Thanks to all the consolidation, restructuring and distress among lenders, the middle market has gone from feasting on financing options to a starvation diet almost overnight. At the peak of the liquidity bubble, a plethora of lenders, including the largest and the smallest banks, independent finance companies and nonbank providers, all competed to serve small and midsize businesses.
For a time, this diversity helped blunt the impact of the financial turmoil on the middle market. But that all changed when the credit markets seized up altogether after the collapse of Lehman Brothers Holdings Inc. For much of 2008, total loan syndications hovered at around $20 billion for both sponsored and nonsponsored transactions worth $250 million or less. But during the fourth quarter, that number dropped to $13.7 billion, according to Thomson Reuters Loan Pricing Corp.
As liquidity problems threatened the broader banking system and troubled banks plunged deeper into deleveraging, bank financing dried up. This drove up costs for borrowers and made capital scarce for all but the healthiest companies. The crisis also hobbled undercapitalized, nonbank finance companies, such as CIT Group Inc.
New York-based CIT, which relies heavily on commercial-paper borrowings to fund its loans, was forced to restructure, ultimately buckling under its debt load and filing for a prepackaged bankruptcy on Nov. 2. Its corporate finance division was among the top lenders to the middle market. Last year its loan originations plummeted by more than 60%, to about $6.3 billion, from nearly $16 billion in 2007.
Even General Electric Co.'s GE Capital Corp., the biggest borrower in the commercial-paper market last year, promised to slash borrowings and scale back financing new deals. But unlike CIT, it has benefited greatly from its parent's deep pockets and from government-financing guarantees.
GE Capital, which includes midmarket specialist GE Antares in its financial services division, stayed atop LPC's league table rankings for sponsor-backed loan issuances in 2008 for transactions of $250 million or below. This year, total lending volume through September totaled $1.9 billion, spokesman Ned Reynolds says. GE Capital "remains a very active player," Reynolds adds.
For sponsor-led transactions, the shrinkage has left precious few avenues for leverage. Buyouts slowed to a trickle. Sponsor-backed financings for transactions of $250 million and below sank to $1.9 billion in the third quarter this year, from $4.7 billion in the same quarter pre-Lehman.
"People are either in wind-down mode, shutting down operations or they've sold themselves to other competitors," says Chris Williams, co-founder of Chicago-based Madison Capital Funding LLC.
Previously active CapitalSource Inc. and smaller rival NewStar Financial Inc. have also had setbacks. CapitalSource, of Chevy Chase, Md., restructured and is managing its real estate exposure in its portfolios. Business development companies, or BDCs, found their closed-end funds impaired by the collapse of the stock markets and underlying portfolio company values. The BDCs' assets are required to be marked to market, and a number of them tripped their tangible-net-worth covenants.
With stock prices falling below net asset value, access to the public equity markets has been limited. Allied Capital Corp. of Washington, which in mid-2008 had the second-largest investment portfolio, excluding real estate, with about $4.3 billion in 149 companies, was hit the hardest. Its stock, already under pressure from short-sellers, sagged further after portfolio company Ciena Capital LLC, a commercial real estate financing and factoring company and Allied's largest portfolio investment, filed for bankruptcy last September. The BDC posted more than $1 billion in losses in 2008 and breached debt covenants, forcing it to sell some assets.
In October, Allied agreed to be acquired by Ares Capital Corp., a subsidiary of Los Angeles private equity firm Ares Management LLC, and about half the size of Allied but with a stronger balance sheet. The $648 million merger will result in a combined portfolio of $4.5 billion.
The largest BDC, Bethesda, Md.-based American Capital Ltd., which boasted nearly $10 billion in portfolio assets in June 2008, is similarly constrained. The firm took big hits on its portfolio and also defaulted on debt covenants. After protracted negotiations with lenders since the beginning of the year, the firm appears to be making headway on a restructuring agreement.
"Clearly, they're not out of the water yet," says Fitch Ratings Inc. analyst William Artz. Whether American Capital ends up merging with another institution is another question. "Its size may be difficult to digest at this point," suggests Artz, and "they're going to be handcuffed in terms of paring the size of the portfolio as a standalone entity."
American Capital, along with a handful of other BDCs, won't be able to lend for the foreseeable future.
