Lower Middle Market Strategies Flourish Amid Private Credit Boon

Lending to companies with just a few million dollars in earnings is gaining greater interest from investors seeking higher yields and better protections as the private credit market grows increasingly segmented and sophisticated.

Firms are looking to raise funds to target companies in the lower middle market, or companies with an Ebitda of less than US$15m, including Deerpath Capital Management, which wants to raise US$1bn for its lower middle market fund, and PineBridge Investments, which announced it has US$596m to invest. At the same time, Main Street Capital Corp said it is continuing to seek opportunities in this segment.

Lower middle market loans have less leverage and come with higher interest rates to reflect the heightened risk and limited liquidity of smaller businesses compared with those in the core middle market.

Direct lenders have flourished in the last decade by tapping into the core middle market, or companies with US$15m to US$50 in Ebitda. It’s an area that some banks have been hesitant to lend to, allowing these financing providers to offer private equity sponsors extra leverage and flexibility at a premium.

But the growing size and sophistication of funds, as well as heightened competition, have weakened terms for loans made to companies with larger earnings.

Private credit firms attempting to win deals in this segment have increasingly come to accept lower spreads. In the fourth quarter of 2019, interest rates on unitranche loans, which are an indicator of the pricing pressure in the middle market, hit a historic low of 578bp, according to data from Refintiv LPC.

Unitranches combine both senior and junior debt into a single tranche and are traditionally provided by non-bank lenders across the segment.

To deploy capital more efficiently, private credit firms have had to look at the upper and lower ends of the space.

SLIDING SCALES

The lower middle market is a haven for many smaller direct lenders and investors seeking better documentation terms. With competition less intense, many of these loans can offer better lender protections.

“There are stricter underwriting standards in the lower middle market – the level of competition is a key factor, and you see less of it in this space,” said Tas Hasan, partner at Deerpath.

Lower middle market deals, for instance, distinguish themselves from the upper segments because they still include a fixed-charge coverage ratio and capital expenditure limit.

In deals with companies that have an Ebitda of less than US$15m, 33% of transactions have a fixed-charge coverage ratio and capital expenditure limit, according to a report from law firm Proskauer. But higher-up, these protections become less frequent.

In deals involving companies recording an Ebitda of US$30m or above there are no capital expenditure restrictions, Proskauer data shows.

“Deals involving companies with an average Ebitda of a US$10m-US$15m all have the leveraged covenant, fixed-charge coverage, and Capex restrictions,” said Tom Hall, managing director and co-head of private credit at asset manager Capital Dynamics.

“After that, it becomes a sliding scale, and lenders become comfortable with just a leverage covenant, and that gets looser at the upper end of the middle market. As companies grow above US$30m-plus cash flow, the market has decided that covenants have become less important,” he added.

BUILD AND GROW

The lower middle market is not as penetrated by private equity sponsors as the core middle market, hence why banks continue to flourish in a segment where borrowers seek lower leverage and are more comfortable with lower pricing.

For some financial sponsors, however, buying into the lower middle market can be part of a long-term plan to expand a business aggressively through add-on acquisitions.

These cases work for private credit firms, which are keen to offer higher pricing in exchange for the flexibility desired by sponsors and are happy to deploy capital into a growing business through delayed-draw term facilities. Private credit firms also need the extra yield compared with banks to compensate for the higher capital costs.

“Private equity funds embarking on systematic growth through acquisitions is a great strategy for a private credit fund,” Hasan said. “We’re happy to support bolt-ons and to fund acquisitions.”

For private credit funds at the lower end of the market, investing further capital into a single company can heighten the risk for funds, which are much smaller than core middle market funds.

Saratoga Investment Corp, a lower middle market lender, had investments in ice rental company Easy Ice and inventory management software company Censis, and added to its position over multiple years. This raised concentration issues for the firm – though it reported exiting both positions in its recent earnings call in January.

Saratoga could not be reached comment.

Michael Grisius, chief investment officer at Saratoga, said in the firm’s January earnings call that it wants to remain focused on the lower middle market.

“We have concentration limits related to industries and portfolio company position size as it’s important to maintain diversity – taking an outsized position can negatively impact the portfolio down the line,” Hasan said.

But the smaller nature of the companies can mean they are a riskier proposition with alternative capital solutions limited; and they are more vulnerable to broader macro-economic factors.

“If you have a US$10m Ebitda company and that loses US$1.5m in Ebitda, then that can be scary,” said Ted Swimmer, head of corporate finance and capital markets at Citizens Bank. (Reporting by David Brooke; Editing By Michelle Sierra and Kristen Haunss)