Nov/Dec 2012

Flexibility: The Final Frontier For Lenders

With an imbalance between supply and demand, conditions this year were supposed to favor lenders. Instead, the first half of 2012 has been lackluster, with loan volumes below last year’s pace. In order to win financings, flexible participation has become increasingly important. And, those lenders with multiple sources of funding are finding themselves at a growing advantage.

Sunny Khorana, Partner and Head of Midwest Originations, Fifth Street Finance

Sunny Khorana, Partner and Head of Midwest Originations, Fifth Street Finance

Since the best laid plans often go awry, it helps to be able to pivot. Many lenders today especially non-traditional ones like business development companies (BDCs) — can certainly appreciate this sentiment.

Conditions this year were supposed to be ideal, with an imbalance between supply and demand turning the tables in favor of lenders. Instead, the first half of calendar year 2012 has been lackluster, with disappointing loan volumes hovering well below last year’s pace. At $7.5 billion, year-to-date U.S. mid-market loan volume is a far cry from the $12.6 billion recorded in the first three quarters of 2011, according to S&Ps LCD.[1]

It is no surprise, then, that mandates have been hotly contested. However, the most obvious levers at a lender’s disposal — pricing and leverage — remain relatively static. Why the disconnect?

A New Battleground Emerges

From a pricing perspective, most non-traditional players are committed to a target dividend payout or net return in order to attract capital. Lowering yields beyond where middle-market credits trade today simply is not feasible. On the leverage front, levels appear to have maxed out, and uncertainty surrounding the current business climate seems to have dampened lenders’ appetites for more.

Today’s reversal of fortune has not impacted all players equally, however. Given the limitations on price and leverage, structuring has emerged as the new battleground. In order to win financings, flexible participation has become increasingly important. And, those lenders with multiple sources of funding are finding themselves at a growing advantage.

Multiple Funding Pockets Matter

Select specialty lenders, such as some leading BDCs, enjoy diverse sources of liquidity, ranging from unsecured/term debt and SBIC financing to securitization financing and long-term credit facilities. Since each pocket carries its own costs and covenants, well-established niche players are able to offer superior product suites that run from low multiple, senior secured debt all the way to straight unitranche or mezzanine financing. The ability to draw on these different pools — even if it means participating in more than one tranche on the same deal — is giving these players a leg up.

To be fair, competing on structure is not new. A few years ago, the unitranche, or one-stop deal was a much sought-after innovation. Today, though the one-stop still plays an important role, its utility as a differentiator has declined as its prevalence has grown. In its place, agility has emerged as the new competitive advantage. Only a select group of niche players can fill this tall order — generally those with multiple pockets of funding that span credit facilities as well as pools of equity.

Agility Secures an Allocation

In today’s scrappy middle market lending environment, for example, having a flexible balance sheet can translate into a choice deal position. Such was the case in the $1 billion plus buyout of a maker of enterprise software. In a hard-fought transaction that closed three times oversubscribed, one niche player parleyed agility into a meaningful allocation.

During the early indication stage, the lender rapidly came back with a sizable commitment. This early nod put the investment bank on favorable footing when broadly marketing the deal, which quickly became oversold. In addition, in exchange for assuming a portion of the first lien at a discount, the specialty lender was guaranteed the largest allocation on the second lien as well as a Syndication Agent title.

Be Nimble When Sponsors Need it Most

In a separate instance, flexibility had more to do with relationship building than with securing a particular mandate. The transaction involved the recapitalization of a provider of K-12 education services. The relatively recent loss of one the company’s largest customers was giving some lenders pause. Although the company had been able to demonstrate momentum across other regions — replacing the lost revenue and continuing to grow — the headline risk, along with the sponsor dividend component of the transaction, proved too much for some lenders to overcome.

Facing a shrinking pool of lenders that could get comfortable with the deal, the sponsor was delighted when an efficient solution emerged. A BDC stepped in as the fourth lender on the senior tranche, while agreeing to take down the full mezzanine tranche as well.

The BDC model is particularly nimble in this regard. Unlike some players who only have a mezzanine fund or a senior pocket from which to draw, select BDCs have both. More importantly, the most agile BDCs have a flat structure where a single credit committee governs decision making over both pools. They recognize that having redundant credit committees inhibits their ability to quickly green light flexible participation.

Think Outside the Structure

Sometimes the most effective competitors are those that proactively offer out-of-the-box solutions, rather than trying to plug a hole in an existing structure.

Take, for example, an energy industry manufacturer whose syndication was jeopardized by a transient soft-patch in performance. As others shied away, the lead arranger suddenly found itself holding more paper than originally intended.

Approached by the sponsor, one specialty lender proposed an attractive solution for all parties: a relatively large term B loan with no amortization. This structure gave the term A loan more amortization on a percentage basis, making it much more saleable to banks. What is more, lending its name to the deal was just the credibility needed for others to comfortably join in and help get the syndication back on track.

Flexibility Provides the Ultimate Edge

At the end of the day, the make-up of a lender’s balance sheet matters. Having multiple sources of funding can mean the difference between winning a mandate and losing an allocation. More importantly, it comes down to supporting sponsors when they need it most.

Sunny Khorana is a partner at Fifth Street Finance. He is responsible for developing private equity sponsor relationships and originating loans in the Midwest region of the United States. Khorana joined Fifth Street after spending over three years at CIT Group in Chicago, where he was responsible for originating and structuring debt financing opportunities for middle-market private equity firms. He previously spent nearly seven years at JPMorgan Chase and its predecessor firms in both Chicago and New York, primarily in the Financial Sponsor Group, where he focused on debt, equity and advisory assignments for private equity firms and their portfolio companies. Khorana began his career at KPMG in its Chicago office. He received his B.S. in Accounting from Indiana University and his M.B.A. in Finance from the University of Michigan Ross School of Business.

[1] As of September 30, 2012. Source: S&P Capital IQ’s Leveraged Commentary and Data (LCD).