Attracted by the relatively higher yield among credit investments, funds have flooded into the middle-market lending space.
Dry powder for North America-based buyouts, though not necessarily targeting middle-market investments, totaled $331 billion as of December 2016, an increase from $308 billion a year earlier and $272 billion in December 2014, Preqin data showed.
Fundraising for North American and European-focused direct lending strategies — again, not solely for middle-market investments — totaled $11.4 billion in 2016, spread over 25 funds, down from $15.4 billion across 28 funds in 2015, and $19.7 billion from 33 funds in 2014, according to Preqin.
Similarly, U.S. debt fundraising totaled $61.9 billion in 2016 in 58 funds last year, a five-year high, compared to $46.3 billion across 101 funds in 2015, PitchBook data showed.
President Donald Trump's nomination of Rep. Mick Mulvaney, R-S.C., as director of the Office of Management and Budget could aid legislation allowing business development companies to increase their leverage, potentially bringing more funds to middle market credit investments.
Despite these funds, coupled with the new firms and partnerships created in 2016, investors insist the pool of investment opportunities will be big enough for everyone going forward. What's more, they are cautiously optimistic for improved M&A prospects in 2017. Much will depend on a kick-start of private equity-backed M&A activity involving middle-market companies.
"Everyone wants it to be up," one middle market lender said.
There are some signs it will be. The Wall Street Journal reported in December 2016 that M&A activity would likely pick up in 2017, but that the deal size would likely drop, citing an Ernst & Young survey that said more than 75% of corporate executives wanted to pursue deals over the next 12 months, most of which would be under $1 billion.
Some market players say expected Trump policies, including an easier regulatory environment, lower corporate tax, and potential repatriation of funds held overseas, could lift M&A activity in 2017. Others say an increase in deals is inevitable given the depressed levels of 2016. In 2016, middle market buyout financing for companies generating $50 million of EBITDA or less fell by one third from 2015 levels, to $3.7 billion, according to S&P Global's Leveraged Commentary & Data.
The healthcare sector may be one area of increased M&A activity, as changes to the Affordable Care Act are very likely. Deregulation could trigger some consolidation, for example among financial services companies. Oil and gas companies may be ripe acquisition targets. That sector had the most defaults globally in 2016, at 66 of 162 total, among the global corporate issuers tracked by S&P Global.
The most recent indicator from the National Center for the Middle Market, a survey of 1,000 middle market company executives, said 64% of respondents as of the third quarter of 2016 say they plan to invest, with 12% saying it would likely be toward an acquisition. This is an improvement from a year earlier, when 9%, of some 63% planning to invest, said extra cash would go toward an acquisition.
The number of investment opportunities is actually larger than data may show.
"Rather than middle market banks syndicating loans advertised in the 'public' data, more financings are bought-and-held by private lenders. These numbers don't always show up in the usual flow," Randy Schwimmer said in a column published at The Lead Left.
Ready for action
Whatever happens, financing for middle-market deals is readily available. And that is expected to continue in 2017.
One favored entity, CLOs, have teed up for middle market investments. The fourth quarter of 2016 saw 10 CLO transactions priced, totaling $4.64 billion, lifting that year's total by 30% compared to the previous year. The late-year rush was in part due to managers pricing new issues ahead of the risk-retention deadline.
For most of 2016, terms on middle-market loans have tilted from lender friendly to borrower friendly. Spreads have tightened, leverage has increased, pressure on covenant cushions has intensified, and EBITDA definitions have loosened. Supply and demand shifts have contributed to the trend.
Demand for private credit, at the expense of traditionally syndicated loans, increased due to market volatility surrounding the Brexit vote in June. In the second half of 2016, investor demand led to more favorable terms for borrowers.
If the evolution of BDCs was in focus in 2015, the theme of 2016 was the rise of nonbank lenders, with those able to write an increasingly larger check coming out as the victors. Origination of senior loans has consolidated among traditional middle-market lenders that have long dominated the market. On the smaller end of the middle market, the market has fragmented, with one estimate counting the active suppliers of junior debt to the middle market at 75.
