By Rit Amin, Regions Securities
We’ve all seen the headlines about volatility, uncertainty, and inflation. But even amid choppy markets and rising interest rates, the middle market remains on solid footing. In fact, deal volume remains relatively stable after last year’s record M&A boom.
The credit goes to strong fundamentals and sustainable valuations among middle-market companies, as well as the continued availability of financing from banks, private equity, and direct lenders.
A ‘Risk-Aware Construct’
It should be an encouraging sign for those in the dealmaking community that the flow of capital remains available and active across sectors. That the deal market has remained stable shows the resiliency of the deal economy in the middle market. Nevertheless, there are pockets of caution developing, most notably among direct lenders moving up market to capitalize on the headwinds in the broadly/rated syndicated markets. Overall, we would say the current marketplace is operating within a “risk-aware construct,” in which financing providers of all types are attempting to balance an abundance of liquidity with a greater consciousness of prevailing economic and market conditions. The result is that available capital and competition for limited deals will continue to be strong overall, but with greater nuances among financing providers.
The Move Upmarket
More traditional sources of financing such as banks—with their larger, more diversified balance sheets—have been somewhat less impacted by current market conditions than rated institutional investors. Broadly speaking, direct lenders’ capitalization vehicles are more sensitive to volatility and uncertainty in the marketplace. This, combined with volatility in the high-yield space, has led many direct lenders upmarket. Larger deals offer the ability to take advantage of the rated loan / high yield market disruption and put out more capital per deal, which usually means better pricing and structure.
Typically, direct lenders operate in the unrated end of the middle market, but they too, are becoming more interested in larger deals, while being more selective at the lower end of the middle market. When the high-yield market stabilizes, we should see conditions revert to normal, although a prolonged disruption could foreshadow a recession. The high-yield marketplace is a fairly reliable indicator of economic prospects historically.
New Measures of Creditworthiness
Since the pandemic, one aspect that has changed for creditors of all types is a greater awareness of key business continuity and resiliency factors that signal a borrower’s ability to withstand an economic downturn. For example, many companies whose creditworthiness looked stellar on paper before or during the pandemic found themselves upended by circumstances few could have predicted. Lenders learned from this to keep a closer eye on the resiliency of cash flow and recurring revenues and the ability to maintain normal operations in the event of unexpected market disruption. Companies that demonstrate stable cash flow and recurring revenues are viewed as safer investments in this post-pandemic era.
As a mix of overall capital structure, equity has remained relatively stable over the past year. Among private equity sponsors, we see equity as a percentage of debt fairly consistently (35-40%) for most deals, a figure that can vary greatly depending on the type of business. Also, despite market volatility, we haven’t seen purchase price multiples come down yet. We have, however, seen private equity sponsors trying to be smarter and more selective about their acquisition targets. Where new offerings are concerned, the recent volatility in the public equity markets has greatly slowed volume for IPOs, SPACs, and other new issues, which is likely to be the case until stock markets rebound.
When could this be? If history is a guide, equities – and new public offerings – tend to rebound substantially in the months after the end of a major economic event. This, along with stabilization in high-yield debt, could be an early indication of improvement in the public equity markets.
Capital Raising in a Volatile Market
The middle market’s current mood seems to be business-as-usual, tempered by greater risk awareness. And while the market is stable, getting deals done in the coming year may take a little more patience, creativity, and focus. Established, long-term relationships are key in this market as financing seekers and providers are prioritizing people they know and trust. Many feel that these conditions favor banks and direct lenders who have a history of adapting and innovating and who are more focused on developing long term sponsor and borrower relationships. Such relationships are generally viewed as more predictable and consistent, steady solutions in challenging market conditions.
Rit Amin is Executive Vice President and Group Managing Director / Corporate & Institutional Markets at Regions Securities LLC. For more information on Regions Securities, click here.