Direct lenders to private equity-backed middle-market companies are concerned about increased risk from rising interest rates, inflationary pressures and a potential recession. But they’re also enjoying healthy returns in part due to their larger peers moving out of the middle market. Direct lenders to private equity-backed middle-market companies reported record deal flow and capital deployment in 2021, and they were on a similar pace in the first half of 2022.
Healthy Deal Flow
For WhiteHorse Capital, a direct lender with $11.8 billion in committed capital, deal flow in 2022 has been robust—at or near all-time highs—from new sponsor-led buyouts and add-on acquisitions, and from recapitalizations for both sponsor-led deals and for companies directly. Compared to just before the pandemic, deal flow is up 60 to 80 percent, says Pankaj Gupta, president of WhiteHorse U.S.
Enterprise value multiples in the middle market are contracting, driven by macroeconomic forces– chiefly inflationary pressures and interest rate increases, Gupta says. But companies continue to seek capital for growth.
So far, most of WhiteHorse’s portfolio companies have maintained their profit margins by offsetting rising costs of materials and labor with price increases. Meanwhile, rising interest rates have put pressure on levered free cash flow for companies, and the companies with lower leverage—in the range of a 4 times debt-to-Ebitda ratio—are more capable of withstanding the higher costs of capital, Gupta says.
Also, companies that tend to have low capital expenditures–such as those in the healthcare, business services, technology and software sectors—can withstand rising interest rates more easily than companies in asset-intensive sectors, such as manufacturing, he says.
There has been a wide disparity between the steep decline in valuations for publicly traded companies and the valuations for private companies.
“Surprisingly, we’re still seeing private equity firms being pretty aggressive in looking at companies,” says Dean D’Angelo, founding partner of Stellus Capital Management, a Houston-based middle-market direct lender with $2.6 billion under management. “We’re seeing a lot of activity in private equity sponsors still willing to pay these multiples for good companies.”
D’Angelo says his firm is being pragmatic about how well individual companies could weather a potential recession, which is guiding the firm’s decisions on credit and leverage. Stellus focuses on lending to businesses with $7 million to $60 million Ebitda and makes small equity investments—less than 5 percent of its total portfolio—alongside most of its debt deals.
“You want to find companies that have variable cost structures so that if things get soft, they can preserve margins, and you want to look at companies that don’t have a need to invest back in the business just to be standing still,” D’Angelo says. That category includes producers of consumer non-discretionary goods and services, companies without capital expenditure strain and companies with low fixed costs—companies that are always attractive, but even more so in this macro environment, he says.
In addition to the macroeconomic factors, current lending activity is influenced by some inherent advantages for direct lenders in the middle market space. One advantage is the absence of competition from regulated banks.
“We’re in that part of the market where you’ve seen the largest retreat by typical regulated lenders,” D’Angelo says. “There isn’t really a syndicated market or a high yield opportunity for the direct lenders to compete against when you’re in our sector of the market.”
Banks have not entirely abandoned the middle-market lending space. But because of Dodd-Frank capital requirements, today’s banks tend to focus on very low leverage cashflow-based loans at 2.5 or 3 times debt-to-Ebitda ratios, or on revolving credit facilities and asset-based loans, Gupta says.
Gupta’s firm focuses on lending to companies with $10 million to $100 million of Ebitda in mostly U.S. companies in the $20 million to $50 million range. In this part of the market, the loans tend to be “old-fashioned bank-type deals” with cash flow-based loans leveraged at 3 to 5 times Ebitda, Gupta says, the types of loans that banks provided in the middle market up until about 15 years ago. “They were regulated out of that market and folks like us filled that void,” he says.
Middle-market direct lending also has some risk advantages for the lenders, when compared to lending deals for larger companies.
WhiteHorse avoids large-cap lending—lending to companies with $100 million Ebitda or greater. That’s because from a risk perspective, both the debt-to-Ebitda and loan-to-enterprise-value ratios are much higher with the larger companies, Gupta says. In the large-cap space, 6 to 7 times debt-to-Ebitda ratios are the norm, compared to 3 to 5 times for the middle market, and loan-to-enterprise-value ratios are often 60 percent to 70 percent, compared to 25 percent to 50 percent for middle-market deals.
The middle market is also appealing from a lender’s perspective because of the loan documentation typically required, such as financial covenants that prevent borrowers from taking assets out of the company. Such covenants are not usually included in a large-cap lending deal, Gupta says.
WhiteHorse seeks to make loans with conservative loan-to-enterprise-value leverage ratios along with tight documentation with financial covenants and restrictions on the borrower’s ability to use their cash flow. “All of those risk metrics we think are better in the middle market,” Gupta says.
Returns are also better, Gupta adds. “We think that there is a healthy multiple-hundred-basis point-spread premium that we are able to generate in the middle market relative to the large cap space.”
Another advantage: Direct lenders are more connected to the companies they lend to, compared to the broadly syndicated loan market for larger tier companies, says Chris Lund, co-portfolio manager for institutional portfolios for Monroe Capital, a lower middle-market direct lender with $14 billion under management.
