September 2012

Uncertainty Rules the Markets –— We’ve Seen This Movie Before And It Feels Like It Keeps Running In A Continual Loop.

There are many factors contributing to an economic malaise that we can’t seem to shake. Nonetheless, there are, quietly, significant improvements in our domestic economic fundamentals that suggest that U.S. companies are positioned to take advantage of the economic recovery.

With unprecedented cash balances and significant gains in productivity, U.S. companies appear to be positioned to take advantage of the economic recovery. Growth was less than robust in 2011, and many companies moved into a holding pattern. As we head into the final quarter of 2012 and on to 2013, uncertainty remains an impediment. The purpose of this article is to shed some light on the financial markets with the goal of understanding the forces and conditions that are likely to impact the upcoming year.

Uncertainty Rules the Markets

We’ve seen this movie before — and it feels like it keeps running in a continual loop. Uncertainty and stresses seem to be a continuation of 2011 across the board. Many of the same issues clouding the 2011 horizon have persisted or recurred, slowing business growth in general and similarly affecting capital providers that typically support expansion. The poor economy in Europe, with a number of European countries in crisis, is among the issues at the top of the list, along with the slowdown in emerging markets economies — China in particular.

At home, the political stalemate and the upcoming election, along with U.S. debt concerns and the status of taxes, add to the reluctance of U.S. businesses to commit capital to hiring and investment in growth. On the financing side of the equation, banks, hedge funds, investments banks and finance companies are grappling with the practical effects of implementing Dodd-Frank regulations. All these factors contribute to an economic malaise that we can’t seem to shake.

All Quiet on the M&A Front*

At the start of 2012, private equity (PE) firms were estimated by Pitchbook, the private equity and venture capital research firm, to have had $425 billion of capital to invest. By mid-year, that number has held steady at $430 billion — remarkable, given the market drive for private equity to put capital to work. In general, market conditions are hampering the return of robust activity in this segment. Although a small number of PE firms have had success in fundraising in 2012, overall deal volume fell by 17% in Q2/12 from Q2/12 — a steady downward trend for nearly a year. The holding pattern — a constant theme in many of the financial markets — is the primary contributor to the slowing trends in deal flow, particularly for mega-deals.

Supply sources have also shifted. After significant bank consolidation in 2008-2009, there are fewer large banks to finance the larger deals. Also, structure trends appear to be compressing returns for investors. Debt as a percentage of deal size declined from 57% in 2010 to 46% in 2011 and 2012 — the lowest in a decade. The reason: given the increase in valuation multiples, there are fewer deals that make sense in this environment.

Sponsors working in the middle market, companies valued between $25 million and $500 million, have found a way to maintain some level of activity, accounting for over 90% of deal volume and over 60% of investment amount in 2012. In Q2/12 corporate acquisitions have dominated activity (54%), followed by secondary buyouts (39%). When financing has been required, sponsors have been able to take advantage of either banks partnering with mezzanine firms, or specialty finance companies providing unitranche financing.

Source: Merrill Datasite

As to 2013, despite record-low activity in Q2/12, private equity experts believe that the significant amount of capital available for investment and the more than 6,300 companies in the market will cause activity to pick up in the second half of 2012, and the first half of 2013.

(*All data taken from Pitchbook, The Private Equity 3Q2012 Breakdown, Merrill Datasite).

Senior Debt Market — Banks Compete for Existing Market-Share

After an active 2011, driven primarily by refinancings, the senior secured loan market has slowed. As banks amended, extended and expanded loan facilities for clients, they pushed the wall of debt out to 2016 and beyond. With fewer refinancings to work on in 2012, banks are reaching for growth by attracting their competitors’ business.

A slow M&A market, tepid economic growth and the environment of uncertainty are a confluence of forces that limit new opportunities for banks. Add to this environment the concerns of bankers and capital providers about changing regulatory requirements and, despite high budget expectations, there is a barely discernible growth trend.

“Sure there is demand, strong demand for just the perfect deal,” according to a syndications executive for one of the larger U.S. banks. “We’ve worked on deals that under normal circumstances would have been oversubscribed, and we work hard to complete the issue.” Asked to what he attributed the tentative behavior of debt providers, he confirmed the overall lack of clarity — economic and political — along with a reluctance to over-commit in an evolving regulatory world.

Mike Maiorino, president of People’s United Business Capital, notes, “We have a fairly complete view of our market, we’ve seen active deal flow, but the market is highly competitive for well-structured deals on the upside of transition. As expected in this type of market, pricing is at the bottom.”

On the positive side, interest rates are at an all-time low, with no expectation of an increase for the foreseeable future. Workout loan portfolios are declining and charge-offs are nearing “low water marks.” Banks certainly are poised to lend and their budgets reflect that expectation. So, what seems to be causing slow growth on the demand side?

