Director
Carl Marks Advisors
By Benjiman Godbout
It seems like a new alternative lender enters the secured lending market every day. In the midst of this constant change, bank-based lenders need to be vigilant in understanding their borrowers’ debt structures as well as the motivations of the other lenders in the capital stack.
With abundant capital to deploy and pressure to put it to work, a growing number of hedge funds, distressed credit funds, opportunistic private equity funds and other alternative capital providers are aggressively investing in the debt of struggling middle-market companies.
This new breed of players is developing sophisticated, under-the-radar strategies for investing in tranches of the capital structure, gaining broader influence and seeking to attain a control position down the road. Since they are unrestrained by the same regulatory pressures that traditional secured lenders face, this new class of lenders can become a disruptive force by calling out companies and management teams, seeking revisions to credit agreements and stretching leverage ratios beyond previous thresholds. For traditional lenders, whose prime motivation is to get paid coupons from creditworthy businesses rather than securing board of director roles to drive management team performance, these strategies can come as a surprise. But that needn’t be the case if banks understand the situation and the techniques being used, and put in place a thoughtful, strategic liability management strategy to respond and execute effectively.
This new dynamic is taking place against the backdrop of a private debt market that has soared from approximately $40 billion in 2000 to more than $1 trillion today, creating ripple effects from Wall Street banks’ leveraged finance groups down to traditional Main Street lenders. Meanwhile, COVID-19-pandemic pressures have forced companies to get more creative in identifying new sources of flexible financing, providing a natural opening for new lenders. Since these alternative lenders typically sit behind and around banks in middle-market companies’ increasingly complex capital structures, they can fly under the radar and establish less evident debt positions and a fulcrum position over time by determining where the value of underlying assets would be impaired and, therefore, seize advantage.
Understanding the techniques these new lenders are using to infiltrate capital stacks can be an arduous and time-consuming task. If banks don’t have the internal resources to confirm who is buying debt, and if trading desks are not talking to each other, it’s easy to be blindsided or disadvantaged in a bankruptcy or restructuring.
The wave of bankruptcies and restructurings that many predicted would result from the economic impact of the pandemic has not yet come to pass. But a recent Carl Marks Advisors survey suggests that the “kick the can” mindset that lenders exhibited toward middle-market borrowers is likely to change as we move into 2022. Support programs such as the Paycheck Protection Program are ending, and lenders are indicating that they will start to get proactive with businesses that are underperforming or at risk of default.
In this environment, understanding the influence and motivations of new alternative lenders demands more careful vigilance from traditional lenders and their workout groups, who would benefit from looking more deeply at the composition of credit stacks and digging into other lenders’ motivations before the fire engines show up. Figuring out how debt in the company is trading, who is buying up debt behind you and how the company/other lenders have behaved in similar situations can help banks determine their best next moves and a go-forward plan.
There are certainly instances where traditional banks are more than content to sell their debt to alternative investors and to exit stage left. But in many cases, they are presented with offers to be taken out that are below par. This, in turn, can force a bank’s hand in determining what, if any, strategic pathways they have going forward.
Given these challenges, banks must focus on three key liability management areas:
- Knowing their specific rights and remedies, including lender consent and required lender thresholds
- Determining the motivations of each investor in the capital structure and being proactive in building a customized approach to them
- Ensuring that covenants and provisions within credit and intercreditor agreements sufficiently protect their interests and the underlying businesses from any surprises due to the aggressive actions of certain investors
As the middle-market lending environment continues to evolve, competition intensifies and a growing array of alternative lenders enter the market, banks will find it increasingly difficult to feel secure in their positions in the capital structure. But by taking steps to enhance their understanding of those around them and their motivations, they can protect against unpleasant surprises, think strategically about potential outcomes and optimize a pathway forward.
Benjiman Godbout is director in the special situations investment banking group at Carl Marks Advsiors, where he focuses on balance sheet recapitalizations and reorganizations, debt and equity capital raises, distressed M&A, lender advisory, litigation support and strategic financial and business advisory services. He is reachable at bgodbout@carlmarks.com.
