managers whose portfolios are less levered.
Are you seeing any notable changes in deal structures?
The middle market has been getting an increasing share of the CLO market, close to 10%, and that’s because the loans have strong documentation, tighter covenants, more contractual amortization and shorter duration, so we get paid back faster—about 2.5% to 5.0% per annum compared to 1% from broadly syndicated loans.
Unlike BSL loans, most of our transactions have financial maintenance covenants and there’s less cushion before the covenants are tripped. We generally haven’t seen maintenance cushions in our market loosen with the broader market over the last several years and they’ve retained fairly consistent DSC [debt service coverage] ratios of 20% to 25%.
And we’ve seen the return of liquidity covenants. Companies that had stronger liquidity positions performed better when the initial COVID-19 shock hit. Prior to 2020 and the pandemic, very few of our loans had liquidity covenants and now probably a quarter of them do.
Do you see the increase in liquidity covenants continuing?
Definitely in businesses with higher capital expenditures, or those in growth mode. There’s more volatility when a business is growing, so liquidity covenants are more warranted in those situations.
We’re more bullish in verticals such as health care services, tech and telecom and infrastructure—you’ve seen a lot of opportunity there, driven in part by the pandemic and the ways people are reimagining work. We’re generally more cautious in some of the consumer-facing verticals.
How are rising rates and inflation impacting middle-market CLOs?
We’re spending a lot more time just stress testing and analyzing the impact of rising costs on our underlying borrowers, to make sure they can withstand increasing costs. And we spend a lot of time analyzing how critical they are to their clients, since we think there probably will be a reduction in discretionary spend in the current environment. We’re seeing an increase in interest rate hedging, where a number of borrowers are looking to lock in longer-term swaps or caps to mitigate some of the interest rate increase.
Finding labor and labor-cost increases are probably the No. 1 concern for our borrowers, and they’re planning for different scenarios, because they don’t want to be so conservative that if current pressures are short-lived they can’t adjust accordingly. But everybody is being cautious. Flexibility is most important in this environment.
Given the geopolitical and financial volatility in recent years, has the type of investors in middle market CLOs changed?
We haven’t had any one investor type pull back. Insurance companies tend to be our strongest group of investors, and banks invest in the higher-rated tranches.
Corporates are less likely to invest in more leveraged CLOs. Over the last two years we’ve definitely seen an increase of corporates in the less levered funds and the sustainability fund. Corporates are looking for managers who have a little bit more of an impact from an ESG lens.
