So much money has poured into the direct lending market over the last few years that it remains very much open for business despite high inflation and economic headwinds. At the same time, credit committees within banks are starting to push back on the high leverage multiples of recent years.
That’s according to Brad Stewart, partner at Boston-based The Capital Solutions Group, which provides both debt advisory and restructuring advisory services to deal sponsors and other clients.
Capital Solutions tends to get called into in two types of situations, said Stewart. In one, the sponsor simply lacks a broad enough group of lending relationships to secure the best financing deal on their own. In the other, the sponsor seeks loans on behalf of a company that has credit challenges—high customer concentration is a common one—that make it a tough sell for most lenders.
A typical assignment for the four-person firm is to raise $30 million to $50 million to help finance a North American lower-middle-market buyout or recapitalization.
Below we ask Stewart five questions that help provide a snapshot of the financing market for lower middle market deals:
How would you characterize the M&A market for buyout firms and independent sponsor deals?
We’re in an interesting place. Last year potential sellers were concerned that the capital gains rate was going to go up. So if they had built a nice business that came through the pandemic strongly, they pushed to get that deal done by year end to take the capital gains risk off the table. That dynamic helped make 2021 a gangbuster year and kept the pipeline full of deals. But deals began drying up by year end which continued into the spring of this year as rising inflation dominated headlines. Buyers and sell-side M&A firms both paused to figure out whether companies were going to be able to successfully pass their higher costs on to customers to protect operating margins. While we now mostly have those answers through their most recent financial results, we’re additionally facing the prospect of a recession thanks in part to the Fed’s effort to curb inflation. Overall, I would say sponsors are having trouble finding high-quality deal flow right now. It feels a tad bit below what I could call a normal market, I would call it a cautious market with all the economic uncertainty out there.
How are lenders reacting to market conditions?
People in the financing markets are assuming that the economy is going to slow down. The big question is whether the economy is heading for a soft landing or for a hard crash. But whatever their prediction, lenders across the board believe that the probability of a recession is definitely much greater now than it was a year ago. And so their thinking is maybe we should take this opportunity to rein in the leverage multiples a bit.
How is the prospect of a recession factoring into sponsor decisions about credit?
With both unitranche loans and asset-based loans, covenants and amortization schedules are moving up in importance for sponsors. If we do enter a recession, liquidity becomes that much more important to companies. They will want as large a performance cushion as possible before tripping covenants. They also want to back-end repayment schedules to save cash. On both fronts heavily regulated banks can be at a disadvantage to private credit funds. Inside banks you have a constant tug between the deal originators and the credit side. When the M&A and credit markets are full speed ahead, the originators sort of rule the roost at the banks and tell the credit guys, “we gotta get this deal done or we’re going to lose it to the shop down the street.” But when the economy turns, as it is assumed to be doing now within many banks, the credit guys wield a lot more power and are able to push back and get the originators to pull in the reins. And that’s where we are now. Through conversations, I’m hearing that the credit guys are starting to push back on the deal originators.
Last spring when we spoke you were seeing six-times leverage multiples on garden-variety deals and L+400 to L+500 loan spreads for lower middle market deals. Where are we now?
Leverage has pulled in a little bit, but not as much as you’d think given all the new credit funds and credit fundraising for established funds that has occurred since we last spoke. A recession-resistant grocery business with a very credible story might still command a six-times leverage multiple in this environment. But in terms of averages and medians, leverage multiples have pulled back to 5 and a half to five and a quarter. And if you have a dubious recession resistance story you’re going to be below that. Lenders are getting better all-in yields, thanks to increases in the LIBOR and SOFR benchmark rates, even as spreads have remained relatively stable so lenders are generally happy with the Fed-driven move in benchmark rates on their portfolios thus far this year. But risk premiums do matter in an uncertain economic environment, especially at banks, and some lenders are trying to increase spreads a little bit too.
What kind of financing is most popular with sponsors?
Unitranche financing is still very much the flavor of the day. It’s to the point where SBIC funds and other traditional sources of mezzanine financing have completely capitulated to the unitranche reality; they’ve largely switched to offering unitranche loans in addition to their core mezz offering. Asset-based lending is also re-gaining momentum as a relatively inexpensive form of financing and also because it typically has no-to-minimal amortization and no-to-minimal financial covenants.