Since the global economic downturn, the lending markets have had their fair share of ups and downs. While the number of lenders still in the business has dwindled substantially, remaining lenders are taking on larger pieces of debt and financing more deals, easing the burden on private equity firms trying to put together a syndicate. What's more, collateralized loan obligations are in full force, with CLOs providing the lowest borrowing costs since the financial crisis. Credit funds are gaining in popularity as well. Mergers & Acquisitions convened a special roundtable to discuss the benefits and challenges associated with different lending vehicles in today's market. Boston-based commercial finance firm NewStar Financial sponsored the event, and the excerpted discussion that follows provides a range of perspectives from key players who are working in and with the financing companies. Participants included private equity investors, one of which invests in financial services companies, and lenders.
Fugazy, Mergers & Acquisitions (Moderator): How do today's overall economic conditions affect the financing market?
Conway, NewStar: Our business is driven, in part, by the volume of M&A activity completed by mid-sized companies. Activity has been relatively slow for a couple of years now, but we have seen a significant pickup in loan demand beginning in the second quarter. In terms of the overall economic environment, we see slow but steady growth in most sectors. The debt markets continue to be very liquid and there's been strong demand for high-yield assets among fixed income investment options from investors.
Brokaw, Corsair Capital: You had a lot of people looking to discuss opportunities coming out of the financial crisis, and as the world heals itself there's a confidence level that's returning in the U.S. One of the challenges is as confidence returns valuations are improving and high valuations can put a strain on people's ability to do transactions. Activity has been moderately active, which has been driven by the fact that financing has been readily available and cheap.
Najjar, Cortec Group: During the fourth quarter of last year there was a lot of deal activity and very good lending markets. Deal flow slowed during the first six months of this year, which has driven up valuations. Financing levels have gotten even more aggressive because a number of lenders have raised capital they want to put to work, resulting in strong demand for good deals. We expect to see an increase in deal flow in the second half of the year because people are starting to see businesses trade for premium valuations and are looking for exit opportunities. In fact, we've seen a significant increase in deal flow over the last eight weeks as people are starting to realize that it's a good market to be selling their businesses.
Fugazy: How have middle-market sources of capital evolved since the credit crisis?
DuBose, Wells Fargo: There's still limited financing available for middle-market loan originators/lenders today in comparison to pre-crisis. If you think about those that participate in the middle market-the finance companies, the business development companies, the direct lending funds, which are a combination of originators partnering directly with the private equity firms and the funds that are acquiring assets/pieces of a syndicated loan that would be structured and agented by a company like NewStar-the range of products and financing opportunities across that spectrum is varied, but the number of banks lending to middle market lenders is still not at pre-crisis levels.
Conway: I would define the traditional middle market as private companies with between $5 million and $30 million of cash flow. Pre-crisis, you could rattle off the names of 30 lenders that were actively involved in direct origination in the middle market plus a wide range of banks. Post-crisis, the nonbank universe really shrank to five or six players. We are now starting to see more banks come back into the market and be more active. I'd say half the deals that we do include a bank in the lending group. I think that will continue to increase.
All the fixed-income markets are under pressure because of an increasing demand for yield. Within the middle market, however, the ability to fund smaller, unrated illiquid loans is much more limited post-crisis and, as a result, provides some buffer against those broader market forces. There are only a handful of non-bank lenders that do it and there are barriers to entry. Although there is a significant amount of new institutional investment capital focused on the middle market, it is primarily being invested through credit funds like the ones we manage. The common strategy is to invest through people like us who do direct origination in the middle market and who are positioned to generate differentiated returns. Most of the primary players who are now very active in the middle market actually have funds they manage alongside their own balance sheets.
Najjar: Lenders that are still in the marketplace have hold positions that are a lot larger than they were before the credit crisis. They have probably doubled their hold positions from what they were comfortable with before, which is better for us because now we can have a syndicate put together much more quickly. We can really pick and choose which lenders we want to be in our credits and it's great that these lenders have the ability, interest and desire to want to hold bigger pieces of our loans.
