With 2016 in the rear-view mirror, it is time to refresh our market outlook for what promises to be an intriguing year ahead. A relatively healthy US economy, recent evidence of generally improving corporate earnings and continued low default rates suggest that the US mid-market will offer compelling opportunities for astute sponsors, institutional investors and lenders in 2017.
But no forecast can ignore the uncertain economic impact of the “Trump effect” and how campaign promises will translate into action. This is particularly relevant to sponsors, which, in a recent survey, identified the state of the economy and sector-specific trends as the most important drivers of private equity deal flow in 2017.
Shifting sources of liquidity
It is apparent that there will be plenty of lending capacity for mid-market deals in 2017, but the sources will shift even further. Last year, the market share commanded by finance companies and other non-bank lenders grew to approximately 70 percent, an increase of 5 to 10 percent. This represents a continuing sea change, with banks’ share of mid-market lending dropping approximately 40 percent since 2013.
There have been rumblings about rolling back portions of The Dodd-Frank Act, including some of the leveraged lending guidance that curtailed bank lending. But it is far from a foregone conclusion that such a change will occur or will reverse the trend.
Regulatory change is not the only reason non-bank lenders have gained market share. They have also raised enough capital to underwrite large transactions that used to be the exclusive domain of banks, as well as to offer more popular and flexible forms of financing such as unitranche loans.
Today, non-bank lenders are firmly entrenched “go to” providers of sponsor financing and they will be difficult to dislodge. In fact, banks are likely to lose additional market share in 2017 given the extensive amounts of capital non-banks have raised and are ready to deploy. This should be particularly reassuring to institutional investors which have made long-term bets that the emergence of non-bank lenders is a truly secular trend, and are providing substantial amounts of capital for them to invest.
Stable terms and pricing
As we anticipated, the pendulum shifted in the first half of 2016, bringing improved loan pricing and more conservative terms, including tightened covenant packages, reduced “large market terms” and a dramatic drop in mid-market covenant-lite issuances. Since more immediate concerns about an economic downturn abated mid-year, the market has generally maintained its equilibrium.
We do not foresee material improvement in pricing and terms in 2017 from the lender standpoint given a fairly positive economic outlook and prevailing market liquidity. Rather, lenders may have to give up some ground, particularly on higher quality credits if deal flow declines.
That being said, many established lead lenders can be relied upon to maintain market discipline. These lenders know they will ultimately be judged on their ability to preserve capital and deliver attractive risk-adjusted returns in the long run, and that maintaining discipline is essential to weather economic cycles and consistently raise additional third-party capital.
Some sponsors may pursue more aggressive terms and lower pricing from new financing platforms that are impatient to deploy capital. However, most sponsors will continue to value predictable, rational financing partners and rely on proven lenders they have worked with for years.
The sponsor challenge: investing capital wisely
Equity sponsors enjoyed substantial success raising additional capital in 2016. Based on recent reports, they have over $800 billion in “dry powder” to invest. This suggests sponsors will be more focused on deploying capital in 2017 than raising new funds. We may see a repeat of 2016, with abundant equity driving intense competition among sponsors and strategic buyers for high quality acquisition targets, and fuelling elevated purchase price multiples.
Debt providers are expected to hold the line on leverage, so sponsors will continue to fund most of the purchase price increases with equity capital. This may place downward pressure on eventual returns to their investors if market multiples revert to more historical norms.
We expect to continue to see sponsors aggressively pursuing add-on acquisitions to support portfolio company growth. This approach lets sponsors average down initial investments with add-ons that command a lower multiple as a means to enhance returns on exit.
The popularity of this strategy means that lenders with sizeable existing portfolios are well positioned to generate significant incremental loan volume. Based on our 2016 experience, we predict almost half of 2017 transaction opportunities could come from portfolio-related add-ons. For investors, this further underscores the value of aligning themselves with well-established managers to deploy capital effectively.
Sectors in the spotlight
There is a decidedly more optimistic outlook heading into 2017 as investors are encouraged by the prospect of fiscal stimulus, tax relief and regulatory reform. Prevailing sentiment anticipates a more extended run for the current cycle.
We expect most sectors to have a green light, yet some industries may see a pause in investment. This is already becoming evident in healthcare and sectors/companies with a sizeable dependence on international trade, as sponsors take a “wait and see” approach to the policies of the Trump administration and Congress.
Several sectors are expected to remain particularly appealing, including technology and businesses that provide goods and services at moderate price points. Interest rate hikes may dampen returns slightly, but rates are still quite low by historical standards. Furthermore, increases will likely be tied to an expectation of growing revenues from a strengthening economy, which will be an effective counter-balance when it comes to investment activity.
The investor outlook: increased commitment to mid-market loans
Institutional investors demonstrated a growing commitment to US direct lending in 2016, including strategies focused on mid-market loans. Published information shows robust levels of fundraising despite the fact that not all transactions are publicly reported. We anticipate a continued upward trend line in 2017.
The rate of growth may eventually slow, but the fundamentals of investing in this asset class remain compelling. Why? The US economy is performing better than most developed countries and the expectation of rising interest rates will enhance the appeal of floating rate loans. Further, US mid-market funds consisting of a diversified portfolio of first-lien, senior-secured loans offer stability, current income, asset diversification and downside capital preservation that are attractive to domestic and foreign investors.
Investor interest might also be spurred by the growing visibility and availability of performance data. Investors which have made multiple mid-market loan investments and their advisors are increasingly able to use actual track records to evaluate performance.
Those considering follow-on investments will make additional commitments to managers that have proven their ability to consistently deploy capital and deliver targeted returns. As the space matures, we expect five to 10 managers to capture the lion’s share of capital invested in mid-market loans.
In conclusion, while 2017 definitely presents some uncertainties, our outlook is quite upbeat. We believe the new administration’s economic policies will largely support business growth. The market will offer a healthy supply of capital for US mid-market transactions. Prudent, disciplined sponsors, investors and lenders will continue to discover compelling opportunities.
Heath Fuller heads capital markets for NXT Capital’s Corporate Finance group, and Neil Rudd is NXT’s chief financial officer. A leading provider of structured financing to the mid-market, NXT Capital’s asset management platform offers proprietary access to floating-rate mid-market loans sourced nationally through its direct origination network. See www.nxtcapital.com.
This article is sponsored by NXT Capital. It appeared in the February 2017 issue of Private Debt Investor.