Middle Market Direct Lending
While quarterly syndicated middle market loan volume remained depressed at just under $16 billion, this was largely driven by the non-sponsored market, as the sponsored market enjoyed a modest increase versus the second quarter. Last quarter, many lenders expected to devote 50% or more of their time to new deal flow in the third quarter, but a recent survey indicated that nearly 60% fell short of their lending goals. Those who were able to achieve their goals did so by taking advantage of a combination of factors, including other lenders being sidelined and being able to focus on portfolio add-ons and secondary opportunities. While a small subset of lenders said their pipeline is as good as, if not better than, pre-pandemic levels, most do not expect their pipelines to return to “business as usual” until some point in 2021. We believe there is likely very significant dispersion among lenders with respect to deal flow, not only based on the EBITDA focus of the lender, but also due to sourcing channels and competitive advantages. Looking ahead, we believe that strong, established lenders will be well-positioned to grab market share from less experienced groups.
With respect to their economic outlook, lenders have varying views, with some optimistic that things will continue to improve, while others believe a more cautious, extremely selective approach is warranted. When asked what their largest concern heading into year-end is, 50% of respondents indicated the uncertainty stemming from a second wave of COVID-19 and the election, while 30% were more concerned about the quality and quantity of their deal flow. Notably, most felt that payment defaults were largely in the past. Another testament to this is the fact that the share of lenders with over 20% of their portfolio on a watchlist dropped meaningfully, from 30% last quarter to only 14% at the start of the fourth quarter. Hold sizes have started trending higher again; although the most common range for direct lenders remains $50-75 million, approximately 20% of respondents indicated a maximum of over $100 million and 10% indicated even larger, at over $200 million. With respect to unitranche loans—which have historically accounted for many of the larger middle market transactions and larger lender hold sizes—while a divergence among lenders in terms of spread tolerance for new deals remains, spreads have definitively declined from the start of the third quarter, with most lenders honing in on L+600-625.
As noted in the past, we believe experienced managers that maintained their stringent underwriting standards and disciplined approach pre-pandemic entered the current cycle on stronger footing. Those that also have extensive, relevant workout expertise should be well-positioned to exit the current cycle on even stronger footing.
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Middle market loans still offer an attractive spread premium compared to leveraged loans.
Using the global financial crisis as a guide, middle market sponsored issuance is expected to rebound into 2021 after falling to its lowest level since 2009.