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

Jason Colodne is a co-founder of Colbeck Capital Management, a middle market private credit fund manager focused on strategic lending. As a senior transaction partner he oversees investment execution, portfolio management, due diligence, and documentation. Colodne's resume includes senior positions at Morgan Stanley, Goldman Sachs, and Bear Stearns. He also served as president of private equity firm Patriarch Partners.

In his free time, Colodne enjoys supporting causes such as the Centurion Foundation, and the Children's Tumor Foundation.

He spoke with 9fin about the balance between banks and private credit funds, direct lending fund managers’ preparedness for rising defaults, the emerging secondary trading market for private credit, and attractive sectors in the current economic climate.

1. You have a background in strategic lending that predates the formation of private credit markets as we know them after the Great Recession, so how has that background in lending influenced your approach to today’s private credit markets?

Strategic lenders provide financing to companies that are going through a period of transition, including both business-specific events and industry-specific dislocations. As a result, it is an all-cycle investing strategy.  Having built and managed strategic lending businesses at Goldman Sachs, Morgan Stanley and Colbeck Capital Management over the last 25 years, I believe the market opportunity for strategic loans continues to exist across cycles for both macro and idiosyncratic reasons.  Transformative growth, stress, and distress all create circumstances during which unsponsored companies may have difficulty accessing commercial banking or sponsor-backed private credit.  Given the current macroeconomic backdrop, Colbeck’s approach to lending in today’s credit market is therefore very similar to that which predates the growth in ‘private credit’ following the great financial crisis.

2. You worked at multiple major banks before founding Colbeck, so as someone who has been on both the public and private sides of debt capital markets, what do you think the future balance between banks and private credit funds will be?

Traditionally, commercial banks have been the primary source of lending for businesses and individuals. Despite the growth of private credit funds, commercial banks still hold a significant market share in the lending industry. According to recent data from the Federal Reserve, commercial banks held over $12.8 trillion in loans and leases.

However, the balance between commercial banks and private credit funds has been shifting in recent years, with private credit funds gaining market share – a trend that is expected to continue. According to a report by Preqin, the global private credit market has grown from $45 billion in assets under management in 2000 to over $1.4 trillion in assets under management today. Private credit funds were particularly attractive to borrowers in the wake of the 2008 financial crisis, as banks tightened their lending standards and became more risk averse.  In the current environment, we are seeing regional banks pull back from lending activity, which should increase private credit’s market share and create unique opportunities, specifically in the unsponsored strategic lending segment of the private credit market.

3. Private credit has been accused of never being truly tested through a credit cycle, so how prepared do you think private credit fund managers are for a rise in defaults?

Private credit funds that do not have restructuring experience or investing experience through different cycles will likely face challenges in an environment with increasing default rates.  High leverage and covenant-lite deals can have a significant impact on the private credit market, particularly for managers who lack significant workout and bankruptcy experience. These types of deals are often riskier and more complex than traditional lending and can pose challenges for private credit fund managers in the event of defaults or bankruptcies.

Covenants act as protective measures for lenders and provide a hedge for negotiations at the early stages of potential stress. Covenant-lite deals, representing almost 90% of the sponsor backed private credit market, will ultimately have the consequence of greater losses and impairments given the lenders involved in such deals do not have the early protective measures present in deals with strong covenants, and may only become involved when it’s too late to protect value.

If a borrower defaults or files bankruptcy, private credit fund managers may need to engage in workouts, restructuring, or other forms of debt resolution. These processes can be complex and require specialized expertise, such as legal, financial, and operational skills. Managers lacking experience in these areas may struggle to navigate the process effectively, which could lead to significant losses for their investors.

Additionally, new conflicts will arise as the number of defaults and subsequent bankruptcies increase in the sponsor backed private credit market.  Furthermore, private credit managers may also become reluctant to pursue their rights and remedies if the borrowers are owned by private equity companies who are their primary deal sources, and thus ultimate clients.

4. There has been talk about a secondary trading market emerging in private credit. Do you see this taking off considering private credit is a hold-to-maturity strategy?

An established secondary trading market for larger deals within the private credit market makes a lot of sense. These large credit facilities, made up of many participants involved at origination, allow for greater liquidity, which could be a benefit from a portfolio management perspective.

That said, many middle market private credit deals tend to be smaller in size, have fewer participants, require a significant amount of diligence to underwrite and likely would have minimal liquidity for follow on trades.  Additionally, many private credit funds generate fees on invested capital and have incentives to hold the loans to maturity.  As such, credit hedge funds would likely find the lack of size, liquidity and required diligence to be unattractive for their structures.

5. Colbeck is ‘industry agnostic’ — what sectors look most attractive now? Which ones are more vulnerable to a potential slowdown in the economy?

We are seeing attractive opportunities for strategic capital in middle market, non-sponsored companies in industries that offer downside protection due to higher margins, recurring revenues, and cost structures that are less impacted by price increase, such as pharmaceuticals and certain business services.  Waste management, insurance, and government contractors in energy, healthcare, and defense typically have more inelastic products and services with defensible cash flows.

Increases in interest rates, energy prices, inflation, labor shortages, supply chain challenges, geopolitical uncertainty, regional banking dislocations, and the potential for future pandemic related disruptions are likely to contribute to a continued slowdown in the economy.  Cyclical businesses and certain industries that overspent on headcount, capex, and inventories in the post-COVID period are also likely to be most affected.  Generally, retail, travel, and homebuilders are most reliant on non-essential discretionary consumer spending and are more likely to be impacted by a slowing economy.

6. Does the collapse of SVB and multiple other bank crises present a potential opportunity for private credit funds to gain market share from regional banks?

Yes, and specifically for unsponsored companies. We are already seeing deals in our pipeline as a result of regional banks pulling back from lending. Additional regulatory interventions could also accelerate the transition to strategic lending of private credit.

7. You’ve described your strategy as taking a private equity like approach to senior-secured lending. Can you elaborate on what that looks like in practice?

Many of our borrowers who are seeking strategic loans are underbanked and unsponsored.  They prefer capital that is non-dilutive and non-control given their respective business trajectories; but they also require more support than just capital. Our loans are strategic to these borrowers because we provide more value than merely access to capital. We become the effective sponsor of the company through a transition to its next stage in its credit lifecycle with an investment expressed as a senior secured loan as opposed to equity. We will often help identify additional hires, board members, consultants, and potential acquisition targets to support a growth strategy.

From a process standpoint, diligence is performed across business functions including finance, operations, supply chains, sales, corporate and IT and compliance. This private equity style diligence also helps us to form strategies and frameworks to enhance value.  Once the companies have grown in scope and scale, we actively help the borrowers gain access to traditional debt and equity markets supporting their potential monetization goals.

8. How much are you incorporating ESG consideration into your analysis — are things being evaluated in a much more systemic fashion these days?

ESG matters are a factor in both investment decision-making and risk mitigation at Colbeck. As such, ESG matters have been and continue to be an element of our diligence, Investment Committee discussion and ultimate decision-making process.

A substantial portion of diligence time, energy, and resources is devoted to understanding the situation-specific risks inherent to each investment opportunity we may pursue. Colbeck considers risk broadly to include factors such as conventional commercial risk, regulatory risk, and potential environmental liabilities. By taking a very broad view of what constitutes risk, Colbeck’s diligence process typically touches upon many risk factors that fall under the rubric of Environmental-Social-Governance.

Additionally, our loan documents include several covenants that are tailored to address situation-specific risks identified during diligence.  While the covenant package varies from investment to investment, risk items such as environmental liabilities, litigation, occupational health, and safety are typically subject to loan covenants and/or borrower representations and warranties.