"There are six BDCs that we think have deleveraging issues where they're essentially unable to make new investments," says Greg Mason, an analyst at Stifel, Nicolaus & Co. These include MCG Capital Corp. of Arlington, Va., though Mason says the BDC may be nearing the end of its deleveraging. New York BDC Prospect Capital Corp. is acquiring another, Patriot Capital Funding Inc. of Westport, Conn.
That leaves about a dozen BDCs -- including Ares, Apollo Investment Corp., Fifth Street Finance Corp., Gladstone Capital Corp. and BlackRock Kelso Capital Corp. -- that are making investments. These BDCs can fill "a small sliver of the void," says another analyst who requested anonymity.
But who might be expected to pick up the slack? Large caps have made increased use of the bond market but for nearly all middle-market companies, this is not an option. Groups such as Chicago's Madison Capital Funding, which manages about $4 billion in funding commitments as part of New York Life Insurance Co.'s investment management group, and New York's Golub Capital Partners LLC have stepped into the breach.
In 2008, GE and Madison Capital financed the most leveraged financings ($250 million in size or less), with 31 and 24, respectively, according to LPC. Golub Capital, which previously wasn't ranked in the top dozen, was next with 13 deals, then CIT with 10.
This year, Golub Capital dominated with 11 transactions.
For all sponsored transactions of $250 million or less, including recapitalizations, refinancings and bolt-on acquisitions, GE, Madison, Wells Fargo & Co., Bank of America Corp. and CIT are in the top five.
Some banks, including Wells Fargo, Credit Suisse Group and Bank of America Merrill Lynch, remain somewhat active. Jeffrey S. Kilrea, a managing director at CapitalSource, adds Bank of Montreal, Bank of Ireland, SunTrust Bank and Toronto-Dominion Bank to the list.
Smaller concerns such as Cincinnati's Fifth Third Bancorp and New York's Amalgamated Bank are trying to make inroads. Both recently launched sponsor finance groups. Names like Regions Financial Corp. also have surfaced more prominently. Nonbank lenders, including hedge funds and smaller private equity-like funds, have also helped bridge the gap.
How can a lender function effectively in this depressed environment? Market participants say maintaining a steady stream of capital is key, or having assets that can be quickly converted to cash.
An August report entitled "A Hole in the Middle of the Recovery" from Glenview, Ill., middle-market financier CastleGuard Partners LLC, says that while government stimulus efforts like the Troubled Asset Relief Program and the Small Business Administration programs have failed to meet the particular financing needs of the middle market, they may be tweaked to do so.
A stalled U.S. Treasury initiative, part of the $30 billion Public-Private Investment Program called the Legacy Loan Program, might allow midmarket banks to sell off troubled loans to provide them access to new capital, the report suggests. Only banks with up to $5 billion in assets could participate, countering criticism that this program is no longer needed because large banks have succeeded in raising private capital.
Expanding the Term Asset-Backed Securities Loan Facility to include trading of collateralized loan obligations, which in turn would generate capital for new corporate lending, is another option. "Funding leverage specifically of any new ventures is the biggest challenge facing new entrants," Kilrea says. "One would make the argument, contrarian perhaps, that this is a perfect time to launch a new middle-market lending initiative given the favorable leverage, pricing structures and competitive landscape, but getting any leverage on equity capital has been near impossible."
Lloyd Greif of middle-market investment bank Greif & Co. says private firms are "morphing into senior debt providers to lock out investment risk. "A lot of these guys are buying bank paper, left, right and center," he says. "It's less of a risk for them and they can get a disproportionate reward because there's less competition. It's a question of who has the money."
Adds Cynthia Krus, partner at law firm Sutherland Asbill & Brennan LLP, "anyone whose got money right now is a god." But financiers need to understand the midmarket's particular nuances as well as those of the industries they are lending to. "The closer you are to the consumer, the less likely you are to get financing," Krus says.
She adds that debt will likely dog the midmarket for months. "All the maturities coming due. It's staggering." Statistics from Thomson Reuters LoanConnector indicate about $450 billion in midmarket loans will mature over four years.
She adds that the federal government has focused much of its attention on larger macroeconomic issues and financial institutions, and the effects have yet to trickle down to middle-market companies. "I'm not convinced that this inability to fund their business operations isn't going to have significant effects into 2010," she says.
Michael Rudnick contributed to this report.