Twin Brook Capital Partners on the shift in the US mid-market

Despite macroeconomic headwinds and the rising cost of capital, transaction activity looks set to pick up in the second half of 2023, says Sarah Roche, head of capital markets and managing director at Twin Brook Capital Partners.

This article is sponsored by Twin Brook Capital Partners

Sarah Roche, Twin Brook Capital Partners

Reflecting on last year, what were some of the key themes coming out of 2022?

M&A picked up coming out of the pandemic-related disruption of 2020, and that elevated pace of activity persisted until Q2 of last year. With rising inflation, geopolitical issues, and a recession on the horizon, we saw lenders begin to pull back around April 2022.

When that shift occurred, many banks had large underwrites in the market that they were unable to syndicate. That dynamic and the balance sheet risk that came with it caused banks to pull back, creating an opportunity for direct lenders to take market share. At Twin Brook, we saw deal activity continue at a significant clip, issuing roughly $9 billion in gross commitments in 2022 – a record year for the team.

In the back half of 2022, market headwinds including rising interest rates, elevated inflation, softer company performance, and a slower fundraising pace led to a drop in lenders’ risk tolerance and hold sizes, resulting in lower leverage and increased pricing across the board. Lenders became increasingly selective, causing the market to shift in their favour – a departure from recent years, where a backdrop of consistently positive market tailwinds had created a more borrower-friendly environment.

How would you describe the state of the market in early 2023?

The start of 2023 brought lenders renewed budgets, but it didn’t change the fact that the fundraising environment generally is more challenging, companies are facing pressure on cost structures, and the cost of capital continues to rise. Overall, companies are more limited in the amount of debt they can take on and service.

Leverage has pulled back a half to a full turn, and there is a scarcity that has continued to increase the cost of capital on top of rising interest rates. Spreads have increased at least 50 basis points, and we’ve heard that investment banks are generally advising borrowers against coming to market unless their businesses are truly non-cyclical and able to withstand these pressures. In this environment, add-ons and transaction activity driven by lenders’ existing portfolios has been key; Twin Brook has a sizeable portfolio of 240 companies, and similar to peers, we’ve seen add-ons outpace new deals thus far in Q1 2023.

How have lenders been responding to these macro headwinds? Have the impacts varied across market segments?

It is important to note that we believe the lower mid-market – which is where Twin Brook operates – tends to be less volatile compared to the upper middle and broadly syndicated loan (BSL) markets, primarily because of its buy-and-hold nature. We’ve observed that the BSL market is quicker to shut down in the face of disruption, as witnessed last year.

That BSL market shut down created an opportunity for direct lenders to step in and provide financing solutions for PE sponsors and their portfolio companies, which led some lenders to change their strategies and move up-market last year. For lenders not established in the lower mid-market – which can be challenging to new entrants, given its relationship-orientated and less commoditised nature – this was likely an attractive prospect, albeit a temporary one.

In the face of macro headwinds, we’ve seen lenders in the upper mid-market start to become more conservative, now pushing for the covenants and lender protections that have long been prevalent in the lower market.

Generally, how are lower mid-market companies faring in this environment?

Not all businesses are experiencing the same impact. Businesses that benefit from well-defined value propositions, clear reasons to exist, knowledgeable management teams, and private equity backing have generally been able to weather the challenges of the last few quarters, as many were able to pass through price increases and preserve margins.

Meanwhile, businesses that are more commodity-based are typically experiencing the most pricing and margin pressure.

Regardless of the quality of the business, borrowers are facing an honesty test around EBITDA adjustments. Plenty of good businesses came into this environment over-levered, as they had historically secured financing based on inflated EBITDA levels that had been adjusted for overly optimistic revenue projections or one-time addbacks. Now, some of those companies are having difficulty generating sufficient cashflow to cover their existing debt, forcing PE groups and lenders to take a more critical approach to what true cash EBITDA looks like.

What challenges and opportunities do you see emerging in the immediate and medium-term as a result of the macro issues at play?

Given the uncertainty plaguing the market, we’ve observed that scaled, experienced lenders with capital markets depth are generally seeing more pipeline volume and opportunities to differentiate themselves. PE firms are seeking agents that can provide certainty of execution when forming a lending group, putting lenders that have strong origination capabilities and track records of serving in lead roles at an advantage.

From a lender perspective, being a consistent, reliable partner to borrowers and PE sponsors should be the focus right now. In this environment, we believe having the appropriate human capital and infrastructure to weather a storm will be more important than ever, and that will ultimately support such lenders’ abilities to further deepen client relationships and win dealflow moving forward.

In this environment, what are the key factors currently driving manager differentiation in the direct lending space?

The credit market has been relatively benign over much of the last decade, and that has made it difficult to suss out manager differentiation; it has been easier to succeed in a high-growth environment. As mentioned before, we believe being a platform of scale and having the appropriate infrastructure and resources already in place, ahead of a downturn, will be key differentiators for lenders. We saw this play out following the GFC and eruption of the pandemic, and we expect it to be reinforced moving ahead in the current environment: deeply experienced direct lenders with proven track records of navigating past market cycles typically benefit from uncertainty in the credit markets, as they often gain market share in periods of disruption.

Looking to Twin Brook, specifically, we believe we are well-positioned to differentiate ourselves in this environment. We have a proactive approach to originations and portfolio management. We’ve been the lead arranger on 97 percent of the deals in our current portfolio and hold the revolver on all of our credits, which provides for a direct line of communication with company management teams and more timely insight on business performance. Additionally, we typically have two covenants in our deals, which we believe positions us well in the event of any issues, as we’re able to work with our PE clients and borrowers to find solutions before there is impairment to a company’s enterprise value.

What is your outlook for the mid-market in 2023?

Through at least the first half of this year, we expect new deal activity to remain depressed and believe most dealflow will continue to be driven by add-ons in lenders’ existing portfolios. Looking to the latter half of the year, the macro environment will certainly impact what transpires, but we expect the pent-up supply of companies waiting to come to market coupled with the tremendous amount of PE dry powder and need for those firms to make realisations could lead to a pick-up in transaction activity.