March 9, 2015
www.buyoutsnews.com
NEWS ANALYSIS
Direct lenders accelerate into middlemarket senior debt as banks fade
By Steve Gelsi
W
hen Golub Capital CEO
Lawrence Golub looked
to add talent to grow his
senior loan practice in the
$250 million to $450 million range last year, he didn’t have much
trouble recruiting two dealmakers from big
Wall Street banks.
Golub Capital soon hired Hyun Chang
and Michael Meagher as managing directors to beef up its middle-market sponsor
coverage. Chang formerly worked as an
executive director at the financial sponsor group at J.P. Morgan Chase & Co and
Meagher worked as director in the financial sponsors group of Deutsche Bank
Securities Inc.
“They were losing business to us and
they were seeing the trends in the industry,” Golub said. “It’s good for us and good
for them. They’re top dealmakers and this
is the right place for them.”
All told, Golub Capital added about 40
people in the past 12 months and may hire
20 to 25 people this year, Golub said.
Golub Capital’s hiring experience is
hardly unusual in today’s market as direct
lenders, also known as non-bank commercial lenders, continue to grow their
presence in middle-market senior loans
as big banks focus on larger deals of $400
million or more. It’s a macro trend that’s
been picking up steam and is likely to
continue with the onset of new rules and
capital requirements for banks both in
the U.S. and Europe, according to industry
players.
While corporations may use public
equities, cash or bond debt to acquire a
target, senior debt remains the biggest
piece of leverage deployed by buyout firms
Hyun Chang,
Managing Director
Lawrence Golub,
CEO
in their deals. Senior debt often comprises 3x EBITDA on a total of 4x EBITDA in
total debt on a given buyout. Senior debt
holders often have a first lien on all the
assets and stock of the company, exposing them to less risk compared to mezzanine debt or second-lien debt. Senior
debt holders are typically first in line to
get paid back in the event of a company
bankruptcy.
Overall, favorable conditions remain
in the senior loan market, with a healthy
pace of mergers and acquisitions stoking
debt deals. With hot competition for targets
and relatively cheap leverage, middle-market senior debt multiples climbed to 4.3x
EBITDA in 2014, up from 4x in 2013 and
3.5x in 2012, according to S&P Capital IQ.
Total leverage in middle-market deals rose
to 5.4x EBITDA in 2014, the highest level
since 2007.
Among larger senior deals for $500 million or less, Credit Suisse led the league
tables with $3.98 billion in book runner
volume in 2014, followed by $3 billion for
General Electric Co and $1.9 billion for
Bank of America Merrill Lynch, according
to Thomson Reuters LPC.
Michael Meagher,
Managing Director
In deals under $100 million, Madison
Capital Funding, a unit of New York Life,
led the league tables with $787 million of
senior loan business in 2014, followed by
$666 million for General Electric Capital
Corp, and $189 million for RBS.
To be sure, these league table mostly
reflect senior loans that have been syndicated to debt investors, and may not be
included if an LBO is financed through a
structure that is not syndicated, according
to a spokesman for Thomson Reuters LPC.
(According to Golub Capital’s own ranking of senior loan lenders that includes its
internal data, the company was No. 1 in
senior loan volume by number of deals in
2014, followed by Madison Capital Funding
and GE Capital.)
Overall the business from the top
senior loan providers grew significantly
in 2014. Among larger senior debt deals
of $500 million or less, the top 20 bookrunners rang up $27.4 billion in senior
debt deals in 2014, up from $15.8 billion for the top 20 in 2013, according to
Thomson Reuters LPC. For senior debt
deals of less than $100 million, the top
20 book runners tallied $3.7 billion of
www.buyoutsnews.com
March 9, 2015 | BUYOUTS
NEWS ANALYSIS
volume in 2014, up from $2.5 billion in
2013.
The interest rate debate
In terms of market conditions this
year, the view remains mostly upbeat,
but less optimistic than a year ago,
according to an annual lender survey
by Lincoln International, an investment
bank that provides debt advisory services to middle-market firms. In its survey
of nearly 100 lenders, Lincoln found 47
percent expect higher loan volume of all
types in 2015, compared to 64 percent in
2014, and 14 percent of lenders expect
lower loan volume, up from 8 percent in
2014. In addition, just 19 percent of lenders think senior loan leverage and pricing will move higher in 2015, a sharp
drop from 47 percent in 2014, the survey
found.
Some of the less bullish sentiment
may reflect the closely watched plan by
the U.S. Federal Reserve System’s Federal
Open Market Committee to begin raising
interest rates this year. Any changes will
reverberate throughout the LBO market.
“If interest rates rise, the cost of capital is higher, your fixed coverage charge
may be higher, and you may not be able
to put as much leverage into a deal,” said
Ronald Kahn, managing director of Lincoln
International.
