Survey Points To Continued Squeeze On Sub-Debt –

It’s well known that a robust debt environment serves as fuel for the buyout industry, and just as everyone wants to know where oil prices are going, private equity pros are constantly trying to gauge the health of the debt markets.

To this end, Cleveland law firm Benesch Friedlander Coplan & Aronoff LLP recently completed a survey of 42 sub-debt funds. While the findings did not necessarily surprise anyone, the survey further illuminates just how crowded the sub-debt field has become.

IRRs, to be expected in this competitive market, have experienced downward pressure. Of those surveyed, the expected rate of return on new investments carried a wide band, ranging from 10% at the low end to as high as 30% on the top, but the higher IRR expectations were characterized as rare by Benesch. Broken up, the small and mid market sub-debt providers are anticipating better returns than the large funds, which have seen their boundaries encroached upon by the senior debt providers and even the hedge funds, while at the lower end, it is not as easy or efficient for companies to shop for better terms.

Overall, there is an added pessimism that engulfs the market in that roughly 65% of the respondents anticipate the number of transactions over the next year to either decline or stay on the same plane. Moreover, many of those polled have seen fewer opportunities to include an equity component in their deals, and the middle-market and larger funds, according to the survey, reported that the “significant majority” of recent transactions have been arranged without warrants.

Lately, the “Goldilocks” reference has been dusted off and is again being used to characterize the economy: It’s not too cold, it’s not too hot, the market’s temperature is just right. The sub-debt players, however, wouldn’t mind a little chill, or at least something not too crippling that could spook some of its competition away from the market.

“When the banks pull back, as they inevitably will, that’s when the sub-debt funds flourish,” Benesch Partner Ira Kaplan, said. “A few years ago, the sub-debt lenders were getting equity-like returns, with IRRS in the low 20s. But since the [debt] market has been so buoyant, their returns are now more in line with the senior lenders.”

Even as the survey points to a less than optimal landscape for subordinated debt players, Benesch’s James Hill, also a partner, believes the cards are about to start falling in their favor. “I think we’re just about to hit an inflection period. Anecdotally, the market is starting to open up for [sub-debt lenders] now… If there’s any kind of economic downturn and the senior lenders recoil, the subordinated lenders will again be toasting themselves like they were three years ago.”