Private Lending in the Lower Middle-Market
By Brett Hickey, CEO
Regulations imposed on U.S. banks and other financial institutions following the 2008-09 financial crisis have increased the supply-demand imbalance for credit in the very large (nearly 200,000 U.S. companies) segment of the lower middle-market. This market segment consists of companies that generally have between $10 million and $150 million of annual revenue.
Banks have broadly retreated from providing cash flow and enterprise value-based loans to this segment, while the U.S. banking industry itself continues to consolidate. Many have neither the resources nor expertise to execute significant due diligence and transaction structuring, particularly for more complex transactions, such as financing acquisitions and management buyouts. Furthermore, it is often uneconomical for a traditional bank to focus on smaller loans, which require materially more labor to process, and where ancillary revenue from deposits, insurance brokerage, investment banking or wealth management is much harder to generate.
Instead, banks are generally focusing on larger loans that are far easier to underwrite, such as those collateralized by real estate or future receivables, or sponsored by large private equity firms (with whom they often do a lot of other business). Most of these smaller company loans are bespoke structured transactions in terms of length of loan, size of loan, amortization, cash interest rate, accrued interest rate (aka PIK), equity co-investment and warrants which can be attractive from an investor’s perspective but furthers the complexity and time consumption involved in these smaller loans.
Meanwhile, large alternative asset managers also tend to focus on larger investments where their capital can be more efficiently employed from a capital utilization perspective. Lower middle-market loans generally fall below their minimum investment thresholds and cannot be packaged into collateralized loan obligations (CLOs) or syndicates, which further reduces market efficiency and the base of investors willing to make these more labor intensive smaller loans, even though they can have a more attractive risk-reward profile.
The result? Credit is limited, particularly from investors who can provide value-added advice, resources and relationships to growing smaller companies. Accordingly, lenders willing and able to provide capital to this market segment can receive higher interest rates, obtain equity upside (often in the form of warrants), and have lower leverage ratios and stronger covenants that can result in lower default rates and higher recovery rates, in addition to the higher potential returns. Taken together, the attractive risk-adjusted returns possible from the lower middle-market makes the segment a compelling asset class for alternative lenders if one has the means to source, underwrite and manage these private investments.
The Banking Blues
There are more than 175,000 companies in the U.S. with between $10 million and $100 million in annual revenues, according to U.S. government statistics. Many require capital for growth initiatives, acquisitions and ownership transitions, yet heightened regulation of banks and specialty finance firms post-crisis means that precisely when a gradually accelerating economy is generating credit demand among these firms, there is a lack of available capital for them – particularly for those with under $15 million of EBITDA. In addition, data from Federal Financial Institutions Examination Council shows the consolidation in the banking industry has brought the number of banks from approximately 12,000 in 1990 to less than 6,000 in 2015.
In the meantime, the banks and traditional lenders that remain cannot efficiently provide capital to smaller companies because of the specialized resources required to source, underwrite and manage smaller loan exposures, as well as regulatory constraints which restrict extending loans to companies that fall outside of a traditional commercial lending matrix.
These conditions are structural, and will remain in place for the foreseeable future. Accordingly, the supply and demand imbalance for credit in the lower middle-market will also persist, allowing for transactions with more favorable pricing and better risk terms such as lower leverage levels, stringent covenant packages, and equity participation. The lower middle-market can therefore offer lenders a rich environment of well-managed businesses in need of credit and willing to participate in structures which offer attractive risk-adjusted returns for lenders.
Why do lower middle-market companies need credit?
We’ve found that companies in the lower middle-market need capital for organic and strategic reasons. On the organic side, they need credit to build and commission new manufacturing facilities, grow their sales forces, invest into new technology, and fund their working capital and inventory needs. Strategically, we’ve found firms also need credit in order to acquire a competitor, or finance the majority or minority investment of a new equity investor (in an internal transition or a change-of-control transaction). The post-World War II “Baby Boomer” population in the U.S. has millions of Americans nearing retirement each year and looking for someone to buy their business, be it a competitor, a private equity firm or a management buyout with employees –in all cases, creating additional demands for debt financing.
