New lending groups continue to enter the market, and familiar names have ratcheted up their marketing activities in hopes of keeping share. And the statistics confirm that leverage levels are either at, or near, record high levels with yields at, or near, record low levels.
So with all this money looking for a home, a question likely to be running across everyone’s mind is “Does this represent the new normal or will this cycle also come to an end?” And perhaps the answer is as easy as, “Just watch the S&P 500.”
For starters, the enterprise value of most mid-market companies is based upon their larger and widely traded public brethren. Great minds can debate over the premium or discount a particular company should get when compared to its comps, but whether buying, selling or financing a privately held company in the middle market, the first step in assessing the company’s enterprise value is almost always to check the public comparables.
And because the S&P 500 is the granddaddy of all comp sets, when that index starts to decline (and, note that today it is near its all-time high so a future meaningful decline is not outside the realm of possibility), just about every mid-market company is going to see a drop in its enterprise value as well.
This, in turn, is going to force lenders to lower the dollars they lend to any particular company. Although debt multiples are the topic of conversation at just about every private equity gathering, lenders are laser focused on their debt as a percentage of total capitalization (i.e., enterprise value).
So when those enterprise values decline, it is only logical to assume that lenders’ willingness to extend debt will correspondingly decrease, and lending multiples will contract. Interestingly, lenders often require higher equity cushions in times of declining enterprise multiples as a precaution against further declines, resulting in an even greater contraction of leverage multiples.
However, there’s another, more subtle correlation between mid-market lending and the S&P 500. As the attached chart shows, there is a correlation between the average stock price of the approximately 40 largest publicly traded business development companies and the S&P 500. With the index at record levels today, BDCs are all trading at, or above, their net asset value, providing them with an almost inexhaustible source of capital due to their ability to raise new equity through serial public offerings. This capital can then be used by the BDCs to fund new debt financings, increasing the overall liquidity in the middle market.
But when that index falls, there is a very good chance that BDCs will begin trading below their NAV and, as a result, their ability to raise additional capital will quickly diminish. This is critical because BDCs have had a tremendous impact on the mid-market lending environment during the last few years.
Since 2012, publicly traded BDCs, which cater almost exclusively to providing debt financing to mid-market companies, have raised more than $5.0 billion of equity capital and, assuming 1:1 leverage, the amount of capital available to fund mid-market debt deals quickly jumps to approximately $10.0 billion.
Now think about the world when these financing entities are suddenly on the sidelines because their stocks are trading at less than NAV and they can no longer access the public markets for capital. Imagine approximately 40 finance companies unable to offer middle market companies debt capital and you quickly begin to understand that today’s lending markets will surely be affected, with leverage multiples sure to go down and the price of debt going up.
So, if you want to know when this financing boom is going to end, don’t talk to your lender. Just pick up the Wall Street Journal and check the price of the S&P 500.
Ron Kahn is a managing director at Chicago investment bank Lincoln International