Private equity investors have found it increasingly difficult to obtain financing for transactions over the last several months. The lessening availability of credit has contributed to the overall slowdown in middle-market deal volume. (See related chart). Many factors are in play. Traditional banks continue to face regulatory scrutiny about how much leverage they should supply to private equity transactions, which has caused them to shy away from lending to PE-backed deals. Capital constraints and shareholder activism are putting pressure on publicly traded business development companies, or BDCs. And collateralized loan obligation, or CLO, issuances are decreasing because of risk retention regulations.

While the climate is challenging for buyers trying to close deals, it’s fair weather for some non-traditional lenders. “We have seen a significant evolution in the credit landscape over the last three years,” says Seth Alvord, managing partner of Balance Point Capital, an alternative bank lender. “From mid-2012 to mid-2013, we didn’t do a deal. Aggressive underwriting led by increased BDC capital created considerable competition and, in many cases, unbalanced risk-return equations. This has changed significantly over the last year. The reality is that a material number of capital providers have pulled back from the market due to regulation or other developments. This dislocation represents a compelling opportunity for us.”

The tightening of the credit markets has been more pronounced in deals above the middle market. Recently, private equity firms such as Kohlberg Kravis Roberts & Co. (NYSE: KKR), the Carlyle Group LP (Nasdaq: CG) and Sterling Partners have struggled to attain the financing they needed to close deals. The good news for larger-market firms is they are usually large enough to swallow the whole deal and look for financing later. Private equity firms have plenty of so-called “dry powder,” amassing more than $260 billion in capital for investment in the U.S., which represents a six-year high, according to Preqin. In KKR’s case, at the end of 2015 when it couldn’t get financing to buy Midwest discount retailer Mills Fleet Farm, the venerable PE firm raised the capital itself and purchased the company for more than $1.2 billion in a deal that closed in February.

In the middle market, while the dislocation is less pronounced, the lending markets have softened. In February, the Availability of Financing component of Mergers & Acquisitions’ Mid-Market M&A Conditions Index was at its lowest level since the monthly polls began in 2013. The component rebounded slightly in March, but still scored significantly under 50, indicating contraction.

The largest, most recent change in the lending market contributing to the tightened credit conditions is the withdrawal of the BDCs. As of March, only a handful of BDCs were trading above book value, leaving most unable to issue new equity. The only way these BDCs can fund new transactions is from repayment on existing loans—a less than ideal scenario. “Many BDCs are not raising money right now. They are recycling money and they tend to be more cautious in this environment,” says Andy Steuerman, head of middle-market lending and late-stage lending at Golub Capital, a lender with multiple products including Golub Capital BDC Inc. (Nasdaq: GBDC), one of the few BDCs trading above book value as of late March.

BDC Challenges

Activist shareholders are pressuring many of the BDCs. Activist investors have focused on several BDCs, including American Capital Ltd., Fifth Street Finance Corp. (NYSE: FSC) and KCAP Financial Inc., calling for them to re-elect board members, lower management fees, and explore sales of their companies or assets, among other changes.

In December, because of costs related to activist investors, Fifth Street’s BDCs’ earnings were substantially below normal. During the first quarter, the BDC reached an amicable resolution with RiverNorth Capital Management, Fifth Street’s largest shareholder. Still, industry professionals predict more companies could come under pressure. For more, see BDC NAV Problems Could Result in M&A.

“The interest from activist investors in the BDC market highlights broader skepticism, which is not likely to fade in the near term,” says Justin Kaplan, a partner at Balance Point Capital. “We will likely see consolidation in this market. BDCs will come back, but there will be a digestion period. Nothing happens overnight.”

The CLO market has softened as well. While NewStar Financial was able to price a mid-market CLO in early March, it is becoming an exception. The Boston-based firm completed a $348 million term debt securitization. Roughly $4 billion in CLOs priced from January until mid-March, compared to nearly $17 billion during the same period in 2015. Issuances have slowed as risk-retention rules—implemented under the Volcker Rule—require managers to hold 5 percent of their CLOs. The rules are set to take effect in December 2016. In response to the coming rule changes, some CLOs have been sold, while the managers of other CLOs are trying to navigate the new world and make themselves compliant. The $417 billion market for CLOs grew more than 50 percent between 2013 and 2015, according to Thomson Reuters Loan Pricing Corp. However, that trend is reversing, with CLO issuance down about 50 percent from a year ago.

“While we do not compete directly with CLOs, they provide a meaningful source of liquidity to the market, so the pullback in issuance has meant less money in the system. This has increased the opportunity for us,” says Alvord.

Regulatory Red Flags

Regulatory measures on banks continue to put pressure on the leverage loan environment. Because of guidance issued by the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency, many traditional bank lenders have withdrawn from making leveraged loans on private equity firm deals. Regulators have said deals in most industries with a debt ratio greater than 6 times Ebitda would raise a red flag to regulators. Almost 25 percent of 2015 middle market loan transactions featured leverage multiples of more than 6 times Ebitda, according to Standard & Poor’s Capital IQ. That is just one of the many points of guidance for banks that discourage leveraged lending. Other red flags for regulators include banks with over-optimistic cash flow projections and private equity firm partners of lenders with histories of paying themselves dividends soon after a buyout is completed.

