When assessing the creditworthiness of senior secured corporate loans, we find that middle market loans are often more favorable to lenders than broadly syndicated loans due to the higher likelihood that these loans have leverage covenants which offer lenders better protection from an aggressive dividend policy, as well as a stronger negotiating position if the credit underperforms. In the middle market, lenders and sponsors tend to be more closely aligned and there is a higher level of trust and comfort that the sponsor is acting in the best interest of the company, especially in cases where middle market lenders and sponsors have formed tight-knit relationships through years of experience working together. This also can lead to better communication between lenders, sponsors and company management in distressed situations and may result in more proactive measures and creative solutions when dealing with a covenant breach.
A global lighting solutions company provides an example of a covenant-lite, broadly syndicated deal that took on too much debt; operating results faltered and leverage rose to 14x in 3Q20, while its $1.7 billion first lien term loan traded at 60 cents on the dollar in October 2020. After the buyout deal in December 2016, the sponsor proceeded to take out dividends totaling more than $500 million since July 2017. This aggressive dividend policy, which included three dividend payouts within one year, resulted in high leverage and poor liquidity at the lighting solutions company during challenging industry conditions in 2019-2020, and sent the capital structure to distressed levels. Elevated indebtedness increases a company’s leverage and constrains its liquidity – in 1H19, interest expense consumed over 80% of the company’s free cash flow. While a rebound in cash flow helped to reduce leverage to around 9.0x in 1Q21 and the term loan recently traded around 77 cents on the dollar, the resulting swing in leverage, constrained liquidity and loan price volatility are suboptimal conditions that lenders can try to avoid by focusing on middle market loans with leverage covenants and sponsors who invest for the long-term success of the business and not mainly for capital extraction.
An IT services company serves as an example of a middle market business that faced a challenging period in recent years and needed lender support. Customers were taking longer than anticipated to pay the company, constraining its available cash balance to operate the business. Further, projected synergies from acquisitions were not realized as quickly as planned. This resulted in lower-than- expected EBITDA and cash flow, and the company breached the leverage covenant on its first lien term loan. To help the company navigate these obstacles, the lender group and financial sponsor of the borrower worked together to find a solution that appealed to all parties. The lenders agreed to waive the covenant breach and amend the credit agreement to provide the company temporary relief from its debt obligations. The amendment reset the leverage covenant schedule and provided a grace period from servicing its debt obligations for up to two quarters to maintain sufficient cash to support operations. In exchange, the lender group received more favorable terms including an amendment fee, higher interest rate and higher amortization rate.
Keeping cash in the business enabled the company to effectively service its existing customer base while also allowing it to execute on new business opportunities. The company was able to grow its client base while simultaneously improving its cash flow. By the time debt service obligations resumed on its term loan, it had a much stronger liquidity position to support the more lender-friendly interest and amortization terms. Shortly after, the financial sponsor sold the business at a substantially higher value than its original purchase price. The lender group was repaid at par as the company refinanced its credit facility at a much lower cost of debt.
In the senior secured loan market, middle market loans frequently offer stronger lender protections than broadly syndicated loans and allow for more creative solutions between borrowers and lenders in the case of a covenant breach. Middle market loans generally include just one lender, or a small club of lenders, as opposed to broadly syndicated loans which tend to have dozens of lenders. Therefore, communication between lenders tends to be much more efficient and transparent in middle market transactions. Middle market transactions also typically offer lenders a direct line of communication to the financial sponsor and management team of the borrower, which is especially critical in times of distress.
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