New Lenders Crowd Market

When Lincoln International Managing Director Ron Kahn was working on a recent deal, he noticed something revealing about the lending market. His firm was putting together a $50 million senior debt placement and out of the eight lenders vying to get in the transaction, the bulk of the bidders were new faces.

“I’m not sure that more than two of them even existed two years ago,” says Kahn.

It has become clear the lending market in private equity is hitting a turning point. The competitive environment has pros wondering when will it all end, and who’ll be left standing when the less-accomodating times do come?

In the meantime, though, sponsors and lenders continue to enjoy the liberal environment, and according to data from Standard & Poor’s LCD, the market up to this point refuses to bend. In the large market, for issuers with EBITDA exceeding $50 milion, the average debt multiple of corporate LBO loans was 5.6x in the second quarter, up from the preceding quarter and the 2005 average of 5.3 times. This is the highest large-market debt multiple since 1997, which averaged 5.7 times. And in the lower strata—issuers with EBITDA of less than $50 million—the market is also thriving. The average debt multiple for an LBO was 4.8x in the second quarter, up from 4.6x in the first.

Overall, new-issue leveraged loan volume reached $246 billion in the United States last year, compared to $195 billion in 2004. The first quarter alone saw $90 billion in newly issued leveraged loans in the United States.

Middle Market Mayhem

The onslaught of new lenders may be most palpable in the middle market. Mark Jones, a partner with River Associates, notes, “It used to be that $10 million EBITDA was the hurdle for the alternative lenders to get involved.”

He says that today the $5 million EBITDA mark has replaced that hurdle as lenders seek out ground they feel will be less competitive. “A lot of people see the lower middle market as a way of deploying capital.”

For sponsors in these markets, this is a great thing. But that is not to say that there aren’t some skeptics who wonder how these new groups will behave when the economy goes South or whether the fresher faces can keep up with sponsor demands.

David Brackett

, a senior managing director of GE Antares, compares the situation today with the 2000-2001 time frame when foreign lenders had become very active in the private equity lending market. “History is a fairly good predictor of the future,” says Brackett. “When the economy turned in 2001, [foreign lenders] all retrenched and we were one of the handful that remained.”

Lawrence Golub, president of Golub Capital, isn’t so sure that the new entrants in the market can live up to sponsor expectations. He says, “Meeting these expectations can be a trap that could potentially hurt some of the newer entrants. Lenders who are new to the market and who are eager to put on assets may end up taking shortcuts in their due diligence that they come to regret.”

Meanwhile, the aggressiveness shown by some in today’s competitive market, could put companies at risk, especially if there are any hiccups in the economy. “There’s little room for error in these very aggressive structures,” says Timothy Eichenlaub, a senior managing director with CIT. “It won’t be too long before we see some of these very aggressive structures start to trip. We see more defaults and more trouble down the road.”

Mezzanine’s Comeback

Indeed, there are widespread expectations for a slowdown. One corollary of that, however, is that the mezzanine market has come back in style. Second lien financings have been decreasing, thanks in part to an increase in LIBOR as well as worries about how the second lien market would handle a downturn. Those factors have compelled sponsors to migrate back into the mezzanine space for financing.

“Mezzanine was getting its lunch eaten by second lien when LIBOR was lower,” says Joseph Kenary, head of corporate finance at CapitalSource.

Moreover, second lien financing is untested as it relates to default situations. Mezzanine has been around longer and sponsors view it as tested and true.

Stephen Boyko, a partner with Proskauer Rose, has tracked the mezzanine rebound. He says that second lien volume in Q2 was $6.1 billion, down from $6.8 billion in the first quarter. Boyko notes that a year ago, two-thirds of the transactions he saw featured second lien financing but now mezzanine and second lien financing are splitting the market evenly.

Lincoln’s Kahn concurs, saying, “I definitely think the pendulum has swung back.”

The Road Ahead

While the lending market continues to appear in good health, the whispers of impending struggles are getting louder. What is comforting to some, though, is that even as new players have rushed into the market, the buyouts space is mature enough that things have not gotten out of control.

According to data from Standard & Poor’s LCD, sponsors are maintaining healthy levels of equity in the deals they do. As of the first quarter, the average equity contribution in LBO deals made up 33% of the purchase price, matching the amount recorded in 2004.

Moreover, unlike other periods that saw new groups come flooding into the market that had no business being there, the new lenders today tend to be former bankers that have experience in private equity lending. This is something that matters a lot more in a downturn than during flush times.

But all this will not stop the inevitable. As Kenary says, “Nobody’s found a way to repeal the credit cycle yet.”

What it will mean, however, is that there likely won’t be the all-out retrenchment from the lending community that was seen after 2001. “There’s not going to be blood in the streets,” says David Brackett. “There’s not going to be carnage…lenders are well positioned to survive.”