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9Questions is our Q&A series featuring key decision-makers in the corporate credit markets — get in touch if you know who we should be talking to!

Specialty lending strategies within the alternatives space are hot right now. It’s why ABF is getting so much attention as LPs seek ways to diversify their private market holdings beyond direct lending and private equity.

HighVista Strategies is a firm at the forefront of the growing trend of specialty lending. The asset manager is dedicated to what the firm calls “structurally inefficient” markets, where a bit of elbow grease is needed when it comes to sourcing and underwriting.

But for those willing to put in the work, the reward of greater lender protections and higher yields can be well worth it. 9fin spoke to Ben Radinsky, partner at HighVista, about some of the specialty strategies and what makes them appealing.

1. What are some of the benefits to investing in specialty lending?

Firstly, rather than focusing solely on EBITDA, we focus on identifying assets with strong downside protection attributes that seek to mitigate risk — superior collateral, conservative structures, and enforceable covenants.

Secondly, we’re looking for spaces that are non-correlated, and third, we’re looking for credits that will perform regardless of how the market does. And that is primarily done by creating shorter duration instruments that can be repaid directly through the cash flows generated by the underlying assets, as opposed to having to worry about a refinancing which could subject a portfolio to market forces.

Bottomline, HighVista’s specialty lending program is specifically designed to offset what we see as the main risks in traditional private credit.

2. What is the attraction of such a strategy compared with direct lending?

Let me start out with sharing three perspectives on traditional direct lending, and why we think there has to be some alternative — such as specialty lending — that will accomplish similar objectives for a portfolio.

Private credit is primarily about LBO lending, and deals tend to have similar characteristics: traditional cash flow that companies borrow against. This creates a three-fold problem:

First, EBITDA is often adjusted heavily, such that the average loan in a traditional private credit portfolio might be marketed as 5x EBITDA, but unadjusted we would estimate that they are closer to 8x-9x EBITDA

Second, there is correlation with all of these credits and the broader market, because you’re buying beta. You’re getting market-like risk, because these are all diversified businesses, and leveraging performing companies makes it highly correlated to equities

Third, we’ve never seen what will happen when things really tighten, since private credit has basically been in a bull market for the past two decades

3. How are some of the current market dynamics bolstering or disadvantaging one strategy over another?

Private credit has grown to about the same size of the leveraged loan and the high yield markets, and we’ve observed that there is crowding developing among them which forces either a reduction in spreads, a loosening of covenants, or both. At HighVista, we focus on identifying spaces where there is inefficiency — places where capital isn’t flowing meaningfully due to structural, size-related, or other market factors.

We believe the simplest reason why opportunities exist for an investor like HighVista is because they’re by definition limited and may not be easily replicable. Direct lenders often source deal flow by relying on the private credit sponsors who bring them deals, which offers a big advantage in that it is a wildly scalable strategy. Huge amounts of capital have entered into the space because that is demonstrably very easy to replicate.

One core reason why a space could be inefficient is if it’s not easily replicable, or if there’s a bilateral negotiation, if each deal looks bespoke, and if you have to actually understand what collateral packages are (i.e., the quality of loans in collateral packages) because it’s not always the same credit metrics. Any market dynamic where you have these bespoke credit instruments, bilaterally negotiated, will inherently be inefficient because it will be harder for scaled capital to compete. That creates an opportunity for us to step in.

4. What are the specific specialty lending strategies that you’ve identified as potential solutions to these issues you’ve raised?

As of today there are five areas where we think these opportunities exist and will continue to persist. In no particular order, these are:

Natural resource lending (renewable energy financing under that)

The common theme across all five areas is that they’re inefficient because it requires lots of work to actually originate and negotiate each transaction. These areas are not particularly scalable, and that allows us to solve for two problems simultaneously: one problem that we’re solving for is an actual risk-return — because the market is inefficient, we believe we can take less risk and get more return, relative to other areas of private credit. The other complementary element is, if you’re a large allocator that is typically writing very substantial checks, it’ll be very hard to access any of these spaces individually because the funds are not properly scaled.

We solve that problem for both larger allocators and smaller allocators. First, for larger aggregators we help by taking several smaller strategies and packaging them as one making for a scaled investment. For smaller allocators we provide real expertise and know-how in identifying and investing in strategies that are differentiated. For both, we provide a portfolio that is continuously monitored and adjusted to ensure it captures what we believe are the most compelling opportunities in the market at any given time.

5. Can you explain what you mean by ‘transitional real estate’ and what is attractive about that space?

Transitional real estate has many instances where there is little dispute over asset value, because you’re dealing with terrific properties in great locations. Because of that quality, the credits should be trading at what we would consider CMBS levels — SOFR+450bps or similar, but at the same time there could be a very specific issue that’s creating difficulty financing that project for some reason.

