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Liquidity
Middle-market lending will be led by finance companies and other non-bank lenders that can provide flexible capital to meet the needs of many sponsors and deals.
Banks will continue to be less active in financing traditional loans for more highly leveraged transactions, as the regulatory focus on these loans has reduced their risk appetite. Due to regulations, many sponsors are finding the structures proposed by banks are less flexible, with increased amortization requirements and very little maneuvering room for acquisition lines to effect platform growth strategies.
Not all middle-market finance companies will prosper in 2016. The most successful will be those with defined, proven investment standards; robust direct sourcing capabilities; deep-rooted investor and sponsor relationships; and the ability to consistently raise long-term flexible capital to fund future growth.
Newer, unproven platforms with limited access to capital and a lack of relationships will struggle with market share, as will lenders grappling with investments in sectors such as oil, gas, commodities and mining. Lenders that depend heavily on access to the public debt and equity markets will face similar hurdles.
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Shifting Terms
As the economy brought more liquidity to the middle-market in recent years, there was a steady shift toward more favorable terms for borrowers. This has been particularly evident in the high-yield and broadly syndicated loan markets, but it is also true of the middle-market.
Today, experienced lenders who have managed through multiple cycles are beginning to recalibrate terms to reflect prevailing conditions and the possibility of an economic downturn in the next few years. In some cases, the pendulum is swinging towards more conservative terms, including tightened covenant packages, reduced “large market terms” and a dramatic drop in middle-market covenant-lite issuances. This discipline is critical for the long-term health of middle-market lending, but may temporarily impact activity as the market adjusts.
Although early, pricing for new middle-market deals has started to trend slowly upwards. The recent actions of the Federal Reserve Bank, coupled with tightening institutional CLO markets and valuation pressure experienced by public BDCs, are expected to lead to continued, gradual pricing upticks in the near-term. This will begin to reverse a fairly long period of contracted pricing that reflected the growing supply of low-cost middle-market capital. But by historical standards, interest rates remain comparatively low and are certainly attractive enough to transact deals.
Originally published in Private Debt Investor’s February 2016 issue