The press of constant developments across the BDC sector has greatly diminished with the end of earnings season. Where the BDC Reporter would wake to multiple new press releases, SEC filings, corporate presentations and analyst recommendations, we now have a blessedly short list of items to review and consider. In fact, we’re already done with the news flow on Wednesday May 25th and nobody is yet even at lunch on Wall Street. This is giving us the opportunity to write about a subject we’ve been meaning to discuss for several weeks. To keep readers awake and focused we’re going to break this into two parts. First, we’re going to review the drastic change in the popularity of leveraged lending in the middle market that has occurred in the past 8 years. In the second part, we’ll seek to explain why BDC investors should be worried in the short, medium and long term, and how they might be able to protect themselves.
A VERY BAD YEAR
The Great Recession ended -more or less – in the spring of 2009. As we all know, the economists date the beginning of the recession to December 2007, but many companies, lenders and BDCs did not get the memo till well into 2008. What followed was a very tough year for leveraged lending by any standard – and we’ve been through several. If you believed the stock prices of many previously high flying BDCs at the darkest times of the Great Recession, you’d have gotten the impression that lending to private middle market companies (which was what BDCs almost exclusively did at the time) was a dying business on the edge of complete collapse. For example, BDC stalwart Apollo Investment – sponsored by one of the most famous credit shops in Apollo Global – saw its stock price drop by 90% in less than two years to reach at a lowest point of $1.99 in March 2009. Highly regarded Ares Capital (ARCC) saw its stock price drop by 85% from its high in February 2007 to its lowest exactly two years later.
Of course, across the whole lending space there was a similar panic and run for the exits. Many banks exited the market during this period and have never returned. Many private funds and hedge funds that had gotten into the lending business during the many years of prior expansion were hard hit and much jettisoning of both under-performing and performing borrowers followed. We remember asking an asset-based lender who we knew well what percentage of the borrowers in his finance company’s portfolio were in financial distress. He answered: “All of them”. (We owned – and still do – a leveraged plywood company during the Great Recession and we managed to avoid any default and make a dollar. Literally).
BDCs were very hard hit from an earnings standpoint too, forced to write down and write off many, many loans that a year earlier were valued at par, and had the hardest time possible raising any new capital given that investors were pretty much convinced that leveraged lending was a dead end business. Total BDC investment assets shrunk by 30% or more, market capitalization by much more and 80% of the 21 BDCs that survived the Great Recession cut their distributions or suspended them entirely. Along the way Patriot Capital and Allied Capital essentially failed and were absorbed by Prospect Capital and Ares Capital.
We are taking readers on this trip down Misery Lane to contrast with the years that have followed and the current mood in leveraged lending. On May 24 Preqin published the results of a survey of 100 institutional investors “active in the private debt space”. As the brief summary from FinAlternatives shows, enthusiasm for lending is high. Very high.
- Private debt is a distinct allocation segment for 91% of respondents, with 82% allocating specifically to US lower-middle-market direct lending.
- This trend looks set to continue: 58% of respondents expect to increase their allocation to U.S. lower-middle- market direct lending in the next 12-24 months.
Why is leveraged lending so popular ? We suspect the answer lies in this next statistic drawn from the survey:
- Most investors in U.S. lower-middle-market direct lending funds have high performance expectations. Sixty percent of survey respondents are targeting returns of 8-12% from their investments.
- Direct lending funds have largely met those expectations, returning almost 10% in the five years to June 2016.
HEARD ON THE GRAPEVINE
None of this is any great surprise to the BDC Reporter. We’ve been hearing for many quarters about the increasing popularity of leveraged lending, and all the new entrants rushing in. Our main sources are the managers of the existing public BDC companies. Read just about any BDC Conference Call transcript for the last couple of years – and we’ve read them all – and there’s almost always a peroration from the CEO (it’s usually the CEO) about how competition for deals is increasing; “other” lenders are underwriting transactions that make no sense or are providing very loose covenants and offering dirt-cheap pricing.
NOWHERE TO HIDE
Till recently, BDCs who specialize in the lower middle market would say their segment was “insulated” from the higher multiples, “covenant-lite” structures and razor thin margins being booked in the middle and upper middle market. After all, the huge wad of capital coming in could not be bothered to make illiquid loans in small sizes to the smaller borrowers in the lower middle market. However, even that “insulation” appears to ripped away.
ALL SIDES NOW
We had a wide-ranging discussion with a senior executive at a public BDC recently, and he discussed in great detail how the competitive landscape is being reshaped by the entry of numerous new lenders with capital to “invest” in middle market borrowers. The money is coming in from every side. Yes, there are the new finite-life private funds being raised to target the middle market, arranged by the big asset managers with the household names but also by many smaller organizations. Then there are family office and other pockets of wealth seeking out the double-digit returns promised by leveraged lending. Plus, there’s the huge expansion of the SBA’s SBIC loan program. Till recently the SBIC limited total debentures by a single lending group to $225mn. Now the limit is $350mn. That capital keeps on dripping in all the time as new SBIC applications are filed, both for the first and second license, but also the new third license.
Also raising capital at a breakneck pace are a large number of non-traded Business Development Companies, many of them (in a delicious irony) sponsored by the very same asset managers serving as Investment Advisors to the public BDCs. We have the almost comical situation of a public BDC CEO complaining – effectively – about competition from his own non-traded sister firm. Finally (and we’re leaving out many more money pockets) there are the public BDCs themselves raising new capital that has to be invested, and quickly, if distributions are to be maintained unchanged and fees received.
WHERE TO GO ?
If the capital available for leveraged lending has greatly expanded in a short time, the number of privately held American companies appropriate for a leveraged buy-out has not. Transaction numbers may increase as all this capital flowing around makes re-financings and dividend recapitalizations easier and more frequent. We agree that there may be even be more private companies coming to market as sellers are being offered the highest multiples we’ve seen in our lifetime. Multiples of 12x EBITDA are not unusual.
[As an aside, even EBITDA is a moveable concept when deals have to be done. As my BDC confidant explained, many lenders are willing to accept very aggressive “add-backs” to EBITDA in their calculations that would have been unthinkable before. Today’s way of calculating “Adjusted EBITDA” may not be the same as yesterday’s, which is why we rely little on these numbers as anything but showing what market trends look like].
However, in our experience, the number of “good” companies –whose management, business and capital structure can handle a leveraged structure through a full economic cycle – has not changed in years, and is not keeping up with the vast increase in capital flowing in both from lenders and private equity firms. Moreover, the increasing levels of debt available are jeopardizing even some of the marginal firms who might have otherwise survived a full cycle unscathed.
So what does all this surplus of capital and shortage of appropriate lending opportunities mean for the 45 BDCs that we track ? That’s what we’ll discuss in Part II, and how the impact will be different over time.