If larger, long-established corporations rely on bank loans to fund their growth plans, and startups rely on angel investors and venture capital, what options are available to those businesses in between?
The answer is middle market lending, a term used to describe the flexible financing options middle market companies have at their disposal to take their businesses to the next level.
To understand middle market financing today, it helps to first understand how the lending landscape changed in the wake of the 2008-09 financial crisis.
While middle market companies have long faced limited lending options from banks, that problem was magnified following the slump, as banks were subject to increased regulation and compliance concerns.
Faced with these tighter restrictions, banks began to favor upper-market businesses with consistent cash flow, sufficient collateral and low debt-to-income ratios. Middle market businesses, as a result, turned to private lenders, which are not subject to the same restrictions as banks.
These institutions can, as a result, take on greater risk, develop deeper relationships with companies and provide flexible, multi-layered funding that fosters strong levels of growth.
By 2018, a staggering 40 percent of private credit managers were actively lending to companies with an EBITDA of less than $25 million, and these companies were in turn showing impressive growth potential. A report from December 2019 noted that 90 percent of middle market companies are planning to invest in new technology that will drive down costs and improve operational efficiency, while 73 percent will engage in mergers and acquisitions.
In this guide you’ll learn about the various kinds of middle market financing, where the middle market lending industry is headed, and what kinds of companies qualify for middle market loans in the first place.
Let’s dive in.
What is Middle Market Lending?
Middle market companies, defined by the U.S. Department of Commerce as those businesses with pre-taxed earnings between $5 million and $250 million, comprise one-third of the United States’ economy.
Investopedia estimates there are about 200,000 middle market firms in the U.S., employing roughly 30 million people. And while companies that sit on the higher end of the earnings spectrum can rely on bank loans, financiers or large investments for funds, middle market companies are more likely to draw funding from business development companies (BDCs), finance companies or debt funds.
BDCs were created as a result of the Small Business Incentive Act of 1980, a piece of legislation passed in response to the Investment Company Act of 1940. The latter measure, which was put into effect following the Great Depression, restricted the number of people/companies who could invest. That in turn reduced the capital available to smaller businesses, but the more recent legislation reopened that spigot. (It’s also worth noting that investors of every stripe can invest with BDCs, not just the wealthiest.)
Middle market companies seek out BDCs and other lenders in order to pursue growth opportunities, refinance their business, pursue a merger or acquisition, or a number of other landmark events in a company’s journey. Making such moves requires careful deliberation and due diligence, so middle market companies often rely not only on these lenders’ flexible financing solutions, but also on their expertise and guidance as they navigate choppy waters.
One popular form of middle market loan is mezzanine financing, which is a hybrid of equity and debt financing that provides the lender the ability to convert equity interest in case of a loan default.
Unlike most bank loans, a mezzanine loan is highly flexible, low-collateral, and funds a company based on its capital flow. The loan may be structured in relation to the priority with which it is paid or as preferred equity for capital financing.
Mezzanine financing is particularly appealing to entrepreneurs and family held businesses, as it enables them to realize dividends they might not otherwise realize, given their personal financial stake in a given company. It also gives them liquidity and an ability to diversify their portfolios.
Senior debt loans are another popular form of lending in the middle market. In fact, Prudential notes that companies will not find a more cost-effective option for obtaining large amounts of capital. Senior debt is a form of corporate debt that, with respect to interest, takes priority over other classes of debt and equity provided by the issuer.
These loans are only issued by banks, making them among the few agreements between such financial institutions and middle market companies, and are protected by concrete collateral, such as real estate, equipment, factories, or other capital goods. For the middle market, senior debt loans are offered at competitive leverage levels and lower interest coverage rates.
As with other forms of middle market lending, senior debt loans offer great flexibility, in that they can be secured or unsecured, and come from various lending markets. A company’s funding need is one of the main criteria for loan terms.
With a senior debt loan, companies put up their concrete assets as collateral, and draw on a low-interest loan that is also low-risk to the lender.
In a situation where a company ceases operations and declares bankruptcy, secured creditors, backed by the company’s assets, will get paid before other creditors because the loans they issued are considered to be the company’s senior debt. That’s why these kinds of loans are alternatively known as asset-backed or asset-based loans (ABL).
Mezzanine loans are often charged at a higher rate compared to senior debt loans because the lender is completely dependent on future cash flow for repayment. Without concrete assets to back the loan, mezzanine loan providers look closely at measures of EBITDA and historical cash flow to determine whether a company’s risk/reward analysis makes sense for their portfolio.
BDCs also tend to engage in cash-flow-based lending, or lending according to the cash flow a business generates. That enables BDCs to support companies like those in the SaaS (Software as a Service) sector. These companies might not have a lot of assets, but they do generate cash flow, affording the opportunity for a relationship to be formed with a lender.
Middle market companies with an EBITDA greater than $50 million may qualify for what are called broadly syndicated loans (BSLs). These BSLs are provided by a team of lenders, yet are structured and administered by commercial or investment banks.
