David Heilbrunn, senior md and head of product development, capital raising and CLOs at Churchill Asset Management, answers SCI's questions

Q: How and when did Churchill Asset Management become involved in the securitisation market?
A: Churchill was established in 2006 by The Bear Stearns Merchant Bank, the private equity affiliate of Bear Stearns. At the time, I was a senior member of the firm’s CLO business and, given my experience creating and working with successful middle market loan managers, I was instrumental in the creation of the Churchill platform. 

Bear Stearns had become attracted to the US middle market lending space several years before Churchill’s inception, as it noted that traditional lenders (i.e., regulated banks) were starting to shy away from extending credit to this important segment of the US economy. Such lenders had become more focused on maximising return on equity and middle market lending - which carried expensive regulatory capital charges and high-cost structures to maintain effective platforms - became less interesting.

In addition, the limited set of identifiable incremental business opportunities (i.e. M&A advisory, public equity and/or debt issuance, etc.) resulted in a further reduction in the appetite of regulated banks to use their balance sheets to support middle market company credit needs. The resulting shortage of bona fide credit alternatives to this important segment of the US economy created an attractive business opportunity for those willing and able to capitalise on it and served as an important catalyst to the growth of the burgeoning shadow banking sector.

Shortly after its 2006 inception, Churchill closed Churchill Financial Cayman Limited, a US$1.25bn CLO. This transaction supported 100% of Churchill’s lending activities through 2014 (the conclusion of the transaction’s reinvestment period). The CLO was a top performer, generating a 17%-plus equity IRR, with all of its rated note tranches - with the exception of its AAA/Aaa class - significantly upgraded over time.

Today, Churchill is a majority-owned affiliate of Nuveen, a TIAA company. Churchill operates as an independent affiliate and receives significant backing from its US$1trn parent in the form of capital and operational (legal, technology, compliance etc) support. The platform currently has just over US$6bn in committed capital, approximately US$2bn of which is from TIAA, fostering a unique alignment proposition for investors. 

Churchill is a best-in-class middle market senior loan manager and offers investors a variety of ways to gain access to the asset class, including separately-managed accounts, levered and unlevered commingled funds and CLOs.

Q: What are your key areas of focus today?
A: Consistent with our 13-year history, Churchill remains focused on the senior secured, private equity-backed, middle market loan space. We are thoughtful in our approach and aim to provide our private equity clientele with consistent, reliable and predictable solutions for their specific financing needs.

Churchill is a conservative investor and incorporates credit and overall management processes developed over time and tested through cycles. We directly originate our opportunities and strive to see the widest array of transactions possible.

From there, we are highly selective (on average, we invest in approximately 10% of the opportunities we evaluate) and keep our funds highly diverse. Individual positions average 1%-1.5% and we remain well-diversified in terms of geography, industry and private equity sponsor.

We have achieved an outstanding track record since our inception, having invested in over 570 loans (committing just under US$10bn in total) and experiencing a cumulative loss rate of less than 1%. Our performance record, which spanned the credit crisis of 2008-2010, demonstrates that our approach can produce attractive and stable returns across market cycles and ever-changing investing environments.

In terms of size of company, we have historically defined the US middle market space to include companies with annual EBITDA in the US$10m-US$100m range, broken down into three segments: the ‘large/upper’ middle market (companies with US$50m-US$100m of EBITDA); the ‘traditional’ middle market (companies with US$10m-US$50m of EBITDA); and the ‘lower’ middle market (companies with less than US$10m of EBITDA).

Today Churchill is squarely focused on the ‘traditional’ middle market segment, given appropriate leverage levels, conservative structures and manageable and like-minded lender groups. For example, during 4Q18, Churchill originated over US$1bn in new commitments across 36 transactions (16 new LBOs and 20 add-on opportunities to existing portfolio companies). Average EBITDA of our new borrowers was just under US$30m, all loans had financial covenants and exhibited moderate leverage (3.8x/4.8x senior/total respectively).

In general, we are attracted to borrowers with proven track records through cycles, experienced and well-aligned management teams and private equity owners who we are familiar with, have worked with in the past and have incremental capital available, should the need arise. 