The Association for Corporate Growth, in a June 2012 article, summarized the soft demand for growth financing, noting that, of 700 middle-market businesses surveyed in 2011, “24% rated their outlook for the next 12 months as pessimistic or very pessimistic. Add to these issues the uncertainty in global markets [primarily Europe] and the ever-changing regulatory environment and the result is a group of corporate borrowers [that] are feeling tepid about the prospects for growing and expanding their businesses, especially with debt.”

When asked what 2013 might bring, a number of bankers and capital providers offered a nearly unanimous response — until the clouds lift and the economy makes clear strides toward growth, more of the same. When that will happen is anyone’s guess.

CLOs Are Back

Once a highly active financing segment fueling debt markets right up to the peak of the economy in 2007, collateralized loan obligations (CLO) froze with the rest of the credit markets as the country descended into recession in 2008. Although CLO volume is still dwarfed by loan and high-yield activity, it is beginning to rebound.

The Wall Street Journal reported in July of this year: “The more than three-fold increase from the year-ago level to the highest reading since 2007 shows that the CLO market is probably a silver lining of the broader credit markets, which continued to be rocked by turmoil, although on an absolute dollar basis, CLO issuance was a sliver of the total new loan and high-yield bond volume during the first six months of this year, according to LCD’s data.” (S&P Capital IQ LCD, July 20, 2012).

The return of the CLO market, although a positive sign, is not expected to significantly impact overall deal activity. Many recent issues are structured to capitalize existing loans, leaving limited capacity for new loans. Additionally there is still $430 billion in capital waiting to be deployed with private equity, limiting demand.

High Yield Bonds — Still Hot

High-yield bonds — an attractive product in a low-interest rate environment — continue to be hot. With inflation softening and the expectation of a low-rate environment for some time to come, the fundamentals are strong for this market. Year-to-date, 2012 has seen $157.5 billion in new high-yield bond issuance. Combined with the $2.1 billion in investment grade bonds that got downgraded to non-investment grade, the overall market has grown to $1.3 trillion, a record high (source: JP Morgan).

Interestingly, there is more demand from the investment community than there are opportunities to issue: “Year-to-date we have about $19 billion more in demand than in new supply. Corporate America continues to have access to cheap credit. But, uneasy about increasing leverage, and with limited investment opportunities, companies are not issuing enough paper to satisfy the enormous appetite for fixed income product.” (

Unitranche Debt a Favored Financing Strategy

Many middle-market companies find unitranche financing — the “one-stop shop” — a popular solution to access necessary capital. “Unitranche structures,” explains the CEO of an investment firm, “are underwritten with a view to cash flow and enterprise value. The primary benefit is the ability to satisfy all the elements of the debt structure — senior, term loan, term loan B, etc. — in one facility with one lender. The borrower usually enjoys a shorter credit process and simplified communication. It can achieve the same result with a bank as the senior lender and a mezzanine provider as subordinated debt, but this structure requires working through two credit processes.”

“It’s a vibrant market for unitranche finance,” confirms the CEO of a finance company. “Some of the larger players are knocking it out of the park, while in the middle market in certain industry sectors there is tremendous demand. The returns in this segment are phenomenal.”

Smaller Middle-Market Activity — The Beat Goes on

Smaller middle-market companies — those with revenues between $15 million and $100 million — continue to provide an active market for finance. There are varied sources of financing available to businesses in this market segment — community banks, commercial finance companies and government lending programs top the list.

Commercial finance companies have been a staple of small business lending through numerous economic cycles. Factors and finance companies primarily underwrite to revolving assets — accounts receivable and inventory — to support working capital as a business grows.

Recent activity in this market segment remains robust, “We have a large pipeline of new business,” confirms Jeff Goldrich, president of North Mill Capital, “but it is a highly competitive marketplace. In the past six months, we’ve actually seen our top competitors shift from our peers to community banks. Although we try to respond to changes in the market, we do have a limit with regard to credit standards. All in all, our business is growing. That’s because our strategy includes geographic and product diversity.”

Indeed, intense competition between capital providers to the smaller middle market is a sign that banks are beginning to work through their troubled portfolios. The companies that survived the recession are looking to finance with firms that offer working capital support for the transition to growth and prosperity.


In conclusion, the capital markets are a reflection of the long, slow march to a full recovery. Interestingly, while the media has laser-focused on the downside to this global climb back from the “Great Recession,” there are, quietly, significant improvements in economic fundamentals in the U.S.

One senior executive at a money center bank summarized: “The rapid de-leveraging of the capital markets, businesses and consumers that began in 2008 is not such a bad thing. There is now underlying strength across the economy, which shows in the reduction in consumer debt, the cash balances and productivity gains across the board for U.S. businesses, and the fact that the financial markets are working through the excess of impacted assets. The U.S. economy is doing better than the rest of the world, so things aren’t as bad as what is reported.”

The only open question is when U.S. businesses will believe enough in future prosperity to move forward.

Kathleen Z. Lepak is the sales/marketing director, SVP at People’s United Business Capital.  She can be reached at 860.280.2720 or kathleen [dot] lepak [at] peoples [dot] com.