Capital Outlook: The Lower Middle Market

Leveraged loans originated prior to the economic downturn are coming due over the next several years. Lender expectations have changed drastically since these loans were originated between 2003 and 2007.

Many senior banks and asset-based lenders that were hamstrung throughout the recession by the loss of liquidity are licking their wounds, which in combination with more conservative underwriting standards could put an end to the “amend and extend” cycles previously seen by the market.

In past years it was common for senior banks to service relationships for several loan life cycles, allowing borrowers to extend a loan, and amending it to current interest rates and a fresh amortization period. Borrowers rarely had to pony up to bullet payments at maturity and everyone was happy.

Today, it’s quite possible that many companies that were underwritten for several cycles will be shown the door after the recession changed both borrower and lender.

Maybe this isn’t such a bad thing. For most companies in these shoes, there are two possible ways to replace capital due to the lenders. First, companies could find new banking relationships. Secondly, companies could be forced to find capital from different types of providers. The third possible outcome is grim: bankruptcy.

A new banking relationship could be found in the form of community banks or alternative lenders. According to a press release by the Federal Reserve, Federal Reserve Chairman Benjamin Bernanke pointed out that community banks who survived the downturn are in good shape. FDIC Chairman Martin J. Gruenberg also pointed out that market share for community banks is ripe for the taking. “Given the labor intensive, highly customized nature of many small business loans, it is not clear that large institutions would easily fill this critical need if community banks were not there,” Gruenberg said.

The equation is simple. Interest rates may be low, banking relationships may be hampered, but one thing is clear: there will be demand for capital in 2012. If community banks will not fill the shoes of extending some of this 2003 – 2007 vintage credit, someone will.

By way of example, according to Hedge Fund Alert, New York-based Terrapin Asset Management has announced its raising of a $100 million fund to write small-balance loans of $2 million to $3 million. Terrapin Asset Management has historically been a fund of hedge funds, but they recognize credit famine that exists and may be growing in the lower middle market.

Furthermore, there is nearly $500 billion of dry powder sitting in private equity funds. This figure has grown from a mere $150 billion a decade ago. Additionally, private equity deal flow was about 50% in 2011 of what it was in 2007. Accoridng to Pitchbook, private equity 2006 vintage IRR was 13% on 2011 exits, meaning private equity returns were about 13% on investments made 5 years ago. The benchmark expectation is in the mid-20%’s. Worse still is capital waiting to be deployed.

Private equity operates in the “use-it-or-lose-it” world. Those firms have overhead which is typically covered by management fees. Any upside for the managers is created by return on investment. If they don’t get capital deployed soon, they could lose it.

Private equity may be forced to reach into the lower middle market to deploy capital, which will enhance company’s ability to find new credit or gain extensions. Of course the downside to owners is that equity is more expensive and puts more hands in the ownership honeypot.

The final possibility is the most expensive: mezzanine debt. Mezzanine (oft referred to as “mezz”) is between equity and debt. According to the 2011 Key Bank Mezzanine Debt Survey, mezz usually has a current coupon of 13%, with equity warrants or deferred interest costing an additional 3-5%. This debt is expensive, but compared bankruptcy, it may be the best bet for some companies.

In summary, there may be some reshuffling in the capital markets in years to come. Companies could find new relationships, while capital providers may be forced to look outside the realm of the usual client base to find deal flow.


2018-02-12T17:33:26+00:00 Capital Formation, Lower Middle Market|