Here is one representative example: a hotel got quoted CMBS rates to refinance their debt, but the equity owners were in a dispute, which made it impossible for them to negotiate the hotel’s debt refinancing. By the time that debt matured a couple of months later, it was too late to get CMBS rates, but we were able to step in and finance what we believe were attractive returns with tighter covenants.

So those types of deals are terrific. Another example is a REIT that had liquidity issues at the end of 2023 and they had to sell some assets to generate liquidity. HighVista’s credit team was able to buy a portfolio, including one loan for a brand-new building in which every condo had already been sold. From a lender’s point of view, there appears to be minimal risk and yet we are able to obtain a return, while solving a problem that existed in the marketplace.

6. What are some of the reasons you see opportunity in the tech ARR space?

We already spoke about the developed world of EBITDA-based direct lending — the larger end of the spectrum for corporate lending.

The other end of the spectrum is venture lending, where lenders typically offer financings for venture-backed companies that were able to raise new third-party equity within the past six months, using equity markets as a proxy for whether the credit risk is worth it. These are the bookends of the market that exists, but there are companies that are orphaned that sit in the middle. These are great companies with solid returns and growth prospects, but sometimes they don’t have a sponsor. Or, alternatively, they’re more ‘growth’ than they are ‘venture’.

For example, in many SaaS companies with recurring revenue, every dollar that they invest in a new customer has a positive ROI. What often happens is that these companies have (limited) free cash flow but that’s intentional because they’re reinvesting any money they’re making into marketing, because every new customer they acquire has such a positive ROI, creating long-term value.

But, if you’re a lender, what do you do with that? It doesn’t fit the first paradigm because they don’t have 10 years of cash flow history. It also doesn’t fit the second paradigm because the company is not venture-backed, so they’re stuck. To me that sounds like a market without a lot of capital.

Some big private equity firms known for doing tech deals can provide these financings if they’re over $100m, but on the smaller end of the market, you can count the number of funds doing it on one hand. We’ve found lots of these situations where we believe credit quality is amazing because you can define what cash flows will look like for the next few years — you know your customer base, your subscriptions, and your gross margins. And if something goes wrong, you can turn off the marketing spigot and amortize the debt over the course of several years.

What some analysis of tech ARR lending misses is that lenders have levers that allow them to get out before material defaults become a problem. For example, lenders can shorten their duration with covenants if they do it smartly.  Having that power as an ARR lender materially de-risks your loan relative to private credit.

7. What is attractive about the GP finance space, and why is HighVista pursuing it as a specialty credit strategy?

There is a general lack of liquidity in the private markets, including in private equity and venture capital. Just think about the number of VC-backed unicorns that have not had any liquidity events. This lack of liquidity filters to fund managers that may have unrealized carry, and who may be unable to raise new vintages as LPs are waiting for liquidity. This is on top of the denominator effect where privates generally have performed quite well, resulting in an overweighting simply by virtue of performance.

Given this dynamic, we believe that there will be an opportunity to provide strategic capital to GPs who are looking to new fund raises or are trying to help solve problems for their limited partners. These solutions though are complicated as they require flexible capital, creativity and serious reputational credibility as general partners are reluctant to deal with just any source of capital.

8. Because cash-flow based direct lending involves floating-rate loans, yields are expected to decline as the Fed lowers base rates. Do any of these specialty credit strategies offer additional protection from this anticipated decline in yields?

Because many of these spaces are capital starved, pricing of credit is less susceptible to changes in base rates. Often the competition is mezzanine debt or preferred equity, and because of that type of competition, a reduction in rates is simply not as severe as in spaces with tighter spreads, or where there is a greater percentage of the rate that is based on the base rate.

9. Can you tell us more about some of the volunteering efforts and causes that you have worked on with HighVista?

HighVista believes in giving back to the community and making a positive impact through our volunteering efforts. Over the past year, our team has been actively involved in several meaningful initiatives. One of our key partnerships has been with Cradles to Crayons in Boston, where we have dedicated our time to support children in need by providing them with essential items such as clothing, school supplies, and toys.

Additionally, we have volunteered at the St. Francis House, a day shelter that offers critical services to individuals experiencing homelessness. These experiences have not only allowed us to contribute to important causes but have also strengthened our team’s sense of purpose and commitment to making a difference in the lives of others and our community.

Enjoyed this interview? Explore our full collection of 9Questions interviews here.

9Questions — Ben Radinsky, HighVista Strategies — Specialty lending takes center stage

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9Questions — Ben Radinsky, HighVista Strategies — Specialty lending takes center stage

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