Bommer, Sentinel Capital Partners: There have been a handful of new groups that have come into the market recently. We define the middle market as deals with less than $150 million of senior debt, and there's now an ample supply of capital to do that, but with fewer players. It used to be to raise $100 million of debt you would have to herd five or six cats into a box. Now you can do it with two or three lenders. It's much easier than it was. That said, we are currently doing business with the same people with whom we worked before the crisis, during the crisis and after the crisis. Before the crisis there was a larger number of players that got some looks -and that list again is growing, but the core group of financing sources for us is pretty consistent. The capital markets rewarded the players that performed well during the downturn-they've gotten bigger and become more relevant.
Brokaw: From an investor perspective, floating rate assets are very attractive. Insurance companies and even banks are now investing in CLOs. They want floating-rate assets.
DuBose: Absolutely. As you see CLOs come back, we've seen competition pick up in folks that are willing to lend on middle-market loan assets. I think it's a temporary window that will ebb and flow. It's definitely stronger than it was in 2009 and 2010, but it's not near where we were pre-crisis.
Brokaw: The CLO market held up surprisingly very well during the crisis from a loss perspective. Community banks and mid-size banks had significant losses, as did other asset classes such as construction, lending and real estate. I think people would have thought that the risk in the CLO books was much higher than some of the other asset classes, but that actually turned out not to be the case. CLOs performed extremely well with very low losses. They proved to be an attractive investment class.
Fugazy: CLOs proved themselves during the downturn. What's their role in today's market and going forward?
DuBose: The bad thing is they go by three letters, which causes everyone to think it's just another version of a collateralized debt obligation, which is still causing people to be alarmed. The nice thing about the CLO is you're able to look at 2005, 2006 and 2007 vintage deals that have moved through their reinvestment period and note the strong performance. You can look at cash-on-cash returns to the equity and see that the structure did work. As we move into 2.0 CLOs, the issuance has been smaller in the middle market than with broadly syndicated loan CLOs. The CLO market in 2009 was very limited. In 2010 there were maybe 20 to 25 deals. And in 2012 we had 121 CLOs issued-approximately five of those were pure middle-market transactions. In 2013 year-to-date, there have been 98 transactions that have been issued. In the first quarter alone there were about 50 transactions and about four of those are middle-market CLOs.
Acceptance is still low, but it's increasing in the middle market because spreads have tightened on the broadly syndicated CLOs, which caused investors to be willing to look at middle-market CLOs again and get paid a little bit more from a yield perspective. In addition to that, middle-market lenders are able to underwrite a bit more of the collateral. The transparency that issuers such as NewStar bring has helped get investors comfortable and coming back into the space. What you find today is much more dialogue around the loan assets with the investors and the CLOs, not only on the day they come into the deal, but on day 364, two years out, four years out and that's actually been a very good fact pattern for the investors.
Fugazy: How many active issuers of middle-market CLOs are in the market now?
DuBose: Lots of folks would answer that question differently. I think if we use your definition of a $150 million loan facility or $25 million to $30 million Ebitda, I would say there's five or six. And it's the same five to six guys that are deemed an originator/agent to most middle market private equity firms.
Conway: There are a couple of things we like about the middle market. Because the number of lenders and CLO issuers is limited, we tend to have manageable lender groups that work well together and actually have a lot of experience working together. And middle-market sponsors tend to have the ability and willingness to be proactive in difficult situations that can make a difference in the performance of a company. We saw that in our track record in a very meaningful way through the cycle where some investors took very active roles-in many cases putting more capital in and changing management teams. They took a very hands-on approach and were able to turn companies around effectively, which is much more difficult to do with a very large company and a very broad bank group.
Bommer: I also think a big factor is that there is a high level of discipline among the lenders in our market so the deals are generally set up to succeed.
Fugazy: Turning to the private equity folks, how important is where the capital comes from?
Bommer: It's very important. Middle-market companies can hit a rough patch and it's very important to know who your partners are. We really view our debt financing sources as partners. If you think of us as managers of private equity firms, we may have 20 to 30 portfolio companies in any given fund. But if you look at the NewStar portfolio, they likely have about 300 loans out across hundreds of companies. It's not uncommon for us to have a discussion with our lender partners about a business problem or use them as a resource because they have lots of experience across a broad range of companies and industries and can be helpful.
