Middle Market Direct Lending
The near-shutdown in economic activity due to COVID-19 took its toll on transaction volumes in the middle market, with quarterly syndicated middle market loan volume amounting to just over $14 billion – the lowest quarterly total since early 2009. As communicated last quarter, the origination outlook was dim, as lenders and sponsors alike turned their focus to their existing portfolios; however, a recent lender survey indicated that most expect to devote 50% or more of their time to new deal flow in the third quarter. At the same time, most lenders do not expect their pipelines to return to normal until the first half of next year. We believe that sourcing advantages will become increasingly apparent over the coming months, as lenders with strong, direct relationships and existing portfolios that create add-on acquisition opportunities will have a distinct edge when it comes to deploying capital versus managers that have relied on others to source deal flow.
There were a number of other interesting takeaways from the survey. After several years of lenders competing on size, there was a steep decline in the number of lenders that can hold $100+ million, dropping from 40% of respondents in 2019 to only 20% of respondents at present. With respect to unitranche loans – which have historically accounted for many of the larger middle market transactions and larger lender hold sizes – there was a divergence among lenders in terms of spread tolerance for new deals, with some still willing to price a unitranche transaction at L+500, many looking for at least L+700, and L+600-675 ranking as the most common response. A bit less surprising is the renewed focus on LIBOR floors, with nearly all lenders requiring a floor of at least L+100. Finally, as it pertains to the expected default rate, nearly 70% of respondents indicated that the peak 12-month default rate will be 5-10%, although another 23% were less sanguine, expecting a default rate of 10-15%.
As noted in the past, we believe that manager differentiation will be key to performance in this cycle. Over the coming quarters, we believe experienced managers that have extensive workout expertise and have maintained stringent underwriting standards will be well-positioned to weather the current environment and also take advantage of the attractive pricing and terms for new loans.
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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 2020 after falling to its lowest level since 2009.