By Antonella Napolitano
When Deerpath was formed back in 2007 with the purpose of investing in privately negotiated senior loans to companies in the US lower middle market, direct lending was considered a new and niche asset class for investors. While the U.S. private equity market had been well established, even within the lower end of the middle market (companies sized between $5 million and $15 million of EBITDA), these buyouts were financed using a combination of senior bank debt and subordinated debt, funded by mostly mezzanine players. At that time, you would not see a dedicated allocation to direct lending in any large institutional investor’s portfolio. Times have changed.
After the 2008 financial crisis, commercial banks reduced their capacity to originate and hold large amounts of leveraged loans to middle market companies due to new stringent regulations imposed on them. Out of this arose an immense opportunity for private direct lenders who were keen to provide financing to support companies and not burdened by the same regulatory constraints in the post-financial crisis investment world.
Direct lending had emerged as the perfect “fix” to fill the void in the loan market.
Investors viewed the direct lending market as an attractive asset class which generated solid risk adjusted returns with high and predicable current income and lower volatility compared to other similar fixed income alternatives.
Over time, competition in the direct lending market intensified as managers amassed larger and larger amounts of capital to deploy predominantly within the “core” middle market (companies with EBITDA over $15 million). What was the result and how are investors being affected?
As private equity sponsors are being forced to pay all-time high valuations to buy companies, they are, in turn, asking their lenders to stretch on leverage (more risk!) but also to reduce pricing (less return!).
The so-called “Race to the Bottom” is now in full effect.
The current direct lending market is showing very clear signs of investment discipline deterioration:
- Senior “stretch” structures – meaningful exposure to second lien, “last-out”, etc.;
- Elevated leverage levels –5.5x or more senior debt/EBITDA, which includes aggressive EBITDA addbacks masking what are likely even higher leverage levels!;
- Weak covenants – “covenant light” or wide margins against covenants, making the value of covenants pretty worthless; and
- “Accordion” draw features, allowing the borrower to draw more money without lender permission.
Worse, despite the added risk, yields are being squeezed. The core middle market has become a 6.0%-6.5% yielding market. But, investors are shrewd!
They no longer look at the pure play US direct lending market as one harmonized market, but as separate and distinct markets with different opportunity sets. Many investors are now looking to the lower end of the middle market to invest, where there is reduced competition, lower leverage multiples and more substantial loan protections compared to the larger loan market. What is the opportunity size at the lower end of the middle market?
In the US, the lower end of the private equity middle market is large and well-established with a large need for senior debt financing. Each year sees around 900 private equity deals with approximately $30 billion of enterprise value, requiring approximately $15 billion senior debt financing. For lenders in this market, there is a far more attractive balance of supply and demand.
Lenders is this market can compete effectively in a much less crowded market segment that offers attractive economics and superior structural protections that aren’t available in other segments of the middle market that are over-stretched by excessive competition (higher pricing, lower leverage levels and a full set of covenants).
Many investors fear that we are at the end of the credit cycle and a recession, whether big or small, is in the not-so-distant future. We agree.
We believe that during the next economic downturn, there will be a clear distinction between lenders who played it safe during the more prosperous times and have a portfolio of “true” senior loans in high-quality businesses, with conservative credit metrics and a full set of protections, versus those who over-stretched in pursuit of yield. Lenders that hold their standards high on credit quality will be well positioned when the credit cycle turns.
This article was originally published as part of Lido Consulting’s Summer 2019 newsletter.
Managing Director Global Head of Investor Relations & Business Development Deerpath Capital Management, LP
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