Tightening Credit Mostly Spares the Lower Middle Market: Here’s Why

The recent volatility and uncertainty in the financial sector has caused the credit spigot to tighten as wary lenders and investors pull back. This is not necessarily bad news for lower mid-market firms, as their access to funding has generally not diminished except for credits in problematic sectors such as oil and gas.

“We are definitely seeing tightening across credit markets due to concerns over the global economy and volatility in the stock and broadly syndicated markets,” says John Finnerty, a group head at NXT Capital Corporate Finance. “These factors are giving lenders a little bit of pause as we are seeing credit standards tightening.”

He says that for credit facilities that are less than $150 million, companies are able to get those done comfortably without any gaps. But for larger facilities, those that are more broadly syndicated, financing becomes more challenging.

Clearly, when it comes to lenders extending credit, the size of the deal counts. According to John Sherman, a portfolio manager, Opportunistic Loan Strategy, at DDJ Capital Management, LLC, they have not seen the banks tighten credit to mid-market deals so far. “The tightening that we’ve seen has been largely in larger and more aggressive capital structures,” he says. “Middle-market deals in the $50 million to $250 million range are generally more conservatively capitalized and thus usually clear the market.”

For larger transactions, the issue has been in obtaining financing for the junior capital part of the financing structure.

“Banks are being more hesitant towards committing to the junior debt tranche for mid-market companies with deal sizes in the $300 million to $500 million range,” Sherman says. “Because of this, companies and/or private equity sponsors have been reaching out to buysiders ahead of syndication so they can pre-place that tranche of debt.” He adds that they saw this trend start in 2015 and escalate in intensity this year.

Charlie Perer, a director at Super G Funding, says that there is a definite tightening in the institutional second lien market, defined as companies that generate greater than $10 million of EBITDA, as well as non-institutional, which comprises smaller companies that have fewer options.

“Institutional tightening is typically driven by macro-economic trends, whereas non-institutional is driven by other factors that pertain to company level rather than industry,” Perer says. “Junior credit tightening in times of economic uncertainty should be expected, especially in light of recent Fed moves as institutional funds manage risk on a macro level whereas smaller funds do not.”   

Pricing Spikes

As one goes down the mid-market spectrum, the cost of company financing becomes less and less of an issue.

Why is this so? David Brackett, a managing partner and co-CEO of Antares Capital, says that the credit tightening in the capital markets has been mostly seen in upper mid-market companies (with EBITDA over $70 million), since they are affected by the large, institutional buyers who move assets to chase yield and have a risk-on and risk-off strategy.

“These investors have shifted away from leveraged loans into high yield to buy attractive large-cap company paper with nice yields,” he says. “But, some now have a risk-off strategy, which means they shifted into cash due to concerns about the economy or markets.”  This is also why, he says, there have been gyrations in the capital markets. For instance, larger deals are pricing at Libor plus 500 to 600 basis points with a 1% floor, increasing from Libor plus 375 basis points with a 1% Libor floor a few months ago.

Brackett says that for companies with $20 to $70 million EBITDA, however, the changes in pricing have not necessarily been as pronounced. Investors are much more concerned with credit quality and they are picking and choosing their spots. “Pricing is meaningfully higher for challenging credits, particularly within the junior debt tranche, which has increasingly resulted in sponsors opting for senior only structures or providing the junior capital themselves,” he says.

“The $10 to $30 million EBITDA club deals have shown the least amount of price variability due to the presence of more consistent financing partners,” Brackett says. “Lower mid-market transactions are now pricing at Libor plus 475-500 basis points versus Libor plus 425 basis points, which is only a 50-75 basis point change.”

Less Funding for the Troubled

In the end, what lenders and investors are looking for remain the same — quality companies and industries. Deal pricing and access to financing naturally reflect these choices.

“Across the board, investors are favoring companies with more stable cash flow, such as software companies,” NXT’s Finnerty says. “These deals still get full leverage. There will always be bidders willing to spend on companies with stable cash flows no matter how expensive they are. If we look back to the 2008 to 2010 timeframe, cyclical companies are getting less leverage or struggling to obtain financing.”

Funding varies by sector. “There is very limited financing from the capital markets available for any commodity-exposed company, i.e., oil and gas, metals and mining, etc.,” DDJ’s Sherman says. However, “we are still seeing plenty of deal flow in less cyclical industries such as healthcare.”

Specific subsets of lenders are providing financing to companies in troubled industries. “Sectors such as oil and gas, heavy industrial, and mining are generally being served by distressed debt lenders rather than mainstream lenders at this point in the cycle,” Finnerty says. “The retail sector is typically served by asset-based lenders rather than cash flow lenders.”

Lenders have to see the silver lining to fund the deals in troubled industries. “Few deals are getting done in the coal, oil and gas, and related industries. If you believe these industries have hit the bottom, then it might be a great time to invest,” Antares’ Brackett says. “But, as a senior lender, we have to be right 99% of the time so we are watching these sectors closely. Unlike equity investors that can get back their return over and above what they invested, we can lose everything and our upside is limited to getting paid our stream rate and closing fees. We have to be judicious and pick our spots.”

He adds that dealmakers are also wary of any area of the economy that is showing signs of slowing, such as the highly publicized retail sector.

Private Equity Reaction

With the recent tightening in credit has come a decline in PE-backed transactions. “There has been a decline over the last six months as strategic or much larger buyers that are better capitalized have come in and acquired private equity-backed companies,” Sherman says. “Whereas similar transactions would have gone to private equity in the past, but these deals are going to strategics because PE firms couldn’t get the debt financing in place.”

Bolt-on acquisitions are expected to increase as well. Antares’ Backett says that because sellers’ purchase price expectations are still sky-high, sponsors are putting more equity into deals. “Private equity firms’ uncertainty about the economy and debt financing has increased, placing more risk on executing platform acquisitions,” he says. “As a result, we expect them to focus on judicious add-on acquisitions until purchase price multiples moderate.”