Link para o artigo original: https://www.man.com/maninstitute/impact-of-scale-on-credit-risk
Why size matters in an increasingly bifurcated direct lending market.
December 2024
Introduction
According to the National Center for the Middle Market, middle-market companies today represent one-third of US private sector gross domestic product (GDP). To put this into context, if US middle-market companies were combined, they would form the fifth largest economy on a global basis with US$10 trillion in annual revenue. While many large companies executed sweeping layoffs in the wake of the Global Financial Crisis (GFC), US middle-market companies added 1.95 million jobs1. Indeed, many middle-market companies provide business-to-business (B2B) services focused on mission-critical niches, and play a part in some of the world’s largest businesses’ supply chains – and the market is continuing to grow.
In light of this growth, we are not only seeing rising demand for capital from middle-market companies, but also an increased need for lenders and lending structures that can accommodate the growing complexity of their business dynamics. As such, the US middle-market lending universe has bifurcated based on size, most commonly by EBITDA (earnings before interest, taxes, depreciation, and amortisation), which is often seen as a proxy for cash flow.
Lenders today tend to think in terms of the lower and core middle market, by which we mean borrowers with less than US$50 million EBITDA; and the upper middle market, which refers to borrowers with more than US$50 million EBITDA. In this paper, we will explore the impact of this segmentation, namely the emergence of different pricing and lending dynamics between large and small borrowers and the implications for investors. We will also underscore the continued importance of credit selection as a driver of performance.
A yield advantage
While recent headlines lament the decline of illiquidity premia in the private credit market, direct lending to the core middle market continues to offer investors significant yield pick-up relative to the broadly syndicated loan (BSL) market. Specifically, current data shows a 188 basis point (bps) yield advantage in the core middle market compared to the BSL market, with much of this attributable to higher spreads in the core middle market2.
As shown in Figure 1, this yield pick-up is notable, broadly driven by the reopening of the BSL market which has given the largest borrowers (typically defined as those with EBITDA exceeding US$100 million) in the upper middle market the choice between private credit and broadly syndicated lenders. Many of these large borrowers have taken advantage of increased income-seeking capital by pitting upper middle-market direct lenders against broadly syndicated lenders. The result has been a fast and furious compression of spreads in the upper middle market, accompanied by continued erosion of lender protection, as covenant light (cov-lite) or no covenant loans have become increasingly common in upper middle-market lending. In contrast, core middle-market loans tend to offer higher creditor protection, as we will discuss next.
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Covenant cushion – smaller borrowers tend to have more creditor-friendly terms
Credit investors are well-versed in the importance of covenants, which are guardrails that protect creditors’ interests in the event that borrowers breach certain pre-set financial triggers. Contrary to the perception that larger borrowers are safer, data shows that credit documentation and loan covenants tend to become stricter as borrower size decreases.
In the core middle market, many loans still have maintenance covenants, such as a net leverage ratio, which obliges borrowers to consistently keep the net debt to EBITDA ratio below a specified threshold. As a result, lenders not only have greater control, but also the opportunity to proactively engage with borrowers and sponsors to get ahead of potential credit events. It’s a delicate balance as excessively tight covenants can restrict borrowers’ ability to operate their business effectively. However, the risk we are seeing in the upper middle market is the opposite: covenants are overly loose, meaning there is too much headroom between the actual current ratios and where the covenant thresholds are set.
Lower default and higher recovery rates on loans to smaller borrowers
Given the tighter covenant headroom in the core middle market, one would expect defaults among borrowers in this space to be higher than those of larger borrowers in the BSL market, but this is not the case, as shown in Figure 2.
Figure 2. Lower defaults among smaller borrowers3
Source: Proskauer Private Credit Group, Q3 2024. Payment and Bankruptcy Default Rate (dark blue line) refers to the default rate of the middle market borrowers in the Proskauer study while the Fitch Ratings (light blue line) refers to the default rate in the broadly syndicated loan market.
As we outlined earlier, greater lender control means more opportunity to engage with the company before any credit issues arise. Further, one of the benefits of lending to sponsor-backed middle-market borrowers is the presence of sophisticated private-equity sponsors who can provide additional operational and financial support during challenging economic environments. Recent market activity has shown that sponsors and lenders have joined together to proactively support portfolio companies when necessary. This support can take various forms, ranging from pricing adjustments in the form of both cash interest and payment in kind (PIK) interest to sponsor infusions, maturity extensions or covenant holidays.