BSLs are usually managed by a diverse and large group of investors. Though BSLs are more liquid than middle market loans, restructuring transactions in the BSL market is often less effective since the investors are difficult to properly coordinate, simply because of their sheer numbers. There can be anywhere from 15 to 100 involved in a single investment.
What Companies Are Considered Middle Market?
Since middle market companies can range in annual revenues from $5 million to $250 million (some even cap the range at $1 billion), the term “middle market” can be woefully imprecise.
Rather than relying on revenue, some analysts look at a company’s employee size and physical assets to determine its mid-market status. The issue of classifying the mid-market is made even more complex since different industries subscribe to their own classifications. What classifies as small, mid-size, and large may vary.
Defining the middle market isn’t just a pedagogical exercise. In terms of funding sources, the distinction between small businesses and mid-market businesses is key. Small businesses, which are defined on an industry level by the Small Business Administration, have access to a multitude of government programs.
To make matters slightly more complicated, alternative lending sources keep their own middle market criteria as to which companies they lend to, and why. (Saratoga Investment Corp., for example, typically lends to companies with annual revenues between $8 million and $250 million). When it comes to picking a middle market lender, it’s important to consider their qualifications and specialties to ensure you find the right fit.
Most middle market businesses do share several key features. Not only are they part of the fastest-growing sector of the economy, but middle market companies are large enough to weather economic storms while having the resources to invest. The middle market is sometimes dubbed “the invisible economy” since these companies often offer business-to-business products unknown outside of niche industries.
Within the mid-market, there are two important sub-categories: the lower middle market, comprised of companies that net annual revenues between $5 to $50 million, and the upper middle market, for companies that net annual revenues between $500 to $1 billion.
Lower middle market companies are those with revenues slightly greater than small and medium-sized enterprises (SMEs). More than 90 percent of all middle-market companies are part of the lower middle market, which generates a significant percentage of the world’s employment and GDP.
The upper middle market comprises just 1 percent of the overall market. These high-revenue companies command premium valuation multiples and have a disproportionately large market share. Some private equity investors find upper mid-market businesses very attractive as a result of their historicity, revenue generation, and contributions to the global economy.
But recently, many private equity firms have turned their attention to the lower middle market to fill the gap left by commercial banks, especially in the wake of the 2008 financial crisis. This trend has been beneficial for both lenders and business owners — middle market companies need capital to fund their growth strategies, and lenders are attracted by promises of high returns, floating rate protection, and low correlation to traditional risk assets.
In fact, since the recession, middle market companies have delivered more stable revenue growth than the S&P 500. Perhaps that is why direct lenders in the United States raised $25.1 billion through the end of 2019, a 70% increase over the $14.75 billion raised just five years earlier. One recent study found that more than 86 percent of non-traditional investment sources have an allocation specific for the US lower-middle market and 77 percent of them plan to increase allocations into direct lending over the next two years.
The Advantages of Middle Market Lending
Middle market lending is not only a necessity, it is a highly advantageous wealth management framework for both borrowers and lenders.
Borrowers gain access to much-needed capital to aggressively pursue growth initiatives while benefiting from the guidance and networks of their lending partners. Lenders, meanwhile, make their money back through creatively structured loans with mutually beneficial terms involving capital interest, equity, or both.
Unlike banks, middle market lenders have a level of flexibility in their relationships with borrowers to support their goals.
At Saratoga Investment Corp., for example, we provided one of our portfolio companies with $12 million in funding, and then made eight more funding rounds over the next four years as business goals evolved. That enabled the company to not only acquire other companies, but also to triple its revenue and EBITDA over the investment period.
Another advantage of BDCs is stability. While banks must not exceed a debt-to-equity ratio of 10-to-1 (i.e., 10 times more debt than equity), BDCs cannot go beyond a 2-to-1 ratio. Certainly it’s a win-win situation, as lenders reap their share of benefits as well with yields as great as eight percent.
The Verdict: Where is Middle Market Lending Headed?
Like many asset classes, middle market lending was adversely affected by the COVID-19 pandemic. As with all economic downturns, it’s unclear how and when full recovery might come about, and the past can only offer a partial guide.
Following the Great Recession of 2008-09, for instance, Congress responded by passing the Dodd-Frank Act, which only served to place greater restrictions on banks, and lessen their ability to serve middle markets. BDCs and other private lenders were able to fill that gap.
Does it follow that Washington will respond to the current crisis with increased regulation?
No one can say for sure.
What seems certain is that middle market companies will continue to rely on business development companies and others for private lending opportunities. Unfettered by the sort of regulatory controls that have limited the focus of banks, these financial institutions can offer companies in this critical sector flexibility and the opportunity to pursue their growth initiatives.
At the same time, the lenders themselves stand to realize some impressive gains, making these relationships the ultimate win-win propositions.