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Middle market direct lending can mean different things to different lenders and investors. Many, if not most, would agree that companies with over $500 million in revenue or a debt facility over $500 million in size, pushes a company outside of the middle market parameters.
However, direct lending continues to expand beyond the middle market and is now taking market share from the more traditional broadly syndicated public market.
In fact, transactions well over $1 billion debt facility size are regularly being funded by large direct lending firms. With the evolution of the market and segmentation within the middle market, a question that may come to mind is, how is the value proposition different across the various segments of direct lending?
There are significant differences in terms and pricing based on the size of a borrower or transaction and the associated competition to provide a lending solution.
At Principal Alternative Credit we focus on the lower middle market, which we define as companies with earnings before interest, taxes, depreciation and amortization (EBITDA) of $5 million to $15 million, and opportunistically pursue lending solutions with companies generating from $15 million to $50 million EBITDA, which we consider core middle market.
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Wholistically, the direct lending middle market continues to represent value compared to other alternatives, such as the broadly syndicated loan market and public high-yield market, where in our view, yields and risk premiums continue to remain compressed in comparison with the private middle market as shown in Exhibit 1.
However, the competitive dynamics within different segments vary considerably and clearly affect the value proposition to investors. Generally, the upper middle market continues to be very competitive as managers seek to deploy ever-growing capital bases.
Many of the larger deals are effectively in competition with the broadly syndicated loan and high yield bond market. Thus, terms must be competitive with the public market, which tends to be covenant-lite and priced aggressively compared to the traditional middle market.
(Courtesy of Principal Asset Management)
In addition to realized yield and internal rate of return (IRR), achieving a positive multiple on invested capital (MOIC) is oftentimes a primary goal for investors and may be adversely affected by several factors such as pace of capital deployment, lower yields and IRRs associated with competitive upper middle market, and refinancing risk. As investors move up-market those factors are quite impactful.
Middle market direct lending has historically delivered positive returns relative to risk and accumulated value for investors through time. The increased competition and factors that drag on MOIC for upper-middle market investors seem to call into question whether all of the middle market segments may deliver risk-adjusted returns that investors have come to expect.
We believe the historic performance in Exhibit 3 of middle market direct lending is more representative of what may be expected from core and lower middle market, where there is generally less competition, greater risk premiums and potential for better risk-adjusted returns.
(Courtesy of Principal Asset Management)
Lower middle market companies also tend to have numerous exit opportunities for the PE sponsor/owner to realize a return on its investment.
The companies tend to be in a life cycle stage that realizes growth and operating scale, which may be appealing to both strategic buyers and other investors such as family offices, as well as larger PE sponsors. As a lower middle market company grows and realizes more scale and business risk diversification, the list of potential suitors expands further, as does the expected acquisition multiple.
Given these companies are of a size that many investors will consider as a platform or add-on acquisition opportunities, and oftentimes are less cyclical and specifically benefitting from secular trends, we believe the value of these firms will tend to hold up reasonably well even in a down cycle. In the event of a default and restructuring, the resiliency of enterprise value is the key determinant of recovery.
The lower middle market space is generally less competitive, as relatively few lenders dedicate the required origination, underwriting and total resources to be successful. In addition, many lenders have chosen to move up market to larger middle market transactions in order to deploy chunkier capital and seek a different risk-return profile.
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The lower leverage and higher equity in the lower middle market company’s capital structure provide additional downside risk mitigation for idiosyncratic and cyclical events.
In addition, the meaningful covenants and more lender-friendly documents such as less EBITDA add-backs and smaller baskets for restricted payments, are meant to limit the downside as well. A condition precedent for lending to any lower middle market company must be thorough due diligence.
Stressing the business model and financial profile is key to consider if the proposed capital structure can withstand the borrower’s potential cash flow volatility. As a lender, there is no reason to take concentrated or binary risks, thus evaluating any supplier or customer concentration, as well as competitor, regulatory and other key risks is a key determinant during the origination and initial underwriting process.
Deal structure and covenants help ensure de-risking of a company. Any lower middle market transaction should have true, meaningful financial covenants. Oftentimes, these covenants will be structured with a significant leverage stepdown, which requires an improved financial profile for the company to remain in covenant compliance.
These covenants also allow the lender to “get to the negotiating table” early if a company is experiencing underperformance.
This early engagement with management and the PE sponsor will provide for many more constructive paths, often an equity injection, and an ability to reprice the loan when compared to a transaction with very loose covenants or essentially no financial covenants at all. Thus, through rigorous underwriting and proper structure, lower middle market transactions may provide better resiliency and potential recovery compared to larger transactions.
There is value across all segments of the middle market with incremental yield and diversification benefits compared to public market alternatives.
However, as investors consider their allocation to direct lending, whether it be incremental or an initial allocation, we believe there is a clear rationale for exposure to the lower and core middle market segments. The historical performance realized by the asset class has been exceptional, but a lot has changed over the last decade which has most likely altered the expected return profile of larger, more competitive transactions.
Tim Warrick, managing director and group head at Principal Alternative Credit (Courtesy of Principal Asset Management)
By Tim Warrick, managing director and group head at Principal Alternative Credit
Warrick leads the Principal Alternative Credit team and is a member of the Direct Lending Investment Committee. With over 30 years of experience, he has spent much of his career managing corporate and US core plus portfolios.
He previously served as portfolio management team leader with responsibility for overseeing portfolio management functions for all total return fixed income products. He also oversaw the corporate trading desk, was one of the first portfolio managers for Principal’s general account and began his career at Principal as a fixed income credit analyst focused on both private and public credit.
Warrick also spent two years with ReliaStar Investment Research where he was an analyst for multiple sectors, including mezzanine debt, leveraged bank loans, corporate bonds and asset-backed securities. He received an MBA from Drake University and a bachelor’s degree in accounting and economics from Simpson College. He holds the Chartered Financial Analyst designation.
Jennifer Nicholson-Breen edited this article.
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