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Credit cycles expose underperformance, and it is thus also imperative that managers focus on mitigating the downside at the initial due diligence and underwriting stage, as well as having access to broad resources both internally and externally to help support positive outcomes in workout or restructuring scenarios.
A good indicator of the quality of underwriting is the manager’s hard default rate. Hard defaults, such as an inability to service principal and interest payments, tend to presage a potential impairment of lenders’ invested capital. Key elements of achieving a low default rate include institutional-grade reporting requirements and covenant packages in credit agreements which allows for active monitoring and early detection of potential issues, which we highlighted the importance of earlier.
Room for alpha in the core middle market
So far, we have discussed the changing dynamics of the middle market but is there scope for alpha generation? There is a common misperception that direct lenders are undifferentiated, but we believe that there is room for experienced lenders with good process to deliver positive alpha on behalf of investors. The lending ecosystem for smaller borrowers remains fragmented as the smaller private equity sponsors of core middle market borrowers continue to focus on lenders with strong relationships and demonstrable ability to provide complex financing solutions and flexible capital. We believe that in any inefficient market, players with a differentiated view and a repeatable process can create a sustainable stream of positive alpha due to the value-add generated by credit selection and strong risk management.
Senior direct lending has historically outperformed traditional credit segments, such as high yield bonds and leveraged loans, reflecting the premium borrowers pay for the efficiency, confidentiality and flexibility of private capital. The stability of those returns and the mitigation of losses are paramount for delivering alpha.
The recent monetary tightening cycle which began in March 2022 was an important case study for middle market lenders. As base rates surpassed pricing floors and spreads widened, lenders’ overall yields increased. Due to the rising cost of capital, mergers and acquisitions (M&A) and refinancing activity was muted, but in our view lenders in the core middle market were well positioned to weather the storm of a higher interest rate environment. In addition to the middle market yield premium, overall yields were higher, while fees generated from new originations and refinancing activity were down. Due to the more stringent documentation requirements and tighter maintenance covenant levels we have discussed, core middle market lenders were able to actively reassess credit risk and demand higher returns via increased payment in kind interest, higher origination fees or amendment fees in exchange for the increased risk. As evidenced, the protections available to lenders in the core middle market are designed to mitigate downside risk, but also enable lenders to stabilise returns during periods of market disruption.
Conclusion: Not ‘one size fits all’
Despite the headlines, the growth of assets raised in private credit and direct lending funds is still sub-scale compared to the dry powder of private equity. With that said, the growth we have witnessed in recent years has led to significant market segmentation. In the upper middle market, we see the largest borrowers are pitting private credit lenders against the BSL market, resulting in fierce competition among large lenders and driving spread compression and the loosening of terms. In contrast, greater inefficiencies in lending to smaller borrowers and stronger covenants have translated into outperformance and lower defaults in the core middle market.
Yet, we believe credit selection remains key. A proactive approach, characterised by downside risk mitigation from the initial due diligence and underwriting stages; access to internal and external resources, including a seasoned team with direct restructuring experience through previous credit cycles; as well as direct contact with sponsors and management, is essential. We believe such an approach enables lenders to capture illiquidity and complexity premia in most market conditions, while also maintaining a path back to the table to ensure appropriate actions are taken to support a company and to protect recovery value in distressed situations.
1. Source: National Center for the Middle Market – Overview of the US Middle Market. Data as of Q3 2024.
2. Source: LSEG Loan Pricing Corporation, as of 30 September 2024.
3. This chart illustrates a comparison between payment and bankruptcy defaults for the loans included in the Proskauer Index as compared to the default rate reported by Fitch Ratings. Proskauer believes that several factors contribute to the lower payment and bankruptcy default rates for private loans as compared to liquid loans, including greater access to financial information and management, the fact that private loans are typically held and not traded, and more lender favourable documentation, including financial covenants, which may provide an early warning of potential distress. While there are many differences in methodologies, Proskauer believes the closest comparison between the Proskauer Index and a publicly reported index for leveraged loans, is the comparison between the default rate reported by Fitch and payment and bankruptcy defaults included in the Proskauer Index. To the extent that you wish to draw comparisons between default rates for broadly syndicated loans (BSLs) and private credit loans, we would encourage you to refer to the chart.
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