MGG: What’s changed and what hasn’t in US mid-market lending

For all the upheaval caused by the pandemic, some things in the US lower mid-market just stay the same, say Daniel Leger and Gregory Racz of MGG Investment Group.

Daniel Leger and Gregory Racz

This article is sponsored by MGG Investment Group

The impact of the covid-19 pandemic on private lending to the US mid-market has been at once profound and almost imperceptible. While the initial reaction of the credit markets to the economic turmoil of early 2020 was predictable – widening spreads, increased demand for stricter covenants and a general retrenchment by lenders more concerned with the balance sheets of their existing borrowers than making new loans – the credit markets, both public and private, snapped back quickly.

A year into this health and economic crisis, however, so much has changed in our daily and work lives. Businesses have been disrupted and many industries have been reshaped forever, while the economy and how we work and travel are likely to be different for many years to come. Here’s a short selection of the things which have changed in the US lower mid-market and those that remain resolutely unaltered.

What has changed

The ‘caste system for credit’: In the post-covid economy, the line between winners and losers cuts across not just different sectors and industries but also the public and private markets as a result of the government’s unprecedented response to this recession. By providing a backstop to the liquid public credit markets, privately held businesses have seen their cost of borrowing rise while many highly levered, failing businesses that just happen to be publicly traded have had access to an abundance of capital. In a December article in the Financial Times entitled “America’s two-track economy: the small business credit crunch”, this divide was described as a “caste system for credit… significant, because its basis is entirely a function of size, not quality.” The implications for the underserved lower mid-market are profound.

Creative destruction – an American virtue: While the human cost of the covid pandemic has been extremely high, from the depth of this destruction, the American economy
re-engineered itself more quickly and more dynamically than any other. Nowhere is this more evident than in the US lower mid-market.

Providers of debt and equity capital to privately held businesses in the lower mid-market are able to address an urgent, current need – to provide growth capital to profitable businesses that are rapidly adapting in order to address changing consumer and business purchasing patterns shaped by the pandemic. By offering creative and comprehensive financial solutions to lower mid-market businesses, an investor can generate compelling risk-adjusted returns in a much less crowded field.

Impact investing: With a new administration in Washington, the focus has returned anew to how businesses can positively impact environmental, social and governance objectives globally. While private lenders may not possess the control that comes with equity ownership, the ability of lenders to make meaningful contributions should not be underestimated.

“The American economy re-engineered itself more quickly and more dynamically than any other”

Through a deliberate focus on the types of businesses that make meaningful contributions to a more sustainable future – from reducing the world’s reliance on hydrocarbons to a focus on businesses owned and operated by minorities and women – private lenders and investors in the US lower mid-market can have an outsized impact that goes beyond a simple return on investment without having to sacrifice high returns. After all, much of the action in ESG is taking place within the US lower mid-market as it consists of newer, growing businesses that can address the larger environmental and social objectives in creative and concrete ways by applying novel solutions and technologies.

The time is now: Private lending has never been more critical to lower mid-market businesses than it is today, nor has the investment opportunity been as favourable since the global financial crisis. In a recent Preqin special report, the highest return vintages for private debt have been concurrent with recessions. The cost of capital has increased and spreads remain above what was experienced pre-covid. Furthermore, the creative destruction of the US economy is on most vivid display in the lower mid-market. Direct lenders and investors that have historically focused on this segment of the market are in a privileged position today to generate above-average risk-adjusted returns for the foreseeable future.

What remains the same

Banks are still not lending to mid-market businesses: Nothing in the government’s response to the pandemic has altered this dynamic. The more than 30-year retrenchment of US banks from private lending shows no sign of reversing and a meaningful loosening of Dodd-Frank rules appears a distant prospect.

Conservative underwriting and covenants matter – in good times and in bad: In the years prior to covid, the majority of leveraged loans made were so-called ‘cov-lite’, coupon-lite, collateral-lite or a combination of all three. The pandemic exposed the hidden costs of these watered-down provisions.

No matter where a lender finds itself in the business cycle, conducting primary due diligence, demonstrating a healthy level of scepticism about management projections and setting tight covenants matter. Tight covenants transfer power and influence to the lender – power and influence that is needed as much when times are flush (keep management focused and on target) as when times are tight (direct any restructuring and get paid for increased risk).

The search for yield: With already low yields lower still as a result of the pandemic, pension, insurance and countless other investors must accelerate their search for yield. While 2020 saw a decline in the amount of capital going to private lenders, inflows have picked up recently and 2021 looks to be on pace for another record year. Most of this capital will go to large GPs lending to sponsor-backed firms, thus compressing spreads to borrowers – just as it did pre-covid.

Leverage cuts both ways: In an era of low interest rates and modest inflation, leverage is an important tool for magnifying returns to meet the obligations of the world’s largest investors.

What goes up must come down, however. Every market cycle begins with hope and euphoria but all cycles come to an end. And the math is unassailable: returns magnified by leverage in bull markets can crash when experiencing sudden shocks to the system as many private lenders experienced in the first and second quarters of 2020. No one rings a bell to tell investors when those shocks will arrive, so it is always best to invest conservatively with downside protection structured into every loan or investment.

As investors look to add capital to their private lending portfolios, or for investors looking to invest in the sector for the first time, the underserved non-sponsor, US lower mid-market offers compelling risk-adjusted returns. Furthermore, as the pace of the recovery accelerates, it is in the lower mid-market where the creative forces of the US economy will be most visible following the destruction wrought by the pandemic.