I recently caught up with Michael Scarangella, managing partner at Carlton Credit Partners in New York. Given our mutual affinity for private credit, I wanted to dig a little deeper into how he and Carlton approach lending to lower middle-market companies.
Carlton Credit Partners provides highly customized financing options to its clients to facilitate growth (acquisitions and buyouts) and solve operational and structural complexities. Carlton’s products include first lien senior secured debt, including revolving lines of credit, term loans, and delayed draw loans. The firm’s transactional expertise and deep professional network are differentiators for Carlton in the private lending arena.
Currently, Carlton’s experience includes nearly $1 billion in private credit transactions representing 68 loans across 39 businesses.
Von Bevern: Thank you for agreeing to share your insights on private credit. Let us start with the basics. Why private credit and not private equity?
Scarangella: My partner Lin Wang and I have spent the last 20-25 years in credit and have a particular affinity for the lower middle-market. We think there is a need for private debt capital in that niche of the market as many highly regulated commercial banks have curtailed their offerings. Also, several private credit funds that started in the lower middle market have moved up market in search of larger deals and require financing. Companies in this segment of the market are trying to grow their businesses to the “next level” either through acquisition, new product launch, geographic expansion, etc., and need capital. We want to partner with them and provide that solution.
Von Bevern: 2020 was a record year for private lending, and 2021 is off to a hot start. As of today, what do you foresee happening in the private credit markets for the remainder of 2021?
Scarangella: It’s early days, but thus far, we have seen strong deal flow this year. The sense we are getting from some borrowers is that while they may have spent part of 2020 on the sidelines waiting for the impact of COVID to subside or the outcome of the U.S. elections to be known, they are entering 2021 with a genuine desire to do business, and in some cases, make up for the lost time.
Von Bevern: You mentioned that your focus is lending to lower middle-market companies. Can you shed some light on what the profile of a lower-middle market company looks like and what makes a company a good borrower for Carlton?
Scarangella: Sure. We will look at companies with EBITDA as low as $3 million, and while there is no upper limit, practically the upper end for us is about $20-30 million EBITDA.
We like businesses with a strong management team, a history of good profitability and cash flows, and some product differentiation or competitive advantage in their market. We will finance both sponsored and non-sponsored borrowers but prefer (and are very experienced) with the latter group, working directly with founders and management teams. We do not shy away from a company with a complex business or one which has experienced recent operational disruption. We like to roll up our sleeves with management and find the company’s true underlying credit strength.
Von Bevern: Please give us an overview of your application and due diligence process?
Scarangella: It starts with a discussion with management to understand the business, financial outlook, and capital need. We will ask for preliminary information to form a credit view, assess it against our screening criteria and decide if we can help. If we think the opportunity is a good fit for our strategy, we will propose a solution. If accepted, we move forward with complete business, financial and legal diligence, and finally to documentation. The whole process probably takes approximately 2-3 months, depending on the availability of management and information.
Von Bevern: I see that with the increase in private lenders, there has also been a relaxing of covenants within the loan agreements. How do you approach loan covenants, and do you see borrowers “covenant shopping” different lenders?
Scarangella: We think covenants are essential in credit agreements, acting as helpful guideposts for borrowers and lenders. The implicit contract between borrowers and us is if they operate their business within the agreed-upon metrics, we stay on the sidelines, ready to help. If the business ends up outside of those metrics, something unexpected has occurred, and we should have a conversation. We have financial covenants in our deals which is expected in the markets we operate. We do not see much “covenant shopping” as our borrowers are more concerned with finding the right partner who can provide a customized solution for their needs.
Von Bevern: I see on your website that you and your partner Lin Wang represent a veteran management team with extensive experience in opportunistic credit deals. As a partner in a women-owned firm, I wanted to get your insights into how you and Lin complement each other? And possibly dig a little deeper into how you both evaluate the management teams of your borrowers?
Scarangella: Lin and I have known each other and looked at deals together for nearly 10 years. Although we approach investing from different backgrounds, we have always had a similar approach to credit.
We are both very diligence-focused and selective about the opportunities we pursue. We are credit investors, not asset gatherers. We both enjoy situations where we can dig in with a high-quality management team and craft a funding solution for them. We like partnering with companies to provide capital and offer our nearly fifty years of combined transactional, industry, and business experience and the professional network that comes with it.
We leverage processes and lessons learned from our prior experience to evaluate management teams appropriately. Obviously, we spend time talking with management about their business, how they have handled challenges, and their future plans. We also do extensive background and reference checks through our own network and third parties. There are also a number of screening tools available in the market, which can be helpful. Once we assess the current team, we try to identify any existing gaps and often suggest (or require) that those roles be filled, sometimes with our professional network’s help. We know if we align with a high-quality team, good things generally happen.
