Middle-market buyout general partners in the US have fond memories of the early and mid-1990s, when the deal landscape was filled with small banks willing to finance LBOs. These GPs grow nostalgic at names like Shawmut, Boatmen's, Sovran, Summit, Bank of New England, Barnett, and Republic Bank of Texas.
What happened to all these lenders? Well, the ones mentioned above are now a single institution – Bank of America. The other big banks – JP Morgan, Wells Fargo, Wachovia – all have played major roles in consolidating the entire lending world out of the middle-market.
Now a crop of new names are popping up in this neglected space, but they're not banks. Dymas, CapitalSource, KKR BDC, Blackrock Kelso. Who are these guys? Answer – they are the future of middle-market private equity finance, and they are already having a major impact on the private equity deal market.
A common complaint heard in the US middle-market, circa 2001, was that cash flow-based lenders had exited the lending business. Ten years earlier, there were hundreds of institutions in the business of providing senior and junior debt to small- and middle-market companies. This multitude of independent debt providers has been gobbled up by big players, and institutions like Bank of America can't be bothered to make small loans. The few small banks that still exist have no one else to syndicate their loans to, and so must be exceedingly conservative.
It didn't take long for Wall Street to sniff out a compelling business opportunity. “In the past three years, there has been a huge transformation in the middle-market,” says Hiter Harris, cofounder of Richmond, Virginia-based middle-market investment bank Harris Williams. “Three years ago, if you were a GP doing a deal, it was extremely difficult to get financing, mainly senior debt financing.”
The banks exited, but the non-banks stepped up. Established groups were the first to benefit. Private leveraged finance providers like Chicago-based Antares saw demand for their services expand. Private mezzanine partnerships enjoyed a heyday. Publicly traded “business development companies” Allied Capital and American Capital Strategies saw a surge in deal flow.
Then came the new groups. Publicly traded debt providers to have emerged in the past three years include Gladstone Capital, CapitalSource, MCG Capital and MVC Capital. Private efforts include Dymas Capital Management, founded in 2002 by distressed debt giant Cerberus and several ex-GE and Heller lending professionals. Merrill Lynch last year launched a commercial debt unit, also with an ex-Heller pro. Insurance firm New York Life established Madison Capital Funding in 2001. George Soros last year launched a lending business, SFM Capital Management.
Now comes the phenomenon that has the US private equity market all a-buzz: business development companies. In the past two months, no fewer than ten new entities – most of them affiliated with a private, private equity firm – have lined up to raise money from the public for middle-market lending.
The proliferation of BDCs, in fact, can be seen as a continuation of the rush to provide services abandoned by banks. To stroll through the many offering documents of these new BDCs is to experience déjà vu – they all present the same case for the middle- market lending opportunity, in a copy-and-paste kind of way.
From the Apollo Capital prospectus: “The market for lending to middle market companies is increasingly underserved by traditional financing sources.”
From the BlackRock Kelso Capital prospectus: “The middle market remains underserved by traditional financing sources.”
From the Evercore Investment prospectus: “The middle market remains underserved by traditional financing sources.”
Even hedge funds are getting in on the act, as more and more non-bank entities are attracted to the risk-reward balance presented by loans to middlemarket companies.
All the new entrants have changed the US buyout market from one in which few deals got done to one in which well financed equity sponsors go to war with each other in the auction process – just like their megadeal cousins. According to Harris, senior and mezzanine debt multiples have risen, and with them the prices at which small- and middle-market companies change hands. This is expected to continue as more and more players enter the debt business.
Still, for many GPs, the emergence of a new class of debt providers is a welcome relief. Jeffrey Stevenson, managing partner of Veronis Suhler Stevenson Private Equity, a middlemarket media investment specialist, commented: “The pendulum has swung so far toward a market with relatively few lenders focused on the middle to small end of the spectrum that these new groups have only begun to fill the void.”