What does it take to be an effective middle-market leveraged lender? Are traditional lending models obsolete? Is this sector now the domain of non-bank debt investors? Whether you are a private equity investor, operating company, or co-lender, these questions can be pivotal to deal viability over the investment horizon. Finding out, mid-deal, that one or more lenders has approached leveraged lending as a hobby and is suddenly pulling back (whether due to whipsaw changes in policy or shaky reviews from regulators) is often revealed at precisely the wrong moment — perhaps disrupting an opportunistic acquisition or timely distribution to equity. “Know Your Lender” is vital to consistent success in middle market dealmaking.
But let us answer those initial questions in reverse order: Are non-banks dominant? “It is hard not to say yes. Traditional banks have fallen to historic lows in market share as non-banks prove nimble and effective in answering demand for debt products”, Are traditional lending models obsolete? “To a large extent, yes – certainly in the leveraged lending sector. Regulatory and competitive dynamics make the stale notion ‘this is the way we’ve always done it’ more dangerous than ever”, and What does it take to be effective? “Effective middle market leveraged lending programs are built on four critical skill domains: core middle market lending acumen, private equity intelligence, cash flow lending acuity, and debt capital markets insights.
These requirements present meaningful hurdles to being truly effective and credible in the sector – and they should. It requires a real investment in capabilities to prudently pursue these opportunities: leveraged lending is not now, nor ever was, a hobby. That said, the capabilities for these domains can be had through smart talent acquisition and internal development. The real critical success factors are to objectively identify where and how big skill gaps are between the lenders’ current state and the desired state. And to design a robust, pragmatic program to close those skill gaps consistent with a particular institution’s mission and culture.
We have worked with different lenders on tailored approaches to building leveraged lending capabilities – both on the initial design and the implementation of the programs. Experience shows some firms have larger skill gaps and need to rely on external support in certain areas over the short term – a robust program design acknowledges and accommodates that. Other lenders need an experienced, independent assessment for targeted areas of development. But in all cases, best practice programs target capabilities in the four areas mentioned above: core middle market lending, private equity knowledge, cash flow lending techniques, and debt capital markets awareness. In this Part I of a two-part series, we will address the first two capability domains.
Core Middle Market Lending Acumen
The first capability is foundational: commanding a true skill in underwriting and managing middle market debt investments. The lender has to start with a solid credit culture backed by policies, procedures and skill sets in their traditional (non-levered) lending activities. However the middle market is defined, there is a world of difference between a typical $4 million EBITDA company and a $40 million EBITDA company. From the number of people in the C-suite with the same last name to bench strength of the sales and the finance functions, from product line profitability to compensation alignment, these idiosyncrasies make investing in smaller firms most often challenging, sometimes frustrating, but overall quite rewarding — if done well. Where do we see middle market lenders getting into trouble in this particular capability?
- Misunderstanding what is valuable in a relationship from the perspective of the customer (such as the new owner after an LBO). Too often we find lenders ‘reading their own press’ believing that just saying you are a relationship banker is distinctive and compelling (to be clear, every lender says they are a relationship lender). We have written before that the most expensive word in banking can be: relationship.
- Having weak senior line bankers overexposed in deals. Not all lenders with 10-20 years experience are, by default, good candidates for exposure to leveraged lending. In fact, without a comprehension of skill gaps to effective management of the process these “Masters-of-the-Universe” managers are credibility busters to leveraged lending efforts.
- Failure to realize that number of years in lending does not equate to skill in leveraged lending. It is a significant risk to retain lenders untrained and incapable of rigorous leveraged lending techniques. We have seen catastrophic results from lenders well past their ‘Use By’ date or brand new lenders fresh out of a 3-week sales training program ‘awarded’ these deals as some kind of favor. Yes, the transactions can be high-profile and very profitable (done correctly), but this is hard work – from careful screening at origination, to rigorous underwriting, to active post-close account management – leveraged lending is not a place for ‘set it and forget it’ mentalities.
This capability is so central that it is really ‘table stakes’ to get into the game. To be effective in the middle market over the long term — and across business cycles — one has to be close to this segment, not a tourist moving down market simply due to a temporary disruption in larger deal flow or an ill-prepared smaller bank flailing away at leveraged loan participations. Private equity investors and co-lenders will recall how difficult inexperienced lenders can be in times of stress where over- or under-reactions made speed bumps in deals – or opportunistic modifications – much more difficult to work through.
Private Equity Intelligence
Far too many middle market lenders rely on stale news, myths, and legends as the foundation for their understanding of leverage lending and private equity sponsors. Perhaps worse, others treat leveraged lending opportunities as just big middle market deals with little insight as to how the equity sponsors themselves can tilt a good deal to a poor deal — or how to evaluate risk-elevation or risk-mitigation of key elements of a transaction from the investment thesis to capital structure to governance of the company. And while a growing number of deals are now minority, growth investments, it is folly to misplace the effective control of the company. A short list of where we see lenders relying more on private equity myths than fact?
- The flawed notion that private equity relies on market timing and leverage for returns. While the private equity world in certainly not monolithic – and there really are sponsors to avoid – the best firms focus on thoughtful, prioritized value creation efforts early and consistently across the investment hold.
- A lack of understanding how, why, and to whom sponsors generate returns. While different deals provide different levers for returns for sponsors and their limited partners, operating focus, financial engineering, and timing all play some role in a typical deal. Much of what happens in the deal will be opportunistic – and while sponsors are typically smart, they are not omniscient. Queries of “How long are you going to hold this company?” and “Are you planning any changes to the facilities over the term?” are good indicators that the lender is lacking experience. And being surprised by a sponsor taking advantage of strong cash flow to provide and early dividend to their limited partners would confirm that inexperience (especially if this was implicit in the investment thesis).
- Inexperienced lenders lack an appreciation for the challenges of implementing the investment thesis and spotting problems early. Most often you’ll hear “we love management and what they are doing” but the evidence shows most deals will require some level of personnel change, refocussing R&D, and sales force realignment to name a few. Many ‘lifestyle’ middle market operations will be transformed into viable growth platforms – be it organic or inorganic growth – and early indications of success or difficulty will be often be seen in the course of well-designed 100-day plans. A lender’s failure to follow progress and inability in account management are really in no one’s best interests.
To be clear, these misconceptions are not isolated to middle market lenders, the media is often wide of the mark when it comes to reporting on leveraged lending and private equity investing. We remain committed to pushing back on these missives where facts are clearly contrary to attention-grabbing headlines.
These first two capabilities are sine qua non. If this foundation is not in place, the lender is begging for real problems down the road. And regulations appropriately require some lenders to demonstrate that these areas have substance – whereas those lenders trying to finesse around guidelines are hobby lenders – sponsor beware. Moreover, private equity firms should be very wary of brining on a lender which has cobbled together a random leveraged lending team that has yet to read a single CIM front to back, yet alone marshall a deal through an investment cycle Failure to do due diligence on a lender and their evidence-based commitment to the leveraged lending sector will add significant — and unnecessary — risk to any investment.
That said, we are encouraged by the number of lenders that we have talked with that are taking a rigorous approach to evaluating what it takes to be a credible leveraged debt provider – and, thus, a credible deal partner for all considered. Experience, capability, and prudence upfront reduce deal-imapacting surprises down the road. In the next installment, we build on these foundational skill domains to show how capabilities in cash-flow lending and debt capital markets drive more success for the lender – and their customers (remember sponsors, that’s you).