The lending landscape for middle market companies is changing rapidly, offer considerable opportunities and challenges alike for borrowers and their executive teams.
In recent years private credit — credit that is extended or held by lenders other than banks — has exploded across the globe, but particularly in the United States. Experienced asset managers have raised progressively larger funds, seeking to address unmet borrower needs.
That need has arisen as traditional bank lenders have de-risked their underwriting activities and retrenched to serve only a fraction of the market they were actively pursuing as recently as 10 years ago.
Today, even modestly sized middle market companies, whether owned by a financial sponsor or not, have the potential to access capital in larger amounts than ever before.
For CFOs, however, the growth in private credit is not a story of unmitigated upside. Rather, it presents many challenges:
Intensity of Process: As incumbent lenders retrench and unfamiliar players enter the field, middle market companies seeking financing are increasingly met with a market that is unrecognizable to them. The result is that it has become increasingly common to retain investment banking advisers for sourcing debt financing for ever-smaller transactions.
A talented in-house finance team once could manage a $25 million financing. Now, the sheer number of capital providers and the varying terms for their financing offering beg an approach that is similar in intensity to an M&A process. As a result of this shift, CFOs must now prepare their companies for longer and more intensive capital sourcing processes, as well as the costs associated with them.
Rising Cost of Capital: Since the global financial crisis a decade ago, banks, especially those in the U.S., have rigorously reevaluated their lending activities. With the costs of compliance up, banks have quietly become ever-more conservative in their approach to the middle market. They’ve steadily increased the minimum size of loans they are willing to pursue and ceded the market to more aggressive private credit players (many of whom receive financing from banks).
The result is that middle market companies are seeing a steady exit of the lowest-cost capital and can expect to see their cost of capital increase over time.
Loan Structures: One facet of the current market is flying under the radar: the preference of many private credit funds for term loans, which hold implications for the middle market.
Experienced middle market CFOs understand that for many companies with EBITDA below $50 million (especially in the U.S.), the single most important aspect of their capital structure is their revolving line of credit.
A secular market shift away from revolvers and toward term loans, with their scheduled amortization of principle or an excess cash flow sweep, will fundamentally alter the cash flow prospects of many companies and may very well force a rethinking of optimal capital structures.
Reporting: Although it can now be fairly stated that debt financing is available to middle market companies across the risk spectrum, the expectations of the diverse capital providers that cover that spectrum will not necessarily be similar.
Bank lenders may seek little more than standard reporting packages monthly or even quarterly. However, many private credit funds will seek board representation and insist on a level of reporting and management access nearly on par with what one might expect from a private equity firm (i.e., an owner).
Optimizing the Capital Structure
The net result of the above challenges is that middle market CFOs must devote increasing time and attention to their capital structure.
The returns from an optimal capital structure are significant, as they can allow companies the strategic flexibility to proactively seize on acquisition, investment, or organic expansion opportunities.
For CFOs seeking to optimize their capital structure, the first priority is to assess their company’s strategic positioning and how well aligns with anticipated capital needs.
While there are many variations, outside lenders will tend to bucket financing opportunities into one of three categories (see Exhibit A). CFOs must be equally prepared to defend their financial forecasts and strategic plan from rigorous inquiry by prospective capital providers and to explain such providers’ mindset to their CEO and board of directors.
Exhibit A: Key Financing Theses
|Growth||Additional capital needed to seize a growth opportunity.||Prospective lenders will be seeking objective market data supporting a growth opportunity and a clear and compelling strategic plan to capitalize on that opportunity.|
|Refinancing||Replacement of incumbent lender(s) with new capital provider(s); little to no change in underlying capital structure.||Focus on collateral, forecast, and key covenants.|
|Purchase||Financing to support a private equity, independent sponsor, or management buyout transaction.||Scrutiny of post-transaction capital structure, buyers’ background, and soundness of plan.|
The Private Credit Market
While the private credit market continues to grow and change, a few key findings from a recent industry report can help shape the thinking of proactive CFOs:
- Private credit strategies globally are forecast to total $1 trillion under management by 2020.
- The private credit market is largely composed of experienced lenders, with 45% of managers having more than 10 years of experience in private credit
- More than 40% of private credit managers are actively lending to companies with EBITDA of less than $25 million.
Today’s middle market CFOs have numerous options when seeking debt financing. However, in the increasingly dynamic middle market lending landscape, it is vital to proceed with caution.
The rise in private credit has yielded an explosion of financing options, but as new players enter the market, many incumbents are pulling back. In these changing times, nothing should be taken for granted, and unpleasant surprises related to intensity of the process, cost of capital, loan structures, and reporting await the unprepared.
On a positive note, there is now a great deal of capital ready to support compelling theses. Proactive CFOs have the opportunity to lay the groundwork for sustained value creation by optimizing their company’s capital structures.
David Johnson is founder and managing partner of Abraxas Group, a boutique advisory firm providing transformational leadership to middle market companies in transition. Contact him at [email protected].