The volatility in the credit markets has been one of the most widely covered topics in the financial industry over the past six months.
The impact of this volatility has been felt throughout the markets with differing severity depending on what segment of the market you play in. Alongside the overall market facelift, lending into leveraged buyouts has changed dramatically but less so in the middle to lower end. The evolution of the secondary markets as a facilitator of funding the larger buyouts set off a wave of aggressive, if not irrational, lending practices. The larger buyouts were extremely profitable for those providing the funds, and transaction activity was unprecedented. Alternatively, the secondary markets had little or no impact on the lending parameters in the lower end of the market.
“It seems to be a bifurcated market where the lower end never participated in the aggressive debt structures we saw in the larger buyouts, and therefore you do not miss what you never had,” according to John Lee, an investment banker at Griffin Financial Group. As the secondary markets have unraveled over the past six months, the discipline from the lower end of the markets has transcended upwards, and credit availability has become more rational and selective. Supply and demand features appear to have taken over the lending landscape, and underwriting standards have tightened alongside the weakening in the economy. At the same time, prospective borrowers are becoming more selective in choosing lending partners in light of the issues many bank and non-bank lenders are experiencing.
While there are numerous ways to define the middle market, for purposes of this article let’s assume the market for mid-sized private companies is broken up into three segments—upper, middle and lower. The activity in middle and lower segments is more difficult to decipher as there is less publicly issued information available on these deals, and there are varying interpretations as to what “middle market” truly means. To make it simple, a company in the mid-range of the middle market will be defined as having EBITDA of $25.0 million and a company in the lower end of the market as having EBITDA of $5.0 million. The market can be analyzed along many other lines that can differ depending on various factors, including industry, cyclicality, geography and global presence, which we will avoid due to the complexities in doing so.
Senior-cash-flow lending to mid-sized private companies has been impacted the most to date by the overall tightening in the credit market. Every aspect of this product has changed, from lower multiples to higher pricing to tighter covenants, mostly driven by old-fashioned supply-and-demand factors and more scrutiny on credit quality. The availability of senior-cash-flow debt, based on EBITDA, is currently in the 2.5-3.0x range with up to 1.5x incrementally available from mezzanine lenders. This compares to a year ago when senior debt multiples were generally reported in the 3.5-4.0x range and total debt in the 5.0-5.5x range. Underwriting standards are more restrictive, creating increased due diligence and greater scrutiny on somewhat subjective items such as “addbacks” to earnings. Not only are there more covenants in today’s cash-flow loans, but cushions set against projections are tighter, creating a smaller window for the borrower to stumble before all parties are back at the table. The lenders in this segment also face greater challenges in filling out bank groups.
Pricing spreads are as much as 150 to 200 basis points higher in the mid-range of the middle market as compared to a year ago. The decreasing number of participants in the market continues to drive debt pricing upwards due to a broad array of issues related to sub-prime loans and contraction in the secondary markets. That said, it is important to note that the actual cost of borrowing has seen a decrease due to base rate declines. The prime rate has decreased to 5 percent from 8.25 percent a year earlier and the 30-day LIBOR rate has decreased to below 2.5 percent from nearly 5.5 percent a year earlier.
While the senior market has evolved, Term B loans that had been readily available in capital structures have merged into a combination of senior Term A and mezzanine loans. “A year ago we would see Term B loans with only 1 percent amortization per year and a large balloon, which most of us recognized as overly aggressive but the market was buying these loans,” said Lyle Cunningham, managing director of National City’s Equity Sponsor Group. “Now you are seeing 10 to 15 percent amortization on these term loans with a more manageable balloon at maturity.” Because of pressures on overall returns, Term B lenders are now also less likely to provide loans below $10 million unless they can generate yields historically more in line with mezzanine loans.
Due to the numerous dynamics mentioned above, mezzanine loans have become more expensive in the mid-range for a company with $25 million in EBITDA. LIBOR-based junior loans have been replaced by fixed rates with equity kickers provided by mezzanine lenders. Pricing on a second-lien Term C note had been near LIBOR plus 6.75 percent, which has often shifted to a traditional mezzanine loan with a cash pay, a PIK (payment-in-kind) component and equity enhancements. It is now rare to see a total debt structure that exceeds 5x EBITDA, while a year ago the ratios were approaching and sometimes exceeding a 6x multiple. In addition to the change in the composition of pricing in this space, we are also seeing stricter underwriting standards, tighter covenants, and higher prepayment penalties.
The good news is that the lower end of the market has seen less of a swing in senior and junior loan availability and overall terms. With continuing concerns about the health of the economy, there has been some pricing pressure on the company with $5 million in EBITDA but nowhere near the increases seen in the mid-range of the market. The funding of senior-cash-flow loans at the lower end has typically fallen approximately one half to a full turn on EBITDA, and the number of lenders willing to provide these financings has also declined. Pricing spreads on the cash-flow loans have seen an increase of 50 to 100 bps, with today’s pricing quotes around LIBOR plus 300 bps, and closing fees have increased to over 1 percent in many cases.
Asset-based loans may trump cash flow loans in this segment of the market, as more discipline is being sought by all parties, particularly on cyclical businesses. For manufacturers and distributors, asset-based loans are becoming a better option in the lower end as borrowing costs are more in line with traditional bank pricing, typically in the LIBOR plus 200 bps range for fully secured tranches. Furthermore, the gap between what assets can cover versus the cash-flow loans has narrowed. Because of the underlying collateral, and the due diligence specifically focused on the collateral, and less emphasis put on leverage ratios, asset-based lenders are less likely to react irrationally to performance issues unless they are severe. Asset-based loans are also a good option in distressed situations where a debt restructure or recapitalization is required.
The availability and characteristics of junior debt in the lower end of the market may have changed the least over the past year. The good news for these lenders is that deal flow has been the strongest in years as they are being called on more as the gap between senior and equity needs to be closed. Lending multiples here may be down by up to one-half of a turn but pricing in deals closed has been relatively consistent. The pricing has not fluctuated a great deal other than the mezzanine lenders taking advantage of some upside opportunity. “While the cash pay aspect of pricing on the lower end of the market has been relatively consistent, there has been a movement towards increased pricing in the form of greater warrant positions for mezzanine lenders,” said Keven Shanahan of
Most experts continue to see the liquidity in the middle market readily available from private equity groups. These groups will likely be called upon to provide more capital to a transaction than they were a year ago and also to provide additional capital to portfolio companies where more liquidity is needed. The larger deals will pose more of a challenge for the reasons noted above but, for the most part, the lower end of the market should remain on course. There will also be tremendous opportunity for those private equity groups seeking “contrarian” investments in downtrodden industries, so long as they can call on their strong lending relationships to provide the financing. A greater challenge may exist going forward for investment bankers in trying to meet seller expectations and putting together deals that make sense to all parties in the softening economy.
Ron Kerdasha is senior vice president, Business Finance Division, Bank of America Business Capital