Successfully Entering the Middle Market
Understanding the Risks, and Maximizing the Opportunities
Date June 2013
Featured in The Secured Lender
With conditions in the U.S. credit markets improving and competition for large cap deals continuing to heat up, many existing lenders and new entrants in the industry are turning their attention to the middle market in hopes of identifying attractive new opportunities to deploy capital. In addition, a range of long-term regulatory and secular trends indicate that non-traditional sources of financing are well-positioned to capitalize on growth opportunities in the middle market over the foreseeable future. These trends include, among others, a wide acceptance by borrowers to seek direct lending partners to meet their financing needs.
While the broad environment certainly looks appealing on multiple levels, lenders considering expanding their presence in the middle markets would be well-served to take a step back and better understand some of the key risks, as well as unique opportunities that are inherent to this sector.
As our experience in this area has repeatedly demonstrated, a lender’s ability to appreciate and plan for these factors over the long term frequently represents the difference between establishing a successful presence in the middle markets and a frustrating – and costly – exit.
Risk Considerations for Lenders and Borrowers
For lenders targeting a successful foray into the middle markets – here defined as borrowers with less than $50 million in annual earnings before interest, taxes, depreciation and amortization (EBITDA) – the first step is to understand the challenges and risk considerations that such borrowers typically face:
- Limited Access to Capital. Would-be middle-market borrowers traditionally struggle with relatively limited access to capital when compared with large-market borrowers, who are able to partner with a broad spectrum of bank-based lenders. Larger companies typically have the ability to raise capital through the public markets as well, while mid-sized companies have fewer, if any, options in this arena.
- Unpredictable Banking Relationships. Middle-market borrowers also tend to encounter more volatility in their relationships with traditional banks when compared to larger companies. Traditional lending institutions are typically slower to lend to middle-market enterprises and quicker to withdraw from this market segment at early signs of economic instability, as seen in 2008 and 2009.
- Greater Vulnerability to Cyclical Downturns. This heightened caution on the part of traditional lending institutions reflects the fact that middle-market enterprises tend to be more susceptible to cyclical downturns than their larger counterparts. Factors contributing to this susceptibility frequently include a higher degree of customer concentration risk, a lack of diversification across geographic markets or fewer sources of alternative revenue streams.
- Less Sophisticated Financial Reporting and Monitoring Structures. Frequently, middle-market borrowers have not reached a point in their organizational development where financial reporting and monitoring capabilities have fully matured, which can create a lack of transparency from a lender’s perspective.
In many cases, these issues are symptomatic of the continued growth and expansion potential that companies at the middle-market phase may have and should not be viewed as “deal breakers” for lenders in this sector.
The upshot of the difficulties for borrowers outlined above is that middle-market lenders must take a disciplined approach to deploying capital in the segment. Unfortunately, many lenders in this space fall victim to several of the following pitfalls:
- Temptation to Compete on Covenants or Credit Quality Rather Than Price. Many middle-market lenders and nontraditional financing sources focus on generating strong absolute returns for their investors, rather than gauging performance against a benchmark. Lenders in this position can be tempted into relaxing covenant or credit quality discipline in pursuing outsized returns or market share in the middle-market arena, particularly when the general financial environment becomes “frothy.”
During periods of heightened deal competition among lenders in the large cap space, this dynamic can be further exacerbated when middle-market companies attempt to push lenders into extending “copycat” terms based on favorable lending arrangements being secured by much larger borrowers. Such deals generally fail to work out for either the lender or the borrower.
- Managing Against a Greater Degree of Illiquidity. Additionally, lenders interested in entering the middle market must be prepared for a greater degree of illiquidity than in other segments of the lending industry. A vast majority of middle-market loans cannot be securitized or sold off – meaning that lenders to middle-market enterprises must be prepared to maintain and manage the loan through the end of its term.
- Insufficient Loan Structuring and Industry Due Diligence In middle markets, loan structuring and industry due diligence are more important than ever. Before providing any funds to borrowers, lenders must have already developed thorough expertise in the borrower’s industry and a strong understanding of the sustainability of the borrower’s cash flows across various economic cycles, as well as a clear view on the actual Net Orderly Liquidation Value (NOLV) of all collaterallized assets.
