As I reach 20 years of advising on debt financing transactions, in particular leveraged acquisition financing, I am going to stick my neck out and say that I don’t recall the mid-market leverage finance operating in as healthy a way as it currently does.
Over that time, there has always been an interplay between institutional capital and bank lending. The growth in B tranches, high yield, PIK and CLO funds reflect that trend. However, until relatively recently, banks have retained control over origination of institutional funding, building products that were sold to relatively unsophisticated buyers as investment products.
That is no longer the case. A combination of pay restrictions and limited profitability have resulted of the loss of senior staff who have populated a much wider community of investors, debt advisors and expert teams in sponsors, many of whom have debt funds of their own.
I recently acted on the financing of a business funded by a debt fund. Three years ago, the business was essentially a start-up, a carve out from a larger business with experienced management on board but with no track record or existing systems. The debt fund was originally asked to provide a stretched senior debt package, but faced with the transaction falling through, went further and provided the equity which got the new business off the ground.
That debt fund has stuck with business through changes in management and coached the business into building out the management team and achieving real operational stability before expanding. Whilst the business has obviously been using a bank for working capital, the business is only now looking to take on some senior debt, most likely funded by a bank.
This is not an isolated example. Debt funds are performing a vital role in funding mid-market businesses, providing a supportive role through financial difficulties.
In the past, these were the sorts of transaction that banks would have funded. But in todays connected world, regulators are disincentivising banks from providing riskier financing. Recent experience shows banks still reducing their exposure to mid-market leveraged lending.
Changes in the banks’ credit requirements reflecting increasing capital requirements have led to a need to for the business to have more equity than previously. These capital requirements are more closely policed and reported. When challenged over their conservatism in relation to a recent financing, one bank said, “you need to understand that the bank no longer can lend against cash flow, it needs to be able to identify assets that it is funding even if that is working capital”.
Banks regulatory driven conservatism extends to structures like cash pooling, where regulatory (rather than strictly legal) concerns over the netting euros and sterling mean that banks are no longer able to provide cash pooling facilities between currencies. Banks are also requiring more covenant protection around regulatory issues (money laundering and sanctions).
Regulatory changes have strongly influenced the mid-market debt market in multiple ways: banks really are disincentivised from more risky lending and they are thinking harder about the products they provide to make sure they work, not just in a strictly legal sense, but also practically.
In the distant past, banks performed the role that debt funds are performing today. Ensuring that business ideas got funded and businesses were guided through (and supported) in difficult times. Increasingly that is not what regulators want banks to do.
Importantly, though, the changes in the market are not driven by upstart new debt funds and challenger banks. They are the output of deliberate regulatory intent. Debt funds are not a challenge to the banks (who will always be able to fund loans more cheaply), it is an efficient mar.