Any changes in interest rates won’t
affect the market dynamic favoring direct
lenders for middle-market deals, however.
Like Golub, Lincoln International plans
to add staff this year after increasing its
ranks by 14 percent in 2014.
“For companies with $15 million in
EBITDA or less, alternative lenders are taking market share from traditional banks,”
Kahn said. “With increased regulations,
banks have become less interested in these
smaller credits, particularly for companies
with limited collateral. However, alternative lenders, such as BDCs, are filling the
gap left by these banks.”
Sunny Khorana, managing director and
head of sponsor coverage at Fifth Street
Asset Management Inc, said his firm has
been tracking a pullback in leveraged lending appetite both at the regional commercial banks and larger arranger banks. Fifth
Street has been moving up market with its
hold sizes on senior stretch and unitranche
offerings as an alternative to the syndicated senior and junior loans arranged by
the banks.
“Nowadays, some of the larger non-bank
institutions can take down sizeable pieces,
and in some cases the entire credit facility,
with these products,” Khorana said.
One banker at a big Wall Street institution acknowledged it’s less appealing for
banks to pursue senior debt deals of less
than $400 million, and that more middlemarket deals of $150 million to $400 million are going to non-bank competitors.
“Broadly defined, large institutions are
under a lot of financial and return pressure,”
the banker said. “As a result, that’s meant
trying to do more business with less bankers
and trying to use capital with the highest
return when they use it. Naturally, that causes the smaller deals to receive less focus.”
Regs may provide pricing
advantage
Under the most recent interpretations
of federal banking guidelines, banks may
have to demonstrate that about 50 percent
of a senior loan can be amortized within
five years, said Stefan Shaffer, managing
partner of SPP Capital Partners, a middle-market investment bank that raises
senior debt. Banks have the leeway to
do loans outside of this guideline, but it
could open them up to increased regulatory scrutiny.
By contrast, non-bank commercial lenders may require as little as 2.5 percent of
the principal in required amortization per
year, giving them an actual cost advantage
on many senior debt loans.
So while most commercial banks may
offer lower interest rates, the cash cost of
paying back the loan may actually be higher with the commercial banks because of
amortization requirements.
Regulatory scrutiny isn’t expected to
ease any time soon. The LBO industry is
working off Federal Reserve guidelines
originally published in March, 2013. This
past November, the Fed published a list
of Frequently Asked Questions for highly
leveraged transactions (or HLTs) in a move
seen as a warning shot to the industry
about following the rules.
“For the first time, banks are saying
as a matter of policy, ‘We won’t do a deal
greater than 3x EBITDA for senior and 4x
EBITDA in total debt,’” SPP’s Shaffer said.
“If they are above 4x EBITDA, they generally want an enhanced amortization rate.”
Jonathan Bock, a director at Wells
Fargo Securities who follows the senior
loan market, echoed the sentiment of a
sustained advantage for non-bank commercial bank lenders.
“There will continue to be a flight
toward the non-bank model because of the
enhanced flexibility it offers,” Bock said.
“Banks will win the low-cost, plain-vanilla
loan all the time, but we don’t live in a
plain-vanilla world.”
Bullish fundraising for senior
debt funds
Golub said non-bank lenders remind
him of commercial banks of the 1960s and
1970s, when big banks arranged loans for
middle-market companies and held them
on their own books, rather than selling
them off to investors via syndication.
“All those players either transformed
themselves into investment banks or they
went out of business,” Golub said. “Non-bank
lenders like us today — at least the ones who
really are structured to be long-term lenders
and solution providers — we’re the successors of the regional bank that used to lend its
own money to companies that made things.”
With LPs looking to find yield, direct lenders have been raising capital for credit funds
and business development company structures. Oaktree Capital Group’s senior debt
pool, Oaktree Enhanced Income Fund II LP,
drew in more than $2 billion last year.
“Fundraising is robust now because a
number of leading players have proven it
works, because we’ve demonstrated good
returns, and because investors have very
few alternatives in the low interest rate
environment,” Golub said.
Jeff Kopocis, principal at Altius Associates,
a separate account and private equity advisor, said he’s seeing more private credit
funds in the market today than six or 12
months ago, partly because of LP interest,
along with long-term changes in rules governing big banks.
“In terms of non-bank commercial lenders, our view is the opportunity is still early
and this isn’t something that’s a temporary
dislocation,” Kopocis said. “Parts of the regulatory environment are going through a
structural shift. The shift is just beginning
in Europe, with banks starting to assess
their problems. So, I’d expect hiring to
continue and more funds to be out in the
market. The capital raised relative to the
opportunity set is relatively small. There’s
still a gap and still an opportunity for plenty
of groups to play in the sandbox.” ❖
(#85358) Adapted with permission from the March 9, 2015 online edition of Buyouts, a publication of Buyouts Insider. Copyright 2015 Argosy Group LLC.
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