When there are fewer parties involved in a matter, privacy will benefit the relationship. We would not ask Romeo to divulge all his data on Juliet to the Capulet data collection company. The same may be true for private deals among non-sponsored borrowers and their mid-market credit providers.
We know little statistically about the terms of private transactions in the lower mid-market among non-sponsored borrowers, making it harder to provide a full-scale picture of how alternative lenders interact with smaller businesses.
“The mid-market is distinct because it is harder to get comprehensive data. That’s part of where the value lies and where experience is an advantage,” says Howard Levkowitz, co-founder of fund manager Tennenbaum Capital Partners. “Many transactions do not make it into datasets from the middle market. When we’re doing bilateral deals where we’re the only lender, we’re not reporting it to data collection services. There are a lot of firms in the same position.”
While data on lower mid-market transaction terms remain opaque, PDI gleaned insights from the broadly syndicated market for large speculative-grade borrowers. The most striking differences between sponsored and non-sponsored deals in this market lie in the yields produced.
Sponsored loans yielded 5.26 percent in 2017, a full 74 basis points higher than non-sponsored loans, according to LCD, an offering of S&P Global Market Intelligence. In the first half of 2018, that spread rose to 102 basis points. Sponsored deals are yielding 5.91 percent while non-sponsored transactions yield 4.89 percent.
Across 10 years, sponsored deals have enjoyed an average of 50 basis points in yield advantage over non-sponsored ones. This begs the question, why are sponsors paying more for credit in the syndicated markets?
“One of the reasons why sponsored deals have higher yields than non-sponsored deals has to do with credit rating, i.e. the sponsored data set has a much higher concentration of B-rated credits vs BB-rated credits,” says S&P director Marina Lukatsky.
“For example, in 2017, 87 percent of sponsored loan volume originated from borrowers rated B-, B or B+.”
“Another reason has to do with liquidity – non-sponsored deals are typically larger and hence, more liquid. Deals which are more liquid yield lower than those that are less liquid, all else being equal,” she notes.
Schwimmer explains: “To the extent sponsored deals are yielding more than syndicated non-sponsored transactions, it’s related to two issues. First, there are often different uses of proceeds. Corporate borrowers by definition don’t do LBOs. So, leverage isn’t pushed as far. Many of these deals tend to be for working capital, growth or acquisitions. There’s also less pressure to meet private equity-driven return requirements.”
Both sponsored and non-sponsored deal counts hit a 10-year high in 2017 with 748 deals and 522 deals, respectively. Based on the run-rate for 2018, sponsored and non-sponsored deals are each on pace to reach new highs in 2018 with 821 and 527 deals, respectively. The ratio of sponsored-to-non-sponsored deals in 2018 matches that of the prior year at around 60:40.
While more deals took place in the syndicated sponsored market, the value of those deals represented $300 billion in 2017 and is on pace to rise to a 10-year high of $369 billion in 2018, which is equivalent to $450 million per deal. In contrast, non-sponsored loan volume represented $350 billion in 2017 and is on pace to decline slightly to $327 billion in 2018, or to $620 million per deal.
Debt managers are finding plenty of incentive to hunt in the mid-market. It accounts for a third of private sector GDP and employs 47.9 million people. The proportion of mid-market companies that reported year-over-year revenue and employment growth stood at 77 percent and 55 percent in the first quarter of 2018, respectively, the highest since the National Center of the Middle Market began tracking these figures in 2012.
There are several telltale signs that competition is heating up among alternative lenders in the non-sponsored market. For one, credit managers face a flood of competition in the sponsored markets. Out of 200,000 businesses which encompass the US mid-market, maybe 7,000 of them are PE-backed. Brian Conway, chairman of private equity firm TA Associates, says: “Credit is very easy right now. Most of the 187 acquisitions that we’ve done [from 2010 to 2017] have been with no equity. A few of them have been done with equity, but I can count them on my hand.”
Sponsored-lending specialist Randy Schwimmer, who oversees origination at Churchill Asset Management, sees higher barriers-to-entry as a driving force for the non-sponsored market: “There’s a reputational barrier-to-entry that debt managers face in covering sophisticated private equity firms. In the non-sponsored space, that barrier may be lower with a borrower dialling for dollars. There are well over 500 PE firms in the US that own mid-market companies. We’re in active dialogue with at least half of them.”
Headcount investment represents another sign of the times. “We’re seeing more clients adding headcount in the non-sponsored space, as interest from credit managers has picked up,” says Gary Creem, a partner and credit specialist at law firm Proskauer.
Competition is also breeding innovative deal structures. Creem tells PDI: “Deals are getting harder to find in the face of competition. One interesting trend that we’re seeing is that more clients are incorporating structured equity in their deals. More clients are using holdco facilities and preferred equity investments as financing tools.”
These structured deals offer alternative credit providers yields that surpass traditional junior capital investments but stay below private equity returns.
Preferred equity, for example, is often issued to mimic the negotiated rate of fixed-income securities, though they have no stated maturity and get treated as equity for tax purposes. Investors give up on exit timing certainty and enforcement power to gain higher returns and favourable tax treatment. Moreover, dividend rates are often structured to step-up across time to incentivise the borrowers to redeem the security at a certain time or pay up.
One manager, who wishes to remain anonymous, believes investors need to educate themselves about the perils of non-sponsored lending.
“Understanding the risks you take on with senior debt yielding 10-12 percent, versus the 7-8 percent earned by traditional first-lien cash lenders, is critical,” the source said. “Investors don’t fully realise that the credit profile of the companies in the former category is very different. It may not seem that way now, but when we hit the next recession, that difference will become apparent.”
That same manager went on to explain how risk could seep into non-sponsored deals: “Our firm’s typical business risk checklist has 25 items we use to screen deals. For example, we look for companies that are less cyclical, with low regulatory risk, less commodity exposure, and without vendor or customer concentrations. If more than three or four items check yes, then we start to worry.”
Deutsche BDC analyst George Bahamondes believes credit providers need to be sure they can deploy their capital at attractive, risk-adjusted levels into a competitive environment: “There is plenty of lender capital available for the middle market as credit funds continue to sprout up. This is a borrowers’ market, so credit funds are competing on yields and loan terms to win mandates. Consequently, loan spreads have been pressured as [debt managers] compete for deals, especially in the sponsored market. While credit trends remain relatively benign, we’ll continue to monitor softer loan covenants and credit trends as we enter the later innings of the current cycle.”