Najjar: It's the most important thing for us. We want to make sure we have lenders who are going to be our partners. Not every company is up and to the right, and we want to make sure we have lenders that are experienced and have lived through downturns. We want lenders who will be patient and are willing to work with us through issues as they occur. And having a smaller group of lenders makes it a more manageable group to work with.
Fugazy: Where do BDCs fit in today?
Bommer: One of the interesting things we've seen with the BDCs is that they have the ability to recycle their capital, and we've found them using that to their advantage against traditional mezzanine lenders. They don't have the same types of pre-payment penalties or co-investment requirements because that money is coming back and they get to use it again and again. We're also seeing them dip into the senior layers, either because they've raised a fund to do senior debt or as a competitive weapon they offer to take some senior debt along with the mezzanine to help with the syndication. It's pretty effective.
Conway: We generally see BDCs in the market buying mezzanine debt or second-lien tranches that are subordinate to the first lien, senior debt where we play. Most often, when we see them doing either unitranche or a senior stretch deal where they get higher yields, we also see them layoff a senior piece to a commercial bank that's able to get out first if there's an issue. Most BDCs in the middle market have investment strategies with higher target yield thresholds than we do and, as a result, they generally focus on different parts of the capital structure or provide unitranche financing that they will carve up on the back end with other lenders and retain a last-out tranche engineered to meet their target yields.
Najjar: BDCs can also underwrite a full loan package of $100 million or more, which is not as evident with some of the traditional lenders. So if you're looking for certainty of financing and to avoid syndication risk or having the loan flex on you, BDCs can be a good option. However, you may find out that they sold the senior most portion of that financing to somebody else you don't know and haven't worked with, and you may wind up with a group of lenders that you just weren't counting on. That's concerning.
Bommer: You have to think deeply about where that piece of paper is going and who is going to own it. If you feel like you can steer it to the right people, it's not a problem. We take a lot of comfort in raising debt capital from people who put it on their balance sheet. It's a comfort level that you've got another principal in the deal and you're not paying somebody a fee to raise debt from strangers.
Fugazy: How are credit funds impacting the market?
Conway: One of the most meaningful changes in the middle market over the last few years is the proliferation of credit funds. We raised our first credit fund in 2005. It's a way for us to commit to a larger piece of a transaction without holding too much of one loan on our balance sheet. So we can maintain diversification on balance sheet, but commit a larger piece to a customer. We've raised our second fund now and we're looking at continuing to grow that part of our business.
From a customer perspective, it's very straightforward and attractive because we have full discretion over investment decisions and approve all transactions ourselves. Our private equity clients are dealing only with us, but we're committing somebody else's capital alongside ours. Essentially it gives us the ability to fight above our weight class in the market without taking an outsized piece of each deal on our balance sheet. It's also an attractive source of fee revenue for us because many institutional investors are interested in investing in the middle market, but they don't want to build out their own direct origination platform. So, they invest with us and we put our combined capital to work by making larger commitments to deals for our customers.
Bommer: We're seeing a lot of this, but you need to be careful and understand how much discretion a manager really has. We've run into at least one instance where one of these credit funds didn't want to go along with the manager, and it made things more complicated.
Najjar: Having the flexibility to underwrite and hold a larger percentage of a loan is appealing from a syndication and risk perspective. We ultimately want to make sure that the loan is responsibly diversified to a number of lenders that we've had a history of working with. We want to make sure our lending partners have dry powder to support the company for acquisitions or other requirements. If somebody is really stretching themselves too far from an exposure perspective to one particular credit, it's not good for us and it's not good for them.
Fugazy: How has securitization changed over the years?
DuBose: As you look at the 2.0 deals, the rating agency methodology is a bit tougher. All-in leverage that can be achieved in the securitization of a rated CLO is lower than it was pre-crisis. And I don't think that will change. By nature, these are unrated middle-market loan assets, and when you decide to go battle with the rating agencies and get shadow ratings on these loans, the rating agencies have generally taken a more conservative route, so you end up with B2, B3, high triple C credits.
If you think about what that portfolio does in a rating agency model, you're capped at AAA leverage somewhere in the mid- to high- 50 percent attachment point. Pre-crisis we were probably 10 percentage points greater. That increases your total cost of funds and that's a meaningful change. However, there is a deep interest in the mezzanine portion of the capital structure via investors like hedge funds, credit managers and large money managers.
