Mid-market lending: bubble or the new norm?

While many might think that people are referring to the Chicago Cubs’s track record of not winning the World Series since 1908 or the recent polar vortex that has made this winter a nightmare, the topic actually refers to mid-market lending and its meteoric growth over the last several years. Virtually no one can dispute that the amount of capital chasing deals and the resulting high leverage levels and low yields are unprecedented.  But what everyone is scratching their heads trying to figure out is, “Will it continue?” Knowing the answer to that question can have a monumental impact on your current investing philosophy, so let’s review some of the key factors that could have a material influence on the 2014 lending environment.

  1. Inflows. Many would argue that capital inflows may be the single biggest factor that will determine the robustness of the lending markets. Business development companies (BDCs), credit opportunity funds, and CLOs have been raking in money at a record pace.  According to S&P LCD, in the trailing twelve months ended September 30 2013, approximately $12.0 billion was raised by traded and non-traded BDCs and middle market CLOs. Many believe the relative high yields these vehicles offer make them an ideal investment, particularly for retail investors. And once these lenders obtain the capital, they are highly incentivized to deploy it, a primary reason that such borrower-friendly market conditions continued throughout 2013. But will those inflows continue in 2014?  As noted in one of my previous columns, watch a BDC’s ratio of stock price to net asset value (NAV) per share. When it starts to trade below 1.00, capital inflows will most likely stall and could be the first indicator that the lending environment is going to get tighter. 
  2. Regulation. Other than one piece of pending legislation, every regulation that has come out of Washington in the last several years, whether Dodd Frank, the Volker Rule, or anything promulgated by the OCC or U.S. Securities and Exchange Commission, will certainly hurt middle-market lending.  Each regulation is designed to make banks less risky by curtailing their ability to lend money. The one exception, and it alone could be a game changer, is the bill approved by the U.S. House Committee on Financial Services that increases permitted leverage for BDCs from 1:1 to 2:1.  It is hard to even imagine that, overnight, every BDC would have the ability to increase the capital they lend by a whopping 33 percent.  With non-bank institutions now accounting for over 70 percent of all loans to middle-market companies, banks’ influence on lending, although still strong, is waning, and the ability of these alternative lenders to increase capital will only further this trend. 
  3. Deal Volume. Across many sectors, M&A volume in 2013 was disappointing. Although most professionals anticipated the year would start slowly due to the 2012 year-end flurry of activity driven by tax changes that took effect in 2013, most also thought the last half of 2013 would be outstanding. With purchase price multiples at near record highs, borrower friendly debt markets, and ample cash that private equity firms needed to deploy, 2013 was sure to be a banner year for M&A. But math took over and the mismatch between the lofty purchase prices most sellers expected and the low growth exhibited by many middle-market companies resulted in a lot of deals that just didn’t get to the finish line. While dividend recaps and refinancings stepped in to absorb a lot of lending capacity, those activities may be waning as many good companies have already redone their capital structures to take advantage of the lower rates and higher leverage. As a result, loan demand emanating from new M&A volume may be the key to determining whether the excess debt capital will be used up (and result in a curtailment of the current robust lending environment) or the lack of deal flow will result in continued competition among lenders.   
  4. General Economy. Last, but certainly not least, one needs to consider general economic conditions. Many economists think 2014 will be the break out year for the United States with GDP growth approaching more than 4.0 percent and unemployment lowering to 6.0 percent. However, to-date this optimism has been inconsistent with the performance of over 450 middle-market companies tracked by Lincoln International. Through September 2013, Lincoln’s database showed that only 58 percent of the companies observed reported revenue growth in Q3 2013 compared to Q3 2012, and only 47 percent showed EBITDA growth during this period. While these metrics have improved over the last several quarters, they still do not support the high purchase price multiples mentioned above. But increases in sales and earnings always put everyone in a good mood and improvements in the general economy could further enhance lenders’ enthusiasm for new loans.    

 So where does this leave us? It is anyone’s guess, but keeping an eye on the factors noted above is unquestionably key to a successful investing year. 

Ron Kahn is a managing director at Chicago investment bank Lincoln International