Evaporating liquidity in the middle market has created a new set of winners and losers among senior lenders. Winners: Banks, finance companies, hedge funds and others that can hold large loan pieces on their books or that can supply mezzanine debt. Losers: Firms that count on generating the bulk of their revenue from senior-loan syndication.
Before the credit flu gripped the market, both varieties of lenders fought for pieces of every deal. Mid-market lenders could earn good money by serving as agents—middlemen, essentially, who collected fees as they sold off portions of debt to other investors, primarily to collateralized loan obligations. Traditional lenders, those with balance sheets big enough to hold sizeable credit chunks, often found themselves outbid by these newer firms hungry for market share.
However, the disappearance of CLOs has left these smaller, more thinly capitalized lenders with few opportunities to arrange new loans and draw their life blood: fee income. One mid-market lender predicated on this model, Cratos Capital, recently sacked one of its two founders and laid off nearly a third of its staff. The firm was founded a little more than a year ago.
“They were trying to be a finance company, but if you look under the covers, they were really a CLO,” one leading mid-market lender said of Cratos Capital.
Even with fewer players in the marketplace, deal flow in the middle market kept up a steady pace through the summer and fall, while the large market essentially shut down. Except for a dip in September, the number of announced deals with disclosed values of less than $1 billion exhibited few changes between July and October, according to Thomson Financial, publisher of Buyouts.
Those deals were primarily financed by a dozen or so players—led by General Electric’s Antares unit, Madison Capital Funding and Merrill Lynch Capital—capable of funding transactions of up to $250 million by clubbing together and holding $25 million to $50 million slugs of senior debt each on their books. These firms have lost some of their underwriting business, to be sure. But they’re also enjoying better pricing on loans (100 extra basis points in most cases), extracting better terms from sponsors, and benefiting from more conservative capital structures.
“From the moment the market shut down over the summer, our pipeline of deals exploded,” said Christopher Williams, managing director of Madison Capital Funding in Chicago. “Our volume of deal flow doubled overnight.”
One active mid-market lender, Golub Capital, recently shelved its IPO plans because of the weakened credit market. But the firm instead raised $500 million from limited partners so it could continue its role as an asset gatherer through mezzanine and one-stop lending.
“We are going to have another record year in 2007, although at a slower growth rate than recent years,” said Lawrence Golub, president of Golub Capital in New York. “We are continuing to hire people and expand our business.”
Larger banks are also taking part in the reshuffling of the mid-market lending landscape. Merrill Lynch, facing cash shortages from big fixed-income write-downs, has put Merrill Lynch Capital on the block. The division, which underwrites and holds loans, is in good health, sources told Buyouts. But its parent needs the $1.5 billion it could fetch to help stem losses from the subprime meltdown. The mid-market’s No. 1 lender, GE, is believed to be in the driver’s seat to buy Merrill Lynch Capital.
But the most pronounced changes in mid-market lending are taking place among companies structured to thrive in a liquid credit market. In many cases, these lending outfits assembled big teams of pros to scour the market for syndication deals in a frothy market, but they could end up being casualties of the slowdown.
“It’s like trying to start a new cola company in the midst of the Coke and Pepsi wars,” one senior lender told Buyouts. “Their model is based on arranging syndication. They’re not designed to hold debt because their overhead demands fee income from syndication. Even if it were a good model at the time, it’s not sustainable today.”
This fall, for instance, Cratos Capital, which opened shop in an Atlanta suburb in October 2006, booted one of its two founders, David Gittleman, and laid off nearly a third of its staff. The firm, which also has offices in Chicago and Charotte, N.C., counts Deutsche Bank as one of its backers, along with an affiliate of an unnamed Atlanta-based family office.
Craig Kitchin, the CFO of Cratos Capital, said the firm initially staffed up “aggressively” anticipating a strong credit market going into 2008. When it became apparent in August and September that capital was becoming more expensive and harder to come by, the firm’s management was forced to create a leaner operation and one that’s based on holding more debt, he said. At least 70 percent of Cratos Capital’s loans have backed buyouts.
“We shifted gears and decided to become not as aggressive,” Kitchin said. “We still have capital to put to work today and plan on growing our portfolio. We’re just going to do it at a more manageable rate and not rely on outside capital to do it.”
The model for this kind of syndication-focused operation, which is premised on an eventual public offering, is NewStar Financial, the Boston-based financial services company. Unlike its imitators, however, NewStar made it to an IPO in late 2006, giving the company a steady stream of capital. Over the last three months, as the credit market nosedived, NewStar’s stock fell by 22 percent, and it’s down nearly 50 percent since its debut. The firm’s fortunes are still tied to the health of the CLO market, said David Long, a stock analyst for William Blair & Co. who initiated coverage of NewStar last month with the equivalent of a “hold” rating.
Nonetheless, Long said the mid-market lender is in good shape. Earlier this month, NewStar secured a new line of credit from Deutsche Bank, giving thee firm a total of $775 million in undrawn commitments. Long said the financing should give NewStar capacity to hold new loans and weather storms in the syndication market; moreover, market participants told Buyouts that NewStar remains on the list of active lenders.
But, Long added, “some of the smaller players that don’t have vehicles to fund themselves through this cycle will have trouble.”