Conway: The agencies' changes to the rating methodology for structured securities coming out of the crisis were healthy for the CLO market. Unlike other types of structured securities, the CLO asset class actually performed very well through the credit crisis and recession. In particular, those of us who retained all of the equity in the CLOs we sponsored and invested really meaningful amounts of equity issued deals that I think would be sound through any kind of economic environment. For us, the methodology changes generally reduced the amount of leverage available at each level of the capital stack. In addition to methodology, however, the structure of the CLO market has also changed, including the composition of investors and a tiering of issuers. The part of the investor base that repackaged CLOs into other leveraged investment vehicles is gone and that is for the best. Underwriters and issuers have also reworked the way loans are financed through ramp-up periods in warehouse lines by requiring sponsors to provide more capital and reducing the risks associated with potential mismatches in assets and liability duration by lengthening maturities. As a result, however, the cost of funds has increased.
Fugazy: Is there a difference in the outlook for the large CLO market versus a mid-market CLO?
DuBose: I do believe that there's more appetite for the middle market when you have an event like the first quarter of 2013 where the supply of broadly syndicated loan CLOs was quite high and spreads became tight. Being able to stretch for some yield and get 25 to 30 basis points more for a middle- market CLO triple A versus a broadly syndicated CLO triple A, the CLO market in general is such a volatile market. So anytime you have a backup in the market, you have a reach for yield issue. Unfortunately, the middle market has not been in a deep enough market to behave differently, so it just behaves at a premium to wherever the broadly syndicated loan CLO market goes. As you educate the investors and the investors are firmly okay with something like a 30- to 40-basis-point premium at the AAA leverage for a middle-market CLO, you do better. But, again, how many true issuers are there for middle-market CLOs? It's never going to be a very deep market, which I think will continue to create limited liquidity for some investors who want to participate.
Conway: That represents a significant barrier to entry for potential new lenders.
DuBose: That's exactly right. We're doing more business with the same names that we've been doing business with for a long a time and that's on purpose because we believe access to capital in this asset class is extremely important. Raising one fund at this point in time doesn't necessarily mean that you'll have the capital to make it through another downturn.
Fugazy: What's the biggest change to the market and what challenges do lenders face going forward?
Conway:The biggest thing that's changed is that we are unable to apply the same amount of leverage to the business that we could before the crisis. We believe that middle market loans are very attractive, and while the funding markets have rebounded, I don't think we will get back to leverage levels that were available before the crisis.
Bommer: We're in a pretty hot market. There's no shortage of debt capital right now. The greatest challenge is finding good deals.
Conway: Private equity firms that have performed well have great access to capital and will continue to do so. I don't see anything on the horizon in the economy, the funding markets or the dynamics of the loan markets that would dry up capital in the middle market right now.
Brokaw: You may see rotation away from fixed income and into equities and floating rate assets, because they're hedged and probably should survive fairly well as rates move, but any fixed rate assets will be an issue.
DuBose: Debt coverage is a concern as you think about rising rates and what it means for borrowers who have been used to a very low interest rate environment from a behavioral perspective. We do have to differentiate credit performance and be cognizant that all lenders were kind of cast in the same curtain as we thought about the middle market.
Najjar: The lending issuance market is very good for the NewStars of the world, which allows them to have access to capital. It causes lenders, generally speaking, to be more aggressive about what they're willing to finance and how they're willing to finance companies right now, which is pushing valuations up, which should ultimately result in increased deal flow. I think that's what we're going to see over the next year.
Brokaw: It's hard to stretch in the middle market, given the amount of leverage that's available where you're likely to see the large capital deals of people that are levering seven or eight times that, and then they have refinancing problem. And you may see some old deals that were done a few years ago that caused dislocation in the market as they continue to get worked out.
Roundtable Participants: Eric Bommer, partner, Sentinel Capital Partners; Clifford Brokaw, partner, Corsair Capital; Timothy Conway, CEO, NewStar Financial; Mary Katherine DuBose, managing director, Wells Farg; Danielle Fugazy, contributing editor, Mergers & Acquisitions; Michael Najjar, partner, Cortec Group