How PE firms and banks evaluate middle-market borrowers

 

“Highly leveraged companies may find difficulty generating enough cash to cover interest payments.”

Where debt providers and private equity firms agree with respect to leveraged loans
The Lead Left discussed several key points that lenders and private equity firms both evaluate before starting leveraged finance deals. Perhaps paramount, lenders and PE firms take a look at company management’s ability to steer through downturns. A company that is already highly leveraged must operate very carefully, as room for error is slim. Especially during a downturn, knowing how companies will perform during a recession will allow private equity firms and lenders to better gauge borrower risk. Cyclicality is natural and downturns sometimes are inevitable, but they can still provide issuers with a good point of reference.

Another consideration for lenders and private equity firms is free cash flow. Companies need cash to repay their debts, and for certain businesses and industries where capital expenditure is high, like retail or manufacturing, during downturns, already highly leveraged companies may find difficulty generating enough free cash flow to cover interest payments. The Lead Left pointed out that failure to make payments can result in substantial devaluation of enterprise value.

How do money providers evaluate highly leveraged middle-market companies?

MarketWatch mentioned how banks have been discouraged by federal regulators from providing companies with highly leveraged loans. Regulators do not want banks to make loans for more than four times EBITDA, but those rules are not set in stone. This is where business-development companies spring to life. BDCs have been around for a long time, but the credit crisis of 2008 made them a more popular investment vehicle, as they are required to pass at least 90 percent of their earnings to shareholders. As a result, they also enjoy tax advantages. Where banks choose not to lend, BDCs make commercial industrial loans to middle-market borrowers with particularly high interest rates. These lenders can charge high rates because the borrowers do not have access to other sources of credit and the BDCs can also charge premiums because the loans are illiquid.

While BDCs are taking a portion of the lending market traditionally serviced by banks, they still have to consider the same points that private equity firms do when evaluating companies for leveraged finance deals. Troy Ward, managing director for Keefe, Bruyette & Woods, noted that the BDCs are doing a good job.

“Not one BDC has ever gone bankrupt,” said Ward, according to the news source. “At any time, they can fully pay off their creditors. They were never forced to sell assets at a discount.”

Regardless, the key points of consideration mentioned by The Lead Left apply. Middle-market companies tend to have a few clients that represent the bulk of their activity. If a middle-market company relies on a large retailer for 30 percent of its sales, and that retailer disappears, the middle-market company suffers.  Additionally, some middle-market companies maintain a dominant market position with high margins. If a larger company were to get into their market, the backlash could be severely damaging for the business. If the borrower has made considerable investment in infrastructure to meet client demand, that can be viewed as insurance against the entrance of another player in the sector. All providers of capital – BDCs, private equity firms and banks – will likely consider these scenarios in similar ways.