Has mid-market lending put the worst of the pandemic behind it? The current evidence suggests that private debt’s most dynamic market is emerging from the downturn in an optimistic mood.
Here are three key trends that emerge from our 2021 Mid-Market Lending report.
The bounce back is on
The overwhelming message that comes through is of an asset class dusting itself off after a nasty scare. “Portfolios have performed remarkably well, overall, given the magnitude of the economic shock they have had to absorb,” says Jens Ernberg, co-head of private credit at Capital Dynamics. “A lot of that has had to do with the massive amounts of fiscal and monetary stimulus that has been injected into the market, supporting businesses and consumers and propping up the economy.”
From a dealflow perspective, 2021 is shaping up to be “on par” with 2018 and 2019, says Grant Haggard, senior partner at Twin Brook Capital Partners. “We saw a lot of companies that were likely positioned for a sale pre-pandemic and held off, so they are now coming to market and creating churn in lender portfolios,” he says.
His colleague Rich Christensen, also a senior partner, agrees: “It’s an active sale environment, and our pipeline remains robust. We are seeing opportunities across both existing portfolio companies and new platforms, so the outlook appears relatively good.”
Anthony Fobel, chief executive at Arcmont Asset Management, believes a disciplined approach to lending has helped. “There is far less exposure to travel, hospitality and other areas affected by covid than there is in the overall economy,” he says. “This is due to a selection bias at an individual asset level, as well as more thorough due diligence.”
Randy Schwimmer, Churchill Asset Management’s co-head of senior lending who oversees senior lending origination and capital markets, says the fact that private debt lenders have historically avoided the more cyclical industries – such as real estate, chemicals and energy – was a big help in this regard. “That defensive posture has helped us weather past business cycles successfully,” he says. “Because our portfolio had no covid-related defaults we were able to pivot back to new business opportunities from the middle of last year.”
But the real test may be yet to come
Pre-covid, there was much talk of how loose documentation and cov-lite loans could prove the undoing of the private debt industry. If anything, though, the pandemic has proved the relative stability of private debt’s lending base.
“Private credit has benefitted from stable, patient capital structures and strong governance and support from private equity sponsors,” says David Ross, head of private credit at Northleaf Capital Partners. “This led to lower-than-projected default rates and ample liquidity through the covid-induced economic shutdown.”
That does not mean that mid-market lenders are taking recovery for granted. “It is important to remember that this crisis isn’t over yet,” says Jon Bock, chief financial officer of Barings BDC. “I think portfolio composition will continue to be a big differentiator going forward, even though the asset class as a whole has proven itself during this challenging time.”
There are signs of tension too in the sponsored lending market. “The biggest change was the shrinking of the number of go-to arrangers sponsors tapped to lead deals in the second half of 2020,” says Churchill Asset Management’s Schwimmer. “Some of that related to covid’s impact on some lender portfolios. Managers with troubled credits hit the risk ‘off’ switch. We saw only a handful of competitors around processes.”
“Healthcare is a trend at the moment, whether healthcare direct lending or healthcare structured credit”
Deal competition is also heating up. “In the private equity-backed market, spreads have gone back to pre-covid levels – or worse,” says MGG Investment Group managing director Daniel Leger. “And while there was a brief window last summer when covenants got tighter, that has now passed.
“There is a bidding war for every loan, resulting in borrower-friendly terms, with lenders relying on nothing but a sanitised due diligence report from the private equity firm. But in the non-sponsored, lower mid-market, leverage levels are lower and risk is still being appropriately priced.”
Don’t ignore the niche
Another mid-market lesson from the pandemic is the importance of specialisation. Capital providers such as Northleaf say more esoteric areas – including legal or healthcare financing – benefit in a downturn from being less susceptible to macro trends.
“The traditional banking system and capital markets are less receptive to lending to niche segments of specialty finance, which creates a compelling opportunity,” says Northleaf managing director Michael Morris. “Investors are increasingly drawn to this market due to strong risk-adjusted returns, high cash yields and the less correlated nature of the underlying investments as compared to the broader economic environment. These assets also offer attractive diversification.”
It is a similar story in European direct lending, which a recent study from Oxford University’s Saïd Business School suggests could be bigger than its US counterpart within a decade. Growth in Europe is bringing opportunity but crowding out the market. “Direct lending, more so than anything else, is congested,” says Tavneet Bakshi, partner and head of EMEA at placement agents FirstAvenue. “It’s not just difficult for newcomers, it’s also very difficult for established platforms as well if they are looking to broaden their investor network. Even the big brands are finding it a challenge.”
The secret, say market participants, involves targeting niche areas where it is easier to stand out from the crowd. One particularly popular way is to target smaller loans – “an underserved part of the market with better structural protections and better risk-return dynamics,” says Jeffrey Griffiths, co-head of global private credit at Campbell Lutyens.
It also involves homing in on specific sectors. “Healthcare is a trend at the moment, whether healthcare direct lending or healthcare structured credit,” says Bakshi. “That resonates with US LPs in particular, who are more comfortable taking a sector-focused approach, whereas in Europe there’s still a preference for more diversified exposure.”