In a sign of enthusiasm for the asset class, law firm Orrick launched a legal portal in 2016 for the corporate direct lending community that it says eases middle-market direct lending transactions and may shorten the time of first reviewing a credit agreement to less than an hour. A key feature of the online tool is the portal's term sheet generator. It also includes a list of direct lenders.
Big deals ahead
Nonbank lenders have wheeled out other larger deals, a trend expected to continue in 2017 as buyers seek to reduce risk of the traditional debt syndication process. For example, KKR arranged and distributed $815 million in first- and second-lien debt financing backing the purchase of a majority stake in Mills Fleet Farm, a Midwestern retailer specializing in farming and hunting related products, sources said.
Although the deal, announced in January 2016, was more of a hybrid structure as opposed to unitranche, KKR Capital Markets was sole arranger for the Mills Fleet Farm debt, directly placing the financing with no bank involvement.
"We will see more deals in the $500 million to $1 billion range that are clubbed," Michael Ewald, who is head of Bain Capital Credit's Private Credit Group and portfolio manager for Bain Capital Credit's middle market opportunities and senior direct lending fund strategies. Clubbed deals have significantly fewer lenders, as opposed to the dozens in a syndicate deal.
"Scale is important in this market. If you are not a large-scale player, you are not going to be able to deliver the certainty of closure to sponsors," Ewald said.
The rise of nonbanks as an increasing force to be reckoned with was no more evident in the appearance last year of the $1.08 billion financing backing Qlik Technologies, the marquee deal of 2016 for its status as is the largest-ever unitranche credit facility. The unitranche loan, which combines different tiers of debt into a single loan, is one product offered by private credit providers. Ares led the Qlik loan. Golub Capital BDC Inc., TPG's credit platform TSSP, and Varagon were lenders.
The financing for Qlik Technologies, which took place in June 2016, backed Thoma Bravo LLC's purchase of the data visualization company, and included a $1 billion term loan and a $75 million revolver. Pricing was L+825, and about a dozen lenders participated in the credit, sources said.
The Qlik Technologies debt stemmed from a period when primary loan issuance was stalled due to financial market volatility that disrupted usual syndication channels and offered the sponsor greater certainty of closure.
Haven in private debt market
Similarly, a private credit solution makes sense when a company has been owned by a private equity sponsor for some time, and thus ratings on a borrower, or a long history of audited financials, are not available.
To that end, Golub Capital was sole book runner and joint lead arranger on a $605 million unitranche loan backing the merger of Pet Valu and Pet Supermarket. Golub was administrative agent on the loan. It was the largest agented loan in the company's history. Joint lead arrangers were Bain Capital Credit, Solar Capital and ING.
The transaction combined longtime Roark portfolio company Pet Valu, acquired in 2009, with Pet Supermarket, which the private equity firm bought in 2016. Golub also provided debt financing for the latter deal. Sales of the combined business, called Pet Retail Brands, was expected to generate around $1 billion.
In addition to unitranche structures, private debt providers have been behind notable second-lien loans this year. In one, Bain Capital Credit was one of five lenders on a $500 million L+950 second-lien term loan backing Pamplona Capital Management's take-private transaction of MedAssets a year ago. A $1.13 billion L+475 syndicated first-lien term loan for the transaction was led by Barclays.
Then in April, Barclays led a $460 million L+550 first-lien loan backing the merger of Pamplona-controlled Precyse and part of MedAssets, the revenue cycle management provider. Bain Capital Credit was sole lead arranger on a $190 million second-lien loan. The company, now called nThrive, reopened that first-lien loan later in the year for an acquisition.
The complexity of the transaction was one reason a private-credit solution made sense. Still, a privately placed second-lien structure is prone to market forces.
In the second half of 2016, arrangers brought to market $8.2 billion of broadly syndicated second-lien term loans, versus $1.9 billion in the first half. This compares to $36 billion in 2014 and $29.3 billion in 2013, LCD data showed.