We’ve also found that the lower middle-market can demonstrate half as much leverage as the middle-market. While conventional wisdom holds that smaller companies are inherently riskier than larger companies, we feel the dramatically higher leverage levels prevalent among larger firms more than outweighs any benefits from size. Moody’s Analytics RiskCalc 4.0 U.S found in 2012 that all things being equal, leverage is the single biggest contributor to default risk, and more than four times (4x) more relevant than company size.
Another attractive element of lending to U.S. firms in the lower middle-market is the equity upside. It remains an integral part of many transactions, often through the use of warrants or attractively priced equity co-investments (often in the form of preferred equity which has some current yield and additional capital protection relative to subordinated common equity). Such positions are generally structured with strong downside protection and a lot of potential growth on the upside, and at valuations ranging from 5x to 8x of the trailing twelve months EBITDA. The lower middle-market environment today is somewhat reminiscent of the larger markets of the 1980s and 1990s, when lenders could receive double digit yields plus warrants on performing loans to high quality companies.
Despite attractive risk-return profiles, investors are sometimes skittish about the U.S. lower middle-market because of the difficulties inherent in sourcing high quality opportunities and scaling the business. It is much more labor intensive to invest in a small company than a large one throughout the life of an investment, from origination to exit.
Origination is inherently challenging, given that smaller companies are not well covered by investment banks and other service providers. Accordingly, while time consuming, maintaining a network of strong relationships with local accountants, lawyers, business brokers and the like can result in attractive opportunities. Star Mountain seeks to overcome the natural inefficiency associated with staying in front of so many service providers through our internal network, strong brand in the lower middle-market, and persistent reinforcement through local events across the country. In addition, although atypical among private debt fund managers, Star Mountain employs a full-time Chief Technology Officer to help keep us at the forefront of data analytics, social media, digital content relevant to business owners (such as through YouTube and live Webinars) and relationship management.
Underwriting smaller deals is also more labor intensive than larger ones, since smaller companies often have less management depth, thinner corporate infrastructure and weaker financial reporting systems. This difference is even more prevalent among deals that are not sponsored by private equity firms. The benefit being that with smaller deals, we are provided the luxury of doing a much deeper dive in due diligence, including site visits, meeting with management teams and speaking with customers, due to the less competitive and more partnership style approach to lending. While this “private equity style” due diligence approach is time consuming, Star Mountain believes it is what can lead to very low realized loss rates and compelling annualized unlevered returns from credit-focused investments.
Accordingly, since one puts much more effort into lending at smaller sizes, and, by nature only a limited amount of dollars can be put to work, the return on time can be unattractive unless you build a specialized business model to address the challenges and opportunities. Ask anyone if they would prefer to make ten loans at $5 million each or one loan at $50 million, and their answer will be clear (assuming the loan terms and risk profiles are equal). Although an investor has to do ten times the work to deploy that same $50 million in this example, in reality they’re getting paid more for lending at lower leverage.
The lower middle-market is also more likely to be made up of lending opportunities backing non-traditional sponsors. We see a rough split of about one third each, in terms of lending to funded sponsor-owned companies, independent sponsor-owned companies and non-sponsored companies owned by a family or entrepreneur. There are pros and cons associated with backing funded sponsor transactions versus opportunities in the other two segments – they are easier to source with a higher likelihood of closing, and they can take advantage of the professionalism, experience and due diligence prowess of a funded sponsor.
On the flip side, transactions with funded sponsor-owned companies tend be sourced through a much more efficient and competitive process. As professional financial operators, funded sponsors are typically quite efficient in sourcing the best possible terms from their lending sources.
The Bottom Line
The lower middle-market can provide superior risk-adjusted returns to alternative lenders, although there is a cost attached – the substantial labor necessary to do it the right way. Given the labor intensity involved, investors should proceed with caution and ensure that should they try to invest directly, they have the skills and resources to find, underwrite and manage these companies through the loan cycle, which can include a recession that many of us are still waiting for.
Note: Unless otherwise indicated, all information provided herein represents the opinion of Star Mountain and/or is based on Star Mountain’s research and/or Moody’s Analytics RiskCalc 4.0 U.S.
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