IFR 03.7.2020

70 International Financing Review March 7 2020

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Lower middle-market strategies flourish

amid private credit boom

„ US Loans have less leverage and come with higher interest rates

Lending to companies with just a few million

dollars in earnings is gaining greater interest

from investors seeking higher yields and

better protections as the private credit

market grows increasingly segmented and

sophisticated.

Firms are looking to raise funds to target

companies in the lower middle market, or

companies with an Ebitda of less than US$15m,

including Deerpath Capital Management,

which wants to raise US$1bn for its lower

middle-market fund, and PineBridge

Investments, which announced it has US$596m

to invest. At the same time, Main Street Capital

Corp said it is continuing to seek opportunities in

this segment.

Lower middle-market loans have less leverage

and come with higher interest rates to reflect the

heightened risk and limited liquidity of smaller

businesses compared with those in the core

middle market.

Direct lenders have flourished in the last

decade by tapping into the core middle

market, or companies with US$15m to

US$50m in Ebitda. It’s an area that some

banks have been hesitant to lend to, allowing

these financing providers to offer private equity

sponsors with extra leverage and flexibility at a

premium.

But the growing size and sophistication of

funds, as well as heightened competition, have

weakened terms for loans made to companies

with larger earnings.

Private credit firms attempting to win deals in

this segment have increasingly come to accept

lower spreads. In the fourth quarter of 2019,

interest rates on unitranche loans, which are an

indicator of the pricing pressure in the middle

market, hit a historic low of 578bp, according to

data from Refinitiv LPC.

Unitranches combine both senior and junior

debt into a single tranche and are traditionally

provided by non-bank lenders across the

segment.

To deploy capital more efficiently, private

credit firms have had to look at the upper and

lower ends of the space.

SLIDING SCALES

The lower middle market is a haven for many

smaller direct lenders and investors seeking

better documentation terms. With competition

less intense, many of these loans can offer better

lender protections.

“There are stricter underwriting standards

in the lower middle market – the level of

competition is a key factor, and you see less of

it in this space,” said Tas Hasan, a partner at

Deerpath.

Lower middle-market deals, for example,

distinguish themselves from the upper segments

because they still include a fixed-charge

coverage ratio and capital expenditure limit.

In deals with companies that have Ebitda

of less than US$15m, 33% of transactions

have a fixed-charge coverage ratio and capital

expenditure limit, according to a report from law

firm Proskauer. But higher up, these protections

become less frequent.

In deals involving companies recording

Ebitda of US$30m or above there are no capital

expenditure restrictions, Proskauer data show.

“Deals involving companies with an average

Ebitda of a US$10m–$15m all have the

leveraged covenant, fixed-charge coverage, and

capex restrictions,” said Tom Hall, managing

director and co-head of private credit at asset

manager Capital Dynamics.

“After that, it becomes a sliding scale, and lenders

become comfortable with just a leverage covenant,

and that gets looser at the upper end of the middle

market. As companies grow above US$30m-plus

cashflow, the market has decided that covenants

have become less important,” he added.

BUILD AND GROW

The lower middle market is not as penetrated

by private equity sponsors as the core middle

market, hence banks continue to flourish in a

segment where borrowers seek lower leverage

and are more comfortable with lower pricing.

For some financial sponsors, however,

buying into the lower middle market can be

part of a long-term plan to expand a business

aggressively through add-on acquisitions.

These cases work for private credit firms,

which are keen to offer higher pricing in

exchange for the flexibility desired by

sponsors and are happy to deploy capital

in a growing business through delayed-

draw term facilities. Private credit firms

also need the extra yield compared with

banks to compensate for the higher capital

costs.

“Private equity funds embarking on

systematic growth through acquisitions is a

great strategy for a private credit fund,” Hasan

said. “We’re happy to support bolt-ons and to

fund acquisitions.”

For private credit funds at the lower end of

the market, investing further capital in a single

company can heighten the risk for funds, which

are much smaller than core middle-market

funds.

Saratoga Investment Corp, a lower middle-

market lender, had investments in ice rental

company Easy Ice and inventory management

software company Censis, and added to

its position over multiple years. This raised

concentration issues for the firm – though it

reported exiting both positions in its recent

earnings call in January.

Saratoga could not be reached for comment.

Michael Grisius, chief investment officer at

Saratoga, said in the firm’s January earnings

call that it wants to remain focused on the lower

middle market.

“We have concentration limits related to

industries and portfolio company position size

as it’s important to maintain diversity – taking

an outsized position can negatively impact the

portfolio down the line,” Hasan said.

But the smaller nature of the companies

can mean they are a riskier proposition with

alternative capital solutions limited; and they

are more vulnerable to broader macro-economic

factors.

“If you have a US$10m Ebitda company and

that loses US$1.5m in Ebitda, then that can be

scary,” said Ted Swimmer, head of corporate

finance and capital markets at Citizens Bank.

David Brooke

9 IFR Loans 2323 p 63 - 76 .indd 70 06 / 03 / 2020 19 : 19 : 51