“We have a lot more control over the situation because there’s typically a lot fewer lenders,” says Lund, whose firm targets companies in the $20 million to $25 million Ebitda range with loans of $100 million to $150 million. “Oftentimes, we’re the only lender to a company, so we have an open line of communication and relationship with the management company.”
Recently some of the largest middle-market direct lenders have taken on deals in the upper tier of the middle market, or just above that, and syndicated them to other middle-market lenders, D’Angelo says. Because these large lenders have had so much success in raising capital from investors, they’re now able to offer PE firms an alternative to the broadly syndicated loan market.
“You have large private equity firms, when they’re doing a $2 billion financing, they don’t have to rely on the high-yield and the broadly syndicated market; it’s getting done in the direct lending market,” D’Angelo says. “That’s really unique and that really just started to happen over the last year.”
As larger direct lenders to the middle market have moved up to target “mega-tranche” $2 billion or $3 billion deals for large-cap companies, more opportunities have opened up for lenders who remain focused only on the middle market, Gupta says.
Compared to 12 or 18 months ago, middle-market direct lending is less competitive now because the larger lenders are focused on the higher tier, Lund says. These larger lenders that once targeted deals with $50 million and $60 million Ebitda companies are now focused on companies in the $200-million-Ebitda and higher range.
“Now they have no interest in coming down to do a $30 million Ebitda company. They’re fishing in the ocean instead of a lake,” Lund says.
For lenders who remain in the middle market, Gupta says, “the risk and return profile provides for ample safety, especially in an uncertain economic environment. And there’s less competition now than there was even three or four years ago.”
Moving up to the large-cap deals is attractive for some lenders—especially those that have raised large amounts of capital because deploying capital there is more efficient than in the middle market.
“One can invest five or 10 times the amount in similar transactions, from a volume and pacing perspective, than in the middle market. But you don’t need five or 10 times as many people,” Gupta says. However, the large-cap space has more risk and less return for lenders because of the higher loan-to-enterprise-value and debt-to-Ebitda ratios, tighter spreads and loan documentation differences there, he adds.
Where Dealmaking Stands
Stellus’ current fund has a 46.3 percent loan-to-enterprise-value ratio, which is an all-time low for the firm, which launched in 2004. By comparison, Stellus’ vintage fund in 2013 had a 55 percent ratio.
Meanwhile, the firm’s leverage levels with its borrowers have remained steady at about a 4 times debt-to-Ebitda ratio. “It’s just an indicator that we are keeping leverage steady, but people are paying more for companies,” D’Angelo says. “Private equity sponsors are still being aggressive and confident in their valuations without additional leverage moving up to meet that need. It shows that the sponsors are still being active in wanting to get deals done.”
While deals are still getting done, lenders are less interested in making deals with the extremely competitive pricing and high leverage that was common at the end of 2021, especially for new borrowers, says Jessica Nels, managing director on the capital markets team at Churchill Asset Management, a direct lender with $41 billion in committed capital that focuses on companies under $50 million of Ebitda.
“They still will get done, just at a lower leverage profile to make sure that they can handle the interest burden,” she says. Direct lenders are also minimizing their risk by committing to more club transactions rather than taking on large deals by themselves. “Those mega-unitranche loans that you would see a year ago where managers were committing anywhere from $500 million to $1 billion in a single deal, that’s not happening right now,” Nels says.
Most lenders will say that they underwrite to a theoretical recession even in the best of times, anticipating a worst-case scenario. But now with a high probability of an actual recession, middle-market lenders are trying to anticipate how rising interest rates and compressed profit margins due to labor shortages and supply chain issues could affect specific companies in the next 18 to 24 months, D’Angelo says.
The unitranche deals levered at 6 to 6.5 times that were prevalent at the end of 2021 and in early 2022 are now more challenging to make because of rising interest rates and their corresponding interest burden, Nels says. “We are certainly being more thoughtful on leverage profiles and enterprise values, particularly in light of rising interest rates and inflation,” Nels mentions. “Deals that have nice cash flow and great margins and low capex are typically less impacted.”
Lenders are also considering how rising interest rates might affect capital structures and enterprise values. “Generally, we haven’t seen enterprise values come down to date, but that is a question that remains throughout the industry,” Nels says. “If leverage comes down because the business can’t handle the interest burden, then will the sponsors contribute more equity to make up that shortfall?”
The macroeconomic conditions are reflected in loan documents that place greater scrutiny on the borrower’s coverage ratios, cash flow, and potential cash leakage to dividends or restricted payments. And delayed draw term loans are getting smaller. “There’s a lot more attention to all those dynamics to ensure we set our portfolio companies up for success,” Nels says.
To account for the additional credit risks that a recession would bring, direct lenders are increasing their own margins. “We’re charging a little bit more and being a little more selective,” D’Angelo says.
Direct lending deals are almost always based on floating interest rates, which is part of the appeal for investors, especially in an environment of rising interest rates. “Investors have direct lending in their portfolios because we’re an interest rate hedge as it relates to the income they receive,” Lund says. ”Because lenders’ pricing has risen “pretty meaningfully” from a year ago, “returns are very attractive; you might not take on forward underwriting risk,” Nels says. “Nobody really needs to be a hero from that perspective.”