Middle Market Lenders Enjoy Potential Enhanced Upside Opportunities
In spite of the challenges outlined above, the long-term opportunities available to disciplined and determined lenders in the middle markets are substantial. Lenders with the requisite focus and ability to remain committed through every phase of the lending cycle will be able to capitalize on the following:
- Enhanced Pricing Power. With fewer established competitors and inconsistent market involvement on the part of traditional financing sources, middle-market lending can present enhanced pricing power for lenders with a long-term commitment to the sector. Middle-market companies that are hungry for capital tend to be attuned to the fact that, under ordinary market conditions, the lending terms available to larger companies – where competition is fierce, the market is crowded and capital is cheap – are simply not extended to mid-sized companies. With this in mind, middle-market borrowers are often more amenable to structuring lending agreements on mutually favorable terms with lenders that are committed to their growth and success.
At the same time, while middle-market lenders’ focus on absolute returns can mean that some will be tempted to relax covenant discipline, it also leads to generally more stable pricing conditions for those capital sources able to establish a long-term presence in this segment.
- Favorable Loan Structures and Monitoring Provisions. The same dynamic also gives lenders in the middle-market space the opportunity to secure more favorable loan structures, including more balanced covenant protection. As another form of protection, strong middle-market lenders may also be able to secure direct and recurring access to borrowers’ management teams, boards of directors and systems, enabling them to identify any potential problems early and work with borrowers to devise solutions before the lender’s capital is jeopardized.
- Asymmetrical Information in the Market Leading to Strong Niche Opportunities. The relative lack of transparency among middle-market companies in comparison to their larger counterparts (many of whom are public companies) presents both risks and opportunities for lenders. Lenders with particular experience in and strong understanding of various segments within the middle markets may be able to identify strong borrowing candidates – taking into account factors such as the company’s growth prospects, market position, cash flow quality and/or underlying collateral value of assets securing the loan – that larger lenders or even competitors within the middle-market space might dismiss or overlook.
How Lenders Can Position Themselves to Succeed
Lending to middle-market companies requires a particular skill set and a keen awareness of the unique challenges and demands inherent to the market. As a long-established provider of capital to middle-market borrowers, we would urge new market entrants and other lenders seeking to expand their presence in this market to consider the following:
- Ability to Adapt to Market Conditions. The opportunities available to lenders in the middle market – as well as the challenges they confront – tend to shift over time, both within the context of the broader market environment and the circumstances of individual borrowers. Various stages of the credit cycle may take lenders from funding widespread acquisition activity – both on the part of operating companies and private equity buyers – in one year to significant restructuring activities in another. Similarly, some market conditions may be more amenable to cash-flow-based lending, while others may call for a greater focus on asset-based loans; similar shifts may occur between first and second lien lending. Lenders that are successful over the long term will be those that understand the unique demands of each of these stages, and possess the appropriate capabilities to respond to each.
- Strong monitoring capabilities. When middle-market borrowers do encounter difficulties, they tend to be more severe than similar challenges for larger companies. In order to develop a lasting presence in this market, lenders must be able to work closely with borrowers’ management teams to facilitate close monitoring of a borrower’s operations and move quickly to implement solutions when challenges arise. In this respect, lending to middle-market companies bears a resemblance to the in-depth ongoing relationships an equity investor might develop with a portfolio company.
- Commitment is Key. Lenders can best position themselves to capitalize on the long-term opportunities available in the middle market by demonstrating that they will continue to support strong borrowers throughout various phases of the credit cycle. In practical terms, this means that lenders should possess a high degree of flexibility in the face of illiquidity and stress on loan portfolios, and that they should have the competency and confidence to extend capital to qualified borrowers regardless of short-term market conditions.
- Strong and Experienced Partners. In entering or expanding into this uniquely challenging and rewarding marketplace, both new entrants and established lenders would be well-served to seek out transaction partners with long-term experience and deep understanding of the middle-market space in order to identify, structure and manage high-quality deals that will contribute to their long-term success.
The middle-market credit space will continue to present excellent long-term opportunities for strong lenders who understand the opportunities and challenges inherent to the sector, and who have the capabilities and expertise to capitalize on them. For new entrants and other lenders seeking to deploy capital in this area, we recommend working with partners who have proven middle-market experience and the necessary endurance to work with borrowers across various market cycles.