In recent years, nonbank lenders, including BDCs, have touted themselves as champions of small- and midsized companies that banks all but abandoned following the credit crisis, which resulted in increased regulation.
Many lenders to middle market companies have benefited from increased regulation for banks, and have moved to fill the void created when banks shunted the loans to smaller companies. In addition to Dodd-Frank, regulation such as Basel III, CLO Risk Retention, the Volcker Rule, and guidelines on bank leveraged lending favor alternative capital providers to the middle market.
With regulatory reform on the table, some say changes could serve to increase competition between non-bank lenders and the banks that traditionally served middle market companies. Indeed, Steven Mnuchin, Trump's pick to run the Treasury Department, has said that a priority is to help get banks lending again.
Some say regional banks are the most likely banks to reenter the business where BDCs and private credit providers have gained market share in recent years. However, any changes are likely some years away, and participation by banks is likely to be selective.
Ted Koenig, founder and CEO of middle market lender Monroe Capital, said leveraged lending guidelines had played more of a role in keeping banks at bay, particularly the community banks.
"Any revisions to the law will most certainly not affect leveraged lending guidelines, which were put in place by the Federal Reserve and other regulators to combat 'systemic risk' in the financial system," Koenig said.
Not really new
Most of these so-called newcomers to the market are familiar faces to the clubby world of middle market lending.
In one, Adams Street Partners LLC launched a private credit strategy in January 2016, hiring Bill Sacher and Shahab Rashid to provide a full range of financing to middle market companies across sectors. The pair had worked together for over a decade at Oaktree Capital Management.
Last year also saw the formation of Owl Rock Capital by Marc Lipschultz, KKR's ex-head of energy and infrastructure investing, and Doug Ostrover, the "O" in GSO Capital Partners, which was acquired in 2008 by Blackstone. Craig Packer, also a co-founder, became CEO.
Owl Rock in mid-2016 hired Arthur Martini as managing director of originations. He joined from Apollo Capital Management, where he was U.S. head of financial sponsors.
In June 2016, Apollo Investment Corp. appointed MidCap Financial co-founder Howard Widra as president, signaling a subtle shift by the BDC toward a more diversified investment portfolio and a vindication of MidCap’s broad-based direct lending strategy.
In January 2016, Antares and LStar Capital launched a venture to provide unitranche loans to middle-market companies to replace the one that included GE Capital. Loans from the venture, called Middle Market Growth Program, can total up to $350 million, compared to $175 million in the previous program.
In December, Pacific Investment Management Co. LLC and Solar Capital Partners LLC unveiled a joint venture to invest in private credit. The venture has its roots in earlier collaboration, in 2014, when the two companies teamed up to co-invest in middle market senior secured unitranche loans.
Rashid, a partner and co-founder of the private credit strategy at Adams Street, said the numbers say it all.
“If you look at the possible future demand for debt, based on upcoming loan maturities and potential LBO financings, versus the supply of dry powder in private debt funds, the supply-demand imbalance is very favorable for the private debt industry,” said Rashid.
"Since private equity sponsors, on average, finance LBOs with around 40% equity, and the remainder with debt, the current dry powder available in North American buyout funds indicates approximately $450 billion of debt demand," Rashid said.
Indeed, the volume of leveraged loans maturing through 2021 totals $500 billion, according to LCD data.
Out of the shadows
There is a general consensus that private lending has become more accepted as a mainstream investment product due to more visibility for the sector and high-profile transactions.
This has coincided with another positive development for the industry over the past year: the diminished use of the term "shadow banking," replaced nearly completely by "nonbank lending" or "alternative capital providers."
The revised nomenclature eliminates an underground or nefarious association for the industry. Also, the previous label wrongly implied competition with banks.
"It sounds like the villain in a Marvel Comic. And we're not a competitor of banks, but a complementary force," said Brett Palmer, president of the Small Business Investor Alliance. "Shadow banking was used when people didn't know what to call it."
Abigail Latour is a senior reporter with S&P Global's Leveraged Commentary & Data.