“The banks that are actively lending have become increasingly particular about who they lend to, and they have limited flexibility within the regulatory framework,” says Steuerman. “They have really pulled back on middle-market and lower middle-market loans.”

Despite the trouble in the lending environment, there is a bright spot for dealmakers. Non-regulated direct lenders, also called non-traditional lenders or alternative lenders, are filling the void. These lenders are able to continue to lend because of their permanent capital fund structures and the fact that they aren’t impacted by market conditions. “There are a number of reasons that non-traditional bank lenders are becoming more trusted sources of debt. They have flexibility to speak to multiple tranches in the capital structure. They can work quickly because they are a one-stop shop. And they are willing to spend time on messier deals, which so many banks are not willing to do,” says Gordon Liao, a co-founder of 4C Capital, an Orlando, Florida-based fundless private equity firm that backs lower middle-market companies. “They truly act as partners.”

Balance Point Capital became 4C Capital’s go-to lender when the investment firm purchased IGeneX at the end of 2015. IGeneX tests for Lyme disease. The owner was looking for liquidity and the company needed growth capital. Balance Point provided both unitranche debt and preferred equity alongside 4C Capital to support the buyout of the company. Balance Point was able to make the commitment within 60 days.

“The banks couldn’t close that quickly and with this flexibility. This is not a plain vanilla deal. It was a family-owned business with no true infrastructure. This wouldn’t work for a traditional lender, but these are often the deals that create value,” says Liao.

The IGeneX deal was good for Balance Point as well. Despite the risk involved, the company had good cash-flow characteristics, it’s in the healthcare space, which Balance Point likes; and it’s fighting a disease, which is proliferating because of the growing deer population. “The company is continuing its growth trajectory and there are a lot of positives. We are glad the banks aren’t interested in these deals. It gives us more opportunity,” says Kaplan.

Steuerman agrees that the change in the leverage lending industry has been good for Golub and other non-traditional bank lenders. “There are fewer firms providing loans right now, but some of us are open for business and ready to finance deals with solid credit at market rates. You don’t need an overabundance of lenders to finance a deal in the middle market. You just need a few solid lenders. Our door is open.”

Additionally, Steuerman says interest has increased in Golub’s one-stop product over the years because the model resonates with dealmakers. “The process is more efficient, and the solution is superior to having to find lenders to speak to every piece of the capital structure. People are realizing more and more that Golub and firms like Golub truly become a partner and offer superior execution. The private equity firms increasingly want to work with us and we appreciate their business and confidence,” says Steuerman.

Trusted Partners

Case in point: The Riverside Co., one of the most active private equity firms in the middle market, looks only to lenders that it has a relationship with already, calling them its lending partners. These lending partners include Antares Capital, Golub Capital, Madison Capital, Maranon Capital, Babson Capital, NewStar Financial Inc. (Nasdaq: News) and New Canaan Capital, among others. These firms are winning market share these days. Newstar won Mergers & Acquisitions’ 2015 M&A Mid-Market Award for Lender of the Year.

“We know our lenders well, and they know us well,” says Anne Hayes, a partner in Riverside’s capital markets group. “By and large, we work with a group of alternative direct lenders that can speak to large chunks of the debt structure. So we are not directly affected by where BDCs are trading, how the large syndicated market is behaving, or the CLO market. Our partner lenders are consistently in the market, supporting middle-market sponsors, and most do not have the regulatory requirements that the banks have to comply with.”

In addition to the non-regulated direct lenders, Small Business Investment Company funds are also cashing in on the dislocation in the market. In December, two regulatory changes were made that are favorable to SBICs and allows them to be more competitive. SBIC advisers have reduced registration requirements, and the amount of capital an SBIC can control has been raised to $350 million from $225 million. Boathouse Capital, which was founded in 2009, was able to close on $230 million for its second SBIC fund, Boathouse Capital II. The Wayne, Pennsylvania-based firm’s first fund was closed in 2009 with $120 million. “There’s no question that more private equity firms are getting comfortable working with SBIC funds. We have a flexible structure that makes working with us easy. We are good partners and the dealmakers see that,” says Bill Dyer, a general partner with Boathouse Capital.

In 2013, Boathouse Capital invested debt and working capital into Accurate Background, an on-demand employment screening service. Since then, Boathouse has given the company additional equity and debt capital to support add-on acquisitions and earn-outs owed to the seller two years later. “This was an interesting transaction that we supported multiple times with debt and equity, which is unique,” says Dyer.

Looking forward, Balance Points’ Alvord expects to continue to find more opportunity and less competition: “Non-traditional lenders continue to step in and fill the gap left by the retreat of BDCs and traditional bank lenders. We think the alternative lending model is well positioned to serve this market.”

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