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Private Credit

Covenants, yields could make lower middle market a pot of gold, lenders say

The lower middle market is known for higher pricing and stronger covenants.

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Lower middle market companies could become the next mega-issuer in private credit. But sourcing a smaller company with this potential may be as challenging as finding a four-leaf clover.

Kevin Griffin, CEO and CIO of MGG Investment Group, acknowledges that investments can emerge in serendipitous ways. MGG invests in non-sponsored and sponsored investments, including in the lower middle market.

One memorable idea came about from a pricey lunch at New York Sports Grill at JFK airport: MGG went on to invest in airport concessions, Griffin said. Another was via a social introduction to a CFO whose company eventually became an investment of MGG.

“The flow of deals is not as consistent, which emphasizes the importance of having strong sourcing capabilities. We rely on intermediaries at single-shingle firms, like boutique investment banks, where we develop relationships,” Griffin said.

MGG focuses on businesses generating $10-50 million of EBITDA. Definitions vary, but businesses generating up to $25 million of EBITDA are usually considered lower middle market.

Some private equity firms specifically target the lower middle market, but many businesses of this size are non-sponsored companies.

An advantage of sponsor-backed companies is that private equity firms generally provide a steady stream of M&A and LBOs in which to invest. Not so with smaller companies that are family or founder-owned, where sourcing deals may require endless networking, cold calling, and on-the-ground originators with extensive local knowledge. Referrals also come from banks and other direct lenders.

Where the deals are
But once potential transactions are uncovered, lenders to these companies say they’re seeing healthy yields, lower leverage, and stronger covenants than for larger borrowers.

In 2024, lenders anticipate stable or tighter spreads in the lower middle market, in line with expectations for the core middle market, as well as lower leverage levels than in recent years.

Lower middle market loans generally have two to three covenants, with a leverage covenant non-negotiable. Fixed-charge covenants of 1.2-1.5x have become more important in the past 18 months. A minimum EBITDA covenant is harder, but not impossible, to obtain, market participants say.

Erosion of covenant packages is more widespread in sponsored deals.

“You don’t realize what you’ve given up until you need it. That has come to light in the last 18 months,” Griffin said. “Covenants on our deals have limited EBITDA add-backs. The definitions are ones anyone could understand, with limited 15-20% cushions.” Looser covenants can mean EBITDA add-backs and adjustments and cushions of 40% or greater.

Even with potentially weaker covenants in sponsored deals, LCD data on larger companies show that non-sponsored deals are inherently riskier.

However, strong covenants have helped to tamp down default rates in the lower middle market, market participants say. The Proskauer Private Credit Default Index in the third quarter showed that for the smallest companies, or those reporting EBITDA of less than $25 million, the default rate decreased to 0.7%, from 2.1%. This compared to a default rate of 1.41% for overall defaults of senior secured and unitranche private loans. “NXT budgets roughly a 2% default rate, and we’ve been running at about that level for the last 14 years,” said Ted Denniston, Co Head of NXT Capital. “Our recovery rate exceeded 85% last year, and I feel it’s due to the covenant protection we have on these deals. It gets us to the table earlier.”

Leverage multiples, which tend to be lower among these smaller borrowers, also help lenders. Denniston says NXT Capital sees up to a full turn [1x] of leverage improvement among smaller borrowers, compared to the traditional middle market. “It’s a sliding scale,” said Denniston. “We see about one turn lower leverage for businesses with sub-$15 million in EBITDA, and a half turn lower leverage once businesses reach $20-$25 million in EBITDA.”

Natalie Garcia, head of underwriting at Deerpath Capital, which targets companies in the lower middle market with EBITDA of $5-20 million, said more conservative structures also offer lenders greater protections against losses. “On all of our deals, we have quarterly financial covenants that typically include leverage ratio and fixed charge coverage ratio covenants, and occasionally, we’ll include a capex ratio covenant as well,” said Garcia.

“[Deerpath’s] loss rate is exceptionally low; it hovers below 10 basis points,” said Garcia. “We pay a lot of attention to loan-to-value, which tends to be below 40% for us, which shows there is an equity sponsor with a lot of capital at risk behind us.”

Sky’s the limit
Yields are higher for these riskier companies, and increase further as borrowers shrink. Loans in the lower middle market tend to carry spreads 50 to 100 basis points wider than in the core middle market, potentially S+650-1000. Other market participants cited yields of roughly 12%.   “We typically see anywhere from 14-17% interest rates with a couple hundred basis points upfront, in addition to a back-end success or exit fees on all of our deals,” said Jamie Shulman, co-founder and fund manager of Portland, Ore.-based Meriwether Group Capital, which targets even smaller companies, with EBITDA from $250,000 to $5 million. 

Of course, higher yields incentivize borrowers to repay loans. Maturities tend to be four to seven years, in line with those in the core middle market, but repayment is typical after two to four years. “We consider ourselves as opportunistic lenders, where we generally help to accelerate organic growth with permanent working capital as well as acquisitions and rollups,” Shulman said, adding that the average hold period is closer to 18 months. “Given our high degree of loan demand, staying ‘short’ on loans minimizes interest rate risk to our investors, and allows us to redeploy capital more quickly.”

Buy and build
With PE dry powder continuing to mount, totaling a record high of $955.7 billion at the end of Q1 2023, opportunities for private credit deals in the lower middle market are poised to improve in 2024 both in terms of deal flow and credit quality, sources said.  

“I think deal volume will be up compared to last year, and quality will be strong,” said Denniston. “The quality of deals we are seeing now are businesses that have adjusted to the higher interest rate environments, and given where the market is at, we’re able to put less leverage on these deals compared to two years ago.”  Of course, the dream is to identify the next platform for a buy-and-build strategy. Borrowers tend to be sticky once they’ve established a relationship with a lender, and deals regularly contain only one lender.

“A loan that originates at $40 million can turn into an $80 million loan over time, for a business and sponsor we’ve already underwritten. It’s a very efficient way to grow your portfolio,” said Garcia. 

Featured image: Brightstars/Getty Images

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