Derek Dubois, md and treasurer at Deerpath Capital Management, answers SCI's questions

Q: How does Deerpath differentiate itself from its competitors in the lower middle market?
A: Deerpath Capital has been around for a number of years. It was founded in 2007 and we’ve always been focused on lower middle market US secured debt as our investment strategy. The lower middle market offers a nice dynamic for investors; it’s a little less competitive than the broader middle market - and especially the broadly syndicated loan market - while still being able to generate nice returns for our investors, as there is still a yield premium for lower middle market investments.

How managers define lower middle markets these days has changed. It was once considered a ‘bad word’ to be a lower middle market lender, but now you’re seeing traditional middle market lenders classify themselves as a lower middle market lender.

This is due to the protections we are still getting in our loan investments, including covenant protection on our loans. We are still getting a nice yield premium, and we have a lot more visibility into the underlying borrowers where we have a lot more direct access to the sponsors, as well as to the management teams of the borrowers that we lend to.

The traditional middle market has gotten more commoditised in recent years. While the BSL market today is virtually entirely covenant-lite, the middle market - while not to the same extent as the broadly syndicated loan market - has certainly let this trend creep in alongside the weakening of credit protections in loan documentation. We intentionally focus our attention on the lower middle market (US$50m-$100m enterprise value) as we think above that size, that’s the area were things have gotten more commoditised due to the intense competition in the market. 

Our track record really speaks for itself. Today, we have over US$3bn in AUM. As of our fourth quarter, we have only one realised loss in our history, and I think it’s due to our focus on credit and lending to high quality businesses that makes the difference for us.

Q: The US middle market CLO sector has had a record year in terms of issuance. In your view, what were the drivers behind this?
A: I think the biggest driver to the middle market CLO space is the demand for yield. This sector still provides a yield premium compared to the broadly syndicated loan market - that’s somewhere between 40bp and 50bp across a stack, but on the triple-As it could be 110bp compared to 150bp-160bp. I think that was why there was a shift in demand towards the middle market, because in this environment with very low yields you are getting a bit of a yield premium.

As well, there was a validation from Covid which proved that while, yes, there is an illiquidity of the middle market loans since you can’t just sell the loans as you can in the syndicated loan market, but the yield premium more than makes up for it. It is a stable asset class – when you look at how the CLOs perform through the cycle, it is very strong.

I think they even held up a little stronger than the BSL market if you look at the tests for the CLOs in the middle market space. The BSL market had a whipsaw of downgrades on loans, but there really wasn’t as much pressure for middle market managers because it’s not as actively traded, so you didn’t see the whipsaw that Covid caused in March 2020.

So, I think it was a validation for the CLO space. People search for yield in this asset class, but it has proven to be strong and stable through several credit cycles, and is time tested that the market structures work as they are intended to.

Q: What are your expectations for the middle market CLO sector this year? Is the market likely to continue growing at a similar pace?
A: I think Q1 this year is going to be slow simply because people will be feeling out the market - particularly the middle market - because of the SOFR transition. I don’t think there’s any concern on the underlying loans or the transitioning to SOFR, but there’s going to be a little bit of a lag – which we are already seeing.

Now the question is: will this ease off once a couple of prints are completed? Personally, I think there could be a little bit of slowdown just at the beginning of the year, but I don’t expect any kind of drop-off from the magnitude we saw last year.

This is provided that the credit markets stay where they are at and continue to churn at the same rate. However, it is clear that there is still investor demand for CLO paper, and there are plenty of deals out there in the loan market to put into CLOs.

Q: Which challenges and opportunities do you currently see in the US middle market CLO space?
A: For challenges, as well as the SOFR transition, I think Omicron is causing some heartburn for the markets in general. It appears that everyone is aware that the uncertainty we are facing with the general health environment won’t be going away anytime soon - although I think that it’s a matter of what variants hit next, and how it trickles through the world.

It could cause some challenges, but I think that it has been proven that we are able to keep churning as an economy. Particularly in the US, there’s been a balance of managing the health crisis and figuring out how to keep the economy going, and I think we are all working towards that point now. So, it is a challenge for the market, but a minor one.

In terms of opportunities, I think it’s more of the same. The market has shown that it’s robust over the last year or so, and to me the opportunity that exists is for investors to take advantage of a yield premium for middle market paper compared to BSL paper.

I think the opportunity is that the CLO market in general has a nice yield premium compared to other investment grade products for investors, and it’s proven to work, and it’s proven to be stable. So, I think it’s starting to attract the demand from other investment bases that perhaps in the past weren’t there in part because of the low yield environment. Additionally, there will be some rate increases throughout the year, where it’s floating rate product, and that should be attractive to investors too.

Q: You just announced your fourth CLO since 2018. What are your expectations for Deerpath CLO issuance in 2022?
A: Our intention is to be an annual, programmatic CLO issuer. Last year was the first time we completed two CLOs in a single calendar year, and we would love to be able to complete one or even two again this year.

I think it’s important for us, as a manager and as a direct originator, to continually access this market - whether that’s one, two or even three times this year. As well, as of right now, I think the capital markets are open and the private equity market is definitely moving at a rapid pace, especially towards the end of last year.

Right now, there is a bit of pause, as I think everyone is catching their breath from the end of 2021. But I would expect by mid-late January, things will start moving again across the market.

Q: There is currently a lot of focus on ESG across the BSL CLO market. Do ESG considerations have a role to play in middle market CLOs?
A: I do – I think we are starting to see this question get asked more and more by investors. Fortunately, Deerpath has been on top of ESG.

We became a signatory to the United Nations Principles for Responsible Investment in 2017 and complete the UNPRI Reporting and Assessment review annually. By joining this group and putting policies and procedures in place to make sure we are following our ESG policy, ensures we have protections for our ESG investors. It’s very clear to me that it’s becoming a hot point, whether it’s in the context of middle market CLOs or private equity, and so certainly my investor relations team has been working on that since 2016 to make sure we are staying on top of the latest trends in the market.

Claudia Lewis