Alternative Investors Penetrate the Middle Market

April 4, 2023
| Articles

By Ben Godbout, Managing Director

With the first quarter of 2023 drawing to a close, and interest rates and inflation continuing to pose challenges for middle market businesses working their way back from the pandemic, now’s the time to look back at the dynamic shifts we have seen in the debt capital markets.

Many retail lenders, looking to choppy seas ahead, have been attempting to either aggressively renegotiate terms or exit challenging distressed situations altogether. Meanwhile, an increasing number of alternative capital sources have been pro-actively looking down-market for opportunities to put capital to work, further emboldening retail lenders to act. 

For middle market companies who are concerned that the patience of their retail lending institutions is wearing thin, the entry of these alternative capital sources couldn’t have come at a better time. For the alternative lenders themselves, there has never been more opportunity to invest into companies throughout the capital structure. 

Last year, I suggested that 2023 would see more opportunities for alternative capital providers down-market. Supply shortages, labor issues and rising inflation are straining businesses, and traditional bank lenders are starting to apply pressure. We are now seeing hedge funds, distressed credit funds, private credit investors and others playing a greater role in providing capital to these businesses. 

Applying additional pressure to middle market companies is the fact that some over-invested during and coming out of COVID – upgrading technology, making large capital investments, and staffing up – all based on the availability of inexpensive capital. Today, these businesses are finding themselves facing a different reality. In many cases, they are struggling with liquidity issues and tripping covenants. Presented with arduous restructuring term sheets, the conversations they are having with their investors have become more contentious. 

Despite these uncertain times, opportunities are available. For middle market businesses facing stress, it is an ideal time to get “stale” capital off their balance sheet and work with investors willing to roll up their sleeves to find a value-maximizing solution for all stakeholders. For incumbent retail lenders tired of “kicking the can” down the road, there have never been more suitors lined up to take their place. The flow of alternative money into the middle market is giving banks an efficient pathway out of businesses at a time when their workout teams are resource constrained. Meanwhile, there has never been a better time for alternative capital providers to buy up debt, find value, and invest in businesses they previously have been unable to access, or otherwise might not have been looking at.  

In the last year alone, we have seen mezzanine lenders restructure to new senior debt positions, providing a solution to the retail lenders, as well as gain equity positions to effectuate a turnaround. We have also seen retail lenders become emboldened. One sponsor-owned company was forced to find a pathway to extricate the lender or face bankruptcy. Knowing bankruptcy was not the value-maximizing way forward, the company permitted the retail lenders to run a debt sale process and, simultaneously, have the equity put to the debt purchaser, effectively running a creative M&A process. This solution avoided the high costs and reputational challenges of bankruptcy, while maintaining company operations and preserving jobs. This was viewed as an extremely successful outcome given the challenges faced. 

There are numerous upsides to this new lending environment. Among them is the opportunity to get lenders off the balance sheet. These lenders no longer wish to be invested in the company, add costs via forbearance agreements, require the company to hire advisors, and impose arduous covenant terms and other constraints. New money is often raised from alternative sources who wish to align their goals with the company’s, particularly if they hold equity or convertible debt instruments.

Furthermore, non-retail lending institutions’ capital is more flexible, less regulated, and has looser covenants/CAPEX constraints; these lenders are seeking to partner with the company in aggressively growing the business. Retail lenders, on the other hand, are often underwriting conservative traditional loans, adding market norm leverage to the balance sheet, charging a market interest rate, and requiring the company to pay principal and interest until maturity. These traditional corporate lending practices often create difficulties when companies face challenges and trip the terms of their credit agreements.

Obviously, alternative investing is a higher-risk, higher-reward form of investing. By seeking higher returns, alternative investors are often underwriting or buying second lien, mezzanine or equity positions in middle market companies. This capital does not have the downside protection afforded to traditional senior secured lenders who are typically first in line for cash distributions in a transaction or restructure. The risk these alternative investors take on is paid for via higher interest rates, larger equity stakes, a seat on the board for more control, or a larger say in business operations.

None of this diminishes the need for companies to be acutely aware of who is in their capital structure, and to understand their track record and motivation. But the growing presence of alternative investors in the middle market has overall been a positive development for companies and investors alike, bolstering middle market companies’ prospects at a time when retail credit is hard to access and is expensive. It has also emboldened retail lenders to stop delaying action when faced with challenges and, in the process, has opened  new markets for alternative capital providers.

Our team has the in-depth knowledge and experience to navigate the complexities of the next phase of your business evolution. Partner with Carl Marks Advisors to achieve your strategic and financial goals.

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