Given current market dynamics, we are somewhat sceptical of opportunities in the ‘large/upper’ end of the middle market, which we believe currently offers riskier   transactions with high levels of leverage, aggressive structures (often with no covenants) and unfamiliar and untested lender groups. In addition, historically, Churchill has shied away from the ‘lower’ middle market, given the challenges that these companies can face in a cyclical downturn.

Q: How do you differentiate yourself from your competitors?
A: Churchill is a well-established, long-standing member of the “middle market club”. Over our 13-year history, we have been a consistent partner to our top private equity clients, becoming somewhat of a household name, all while achieving one of the top track records in the market.

With detailed credit processes developed over a long timeframe (which spanned a very challenging period) and a senior team which has been together since the inception of the company, we are a reliable lender to the private equity community. In particular, Churchill’s platform compares favourably to our competitors in several ways.

Churchill’s long-standing presence in the middle market has contributed to its reputation as one of the most active and reliable middle market lenders.  The firm is well-known and respected among its private equity clientele, a relationship which is further enhanced by the fact that its ultimate parent’s (TIAA) is one of the largest investors in private equity funds in the US.

The senior members/founders of Churchill are still together today. In addition to building a strong culture anchored in fundamental credit analysis, this consistency is highly valued by our clients and investors alike.

With over US$6bn in committed capital (spread across numerous vehicles), Churchill can commit significant amounts on a per loan basis (up to US$200m in select circumstances). Our processes enable us to provide early feedback to our private equity clients, which - along with certainty of execution (with a lender who they have likely worked with before, including through past cycles) - is highly valued.

Finally, Churchill has unique alignment with and benefits from the resources of a US$1trn parent. TIAA retains approximately a third of all loan exposure originated by the Churchill team on the same basis as third-party investors. This reality creates a unique and strong alignment of interests proposition for third-party investors.

Q: What is your strategy going forward?
A: Today, Churchill has over US$6bn of committed capital, roughly a third of which comes from its ultimate parent TIAA (which retains approximately a third of each loan Churchill extends, creating a unique alignment proposition for investors), with the balance coming from third-party investors. The size and scale of Churchill’s platform enables it to commit significant amounts per transaction to its private equity clientele.

Given the diversity of its product offerings (separately-managed accounts, levered and unlevered commingled funds and CLOs), Churchill can commit these amounts while remaining well-diversified in each of its underlining funds. Scale while remaining well-diversified at the fund level is central to Churchill’s strategy today and going forward.

CLOs are an important part of Churchill’s product array, as they represent an efficient alternative for raising long-term, locked-up capital, especially for firms who have a demonstrated history of managing these transactions and the litany of associated portfolio management requirements. Churchill has consistently managed significant portions of its business within the constraints of CLO/securitisation structures and such requirements have become part of the overall credit management approach employed by the firm. As such, Churchill remains active in the CLO space with two closed transactions – TIAA Churchill Middle Market CLOs I and II (CLO I was successfully reset in October of 2018) – and three more in various stages of ramp (two of which are expected to close in 2019 and the third in 2020).

Churchill’s ultimate parent (TIAA) has the appetite for the equity and lower rated tranches issued by these CLOs. As such, Churchill’s CLO transactions comply with US and European risk retention requirements.

Q: What major developments do you expect from the market in the future?
A: As we head into the later part of the credit cycle, aggressively structured middle market CLOs are likely to experience challenges. For example, if and when overall market conditions start to deteriorate, the rating agencies are likely to become more conservative as it relates to the rating estimates they provide on the loans included in middle market CLOs, often downgrading their estimates on solid credits below B3/B-.

When coupled with increasing default rates, excess exposure to assets with rating estimates below B3/B- will erode critical overcollateralisation cushion levels, thereby increasing the probability of an early capital structure amortisation event. Therefore, it is very important, especially later in the credit cycle, that middle market CLOs are structured with the appropriate amount of portfolio management flexibility and avoid setting unnecessarily tight covenant levels to maximise leverage and projected equity returns.

Middle market CLOs still provide attractive return profiles, but recent widening in the associated liability spreads has put pressure on the overall arbitrage and resulting equity returns. Asset spreads have normalised, so we hope to see the situation improve over the coming months, as CLO debt investors continue to look to put money to work in this important segment of the market.