Navigating Today’s Debt Capital Markets

The U.S. economic recovery is firmly underway and the growth prospects for many mid-size companies are better today than they’ve been for half a decade or more. The Federal Open Market Committee (FMOC) expects steady growth in the 3 percent range through the end of 2014, and it has also pledged to keep its ultra-low benchmark interest rate until 2015.As traditional middle-market lenders are being joined by institutional investors with deep pockets and a strong desire to participate in these loans, ample liquidity exists for mid-size companies — those with anywhere from $10 million to $1 billion in revenue. What’s more, new products are available that afford more flexibility among lenders. The end result is a combination of steady growth and affordable capital, in short, a near ideal environment for mid-size company borrowers.As businesses begin to navigate the increasingly intricate debt capital markets, it’s crucial for lenders to anticipate the complexities of the financing landscape. There are new senior debt options available that can be structured as either asset-based loans (ABL) or cash-flow-based loans, and junior debt offerings in the form of second-liens and mezzanine funding remain widely available in the private market.Meanwhile, the biggest mid-size firms could bypass these private offerings altogether and tap the public debt markets instead, where they can lock in low rates for longer periods. As CEOs and chief financial officers (CFOs) of mid-sized businesses look to take advantage of the current environment to ramp up borrowing, lenders should keep a few developments in mind when providing strategic industry counsel to customers and partners.

In the past, lending to mid-size companies was dominated by banks and finance companies. But now large institutions, such as pension funds, hedge funds and bank-run mutual funds, are getting involved and account for 60-70 percent of senior lending at the higher revenue end of the middle market. While these institutions lend directly to the company, they typically don’t have a direct relationship; instead they participate in syndicates arranged by an agent such as a bank or finance company.A big reason for this increase in lending is institutional investors’ desire to diversify their holdings from fixed-rate debt to include more floating-rate debt, which offers some protection should interest rates start to rise. Plus, the yield is relatively good.Asset-based lending for middle market companies is typically 175-200 basis points over the London Interbank Offered Rate (LIBOR), while cash flow lending is usually rating-dependent with typical spreads at LIBOR plus 300-500 basis points.

Historically, the long-term financing available in the bond markets has only been open to larger mid-size companies with revenues closer to $1 billion. Most middle-market companies have had to settle for bank loans that amortized in five years. But following the financial crisis, institutional investors are once again reemerging to offer bond-like facilities to smaller middle-market companies. They are offering loans with virtually no amortization, as low as 1 percent, so these loans function more like bonds.Other products that borrowers are exploring include “delayed draw facilities” and “incremental draw facilities.” In a traditional loan, the company gets all the money up front and immediately begins paying interest on the whole loan. For a fee, delayed draw facilities give a company the flexibility to draw down the cash and begin paying interest when they need it — often over a one- or two-year window. It’s similar to a revolver but in the form of a term loan, and can be a cost-effective option for borrowers.What’s more, “covenant-lite” loans for mid-size companies have also returned. Loan covenants are certain measures that serve as early warning signs should a borrower run into trouble. Covenant-lite loan agreements have fewer restrictions and allow the borrower greater flexibility and often fewer reporting requirements.

There are some important lessons from the financial crisis that CEOs and CFOs are now considering when assessing lenders. One of these is the “loan syndication” strategy. There are three types of syndications. In an underwritten deal, the arranger guarantees the entire loan and then places part or all of the loan with a group of lenders.

In a “best-efforts” syndication, the arranger commits to underwrite less than the entire amount of the loan, which means if other lenders can’t be found the loan may not close.Finally, there is the “club deal.” These are smaller loans, usually $25 million to $100 million, but as high as $150 million that are pre-marketed to a group of lenders. The arranger is generally a first among equals and each lender gets a full cut, or nearly a full cut, of the fees.In all types of syndications the agent’s relationships with other lenders and the ability to hold part of the loan on its own books are critical to the smooth execution of the deal. Before the financial crisis, many agents would syndicate the entire loan and not hold any on their own books.That wasn’t a problem unless, as frequently happened during the financial crisis, the borrower ran into a rough patch and tried to amend the loan terms. If its agent didn’t own the loan, the borrower had to negotiate with a large group of lenders with whom it had no relationship. For this reason, many mid-size company borrowers now prefer to have their agent and a few core lenders hold at least 51 percent of the loan. This also makes the initial syndication easier since less of the loan must be placed.

Some borrowers are also pursuing agents that actively trade in the secondary market — where investors buy and sell previously issued loans — and make a market for their loans. This trading activity offers valuable insight into how the company is viewed by the market.

If, for instance, a company’s loan trades above par, it’s a sign that lenders might be willing to extend the company a new loan at a lower interest rate, as with bonds, loan prices and interest rates are inversely related.

The evolving regulatory landscape has become more burdensome since the financial crisis. Just recently, the Federal Reserve released new guidance for highly leveraged transactions (HLTs) directing all lenders to be extra vigilant when underwriting loans and demonstrate adequate capital to withstand losses. It is too early to know the effects of the new guidance with certainty, but it could dampen some bank lending in the future.Though the environment for mid-size company borrowers is bright — with more lenders, new products and good terms — the market complexities present challenges. By keeping a few key developments in mind, lenders can successfully enable mid-size companies to navigate today’s debt markets and secure the right financing to build their businesses.Bob McCarrick ([email protected]) is chief commercial officer, Lending, at GE Capital, Corporate Finance, specializing in providing commercial loans and equipment finance to mid-size companies for growth, acquisitions, turnarounds and balance sheet optimization. Visit gecapital.com/americas.

This article first appeared in the July 2013 issue of Financial Executive magazine.