Article Highlights

• Many assume debt is growing more expensive as interest rates rise. In reality, borrowers can still achieve near-historically low interest rates
• Competition and dry powder are placing downward pressure on rates, implying that borrowers who create a national competition for their deal can secure the best terms and lowest cost of capital
• Macroeconomic conditions have sharpened the focus on credit quality. Lenders would prefer to issue a lower interest rate on a more conservative deal than accept a riskier deal at a higher rate, for a potentially higher return
• All of this can change on a dime, if (a) the default rate increases meaningfully, or (b) a prolonged recession reduces deposit levels at banks

Credit Comes into Focus

As inflation came to dominate the headlines, and the Fed began raising interest rates, lenders tightened their standards with a focus on credit quality (larger borrowers, borrowers with an established track record, or businesses that are ‘recession proof’). 

Downstream Effects

• There is greater uncertainty around the loan approval process for borrowers 
• Lenders are issuing more restrictive terms with higher costs of capital (at least initially) 
• Borrowers may experience delays during lender DD process

Despite the above, we have seen borrowers obtain near historically low interest rates, even during the current inflationary cycle.  

The key to borrower success lies in their capacity to exploit a pair of dual drivers within the middle-market debt sector: competition and dry powder. 

Different Incentives, Similar Outcomes

When examining the middle-market debt world, we must first explore the incentive structures of two lender types: banks and direct lenders. 

The interest rates charged by banks are driven by their cost of capital (interest rates they pay to retail depositors), and default rates (the cost of covering the losses from unpaid loans).

The good news for banks is that they are currently sitting on historic levels of cash deposits.

Additionally, default rates remain at historic lows, hovering just over 1%.

The combination of these two factors means banks have plenty of capital to lend, and therefore don’t have to raise rates to attract depositors. This keeps interest rates on loans in check, at least for the time being. 

What We’re Seeing: Many banks are issuing term sheets with a relatively high interest rate, only to be negotiated down once the borrower is able to produce competitive terms (more on this below). 

On the direct lending side, large lenders have the option of deploying capital in liquid or illiquid markets. Middle-market direct lending is illiquid, and therefore must command a premium in order for these lenders to participate (the premium can come in the form of a higher return for a similar level of risk, or a similar return with lower risk in the liquid securities markets). In the current climate, large lenders can readily capture yield in liquid securities like institutional term loans, HY bonds, etc. Therefore, large lenders are gravitating to deals with higher credit quality or higher interest rates when lending to the middle market.

Smaller lenders, however, cannot afford to be as selective. Small or midsize middle-market lenders do not have the capability to deploy capital into the liquid securities markets, hence they must commit to middle-market lending. And given that direct lenders must deploy capital to earn management fees and carry (similar to how the PE industry operates), fund managers are feeling added pressure to put capital to work, especially as dry powder levels remain elevated.

Lenders exist to issue loans, not to keep capital on the sidelines. So even though broader macro-forces might be prompting them to tread cautiously, lenders are still eager to actively participate in middle-market lending, given the excess dry powder at their disposal. 

What We’re Seeing: Similar to banks, we have seen direct lenders issue initial terms with a higher rate of interest, only to lower their cost of capital once competition for the deal emerges.  

Key Considerations

• Banks and direct lenders are competing under different incentive structures, yet behaving similarly. 
• While macroeconomic forces (economic uncertainty, interest rate increases) are conspiring to push rates higher, market forces (competition, dry powder) are counteracting as extremely powerful headwinds. 
• Market dynamics can change abruptly, should (a) the default rate increase meaningfully, or (b) a prolonged recession reduce deposit levels at banks. Either of these circumstances would have a cascading effect on middle-market lending, leading to a higher cost of capital and fewer deals getting done overall. 

The Effect of Rising Interest Rates 

Almost all middle-market loans have floating interest rates, with the Secured Overnight Financing Rate (SOFR) as the most popular index. SOFR has continued to increase over the last few months, since the Fed began increasing short-term rates. This means borrowers will likely pay for a higher SOFR rate, even though a lender has not increased its interest adder meaningfully.

Said another way, lenders themselves might not be earning additional interest income by charging higher rates, but borrowers are paying higher total interest costs, due to the increase in SOFR.

The current push-pull dynamic won’t hold forever. Either inflation peters out, and with it, uncertainty over a ‘hard landing’ gives way to something more akin to cautious optimism (prompting lenders to deploy ever more of that dry powder), or recessionary forces overwhelm lenders, forcing them to tighten their standards and leave otherwise attractive deals on the table.

We are already seeing examples of the latter. A borrower recently approached us explaining that their coverage banker expressed enthusiasm over the borrower’s deal. A long and sequential diligence process began, which included a $150,000 deposit and external DD parties brought in. The process was going smoothly, until three months down the road—at the very last minute—the lender rejected the deal. It turns out a similar borrower in the lender’s portfolio defaulted on a loan, and the credit committee grew cautious over similar deal types.

Key Takeaway

Economic uncertainty creates downstream effects. One of those is predictability—or a lack thereof. Borrowers used to be able to rely on their front-end banker, or coverage banker, for a temperature check on how the lender will evaluate their deal. But these days, front-end bankers have less insight into how credit committees will perceive the deal once it reaches their desk.

Going Beyond Your Lender Network

Most borrowers assume that their immediate network of 5-6 lenders is enough to test the waters. While approaching a small cadre of lenders will grant an insight into the terms lenders are willing to issue, it does not afford borrowers the tactical advantage necessary to achieve the best possible terms (and it certainly does not protect against the aforementioned example of the borrower who waited three months for a term sheet that never came).

The current moment of intense competition in middle-market lending, coupled with elevated levels of dry powder can be advantageous to borrowers, but only if they are patient and obtain term sheets from multiple lenders.

Final Takeaway

Expanding one’s lender outreach is the only way to ensure the best terms and lowest cost of capital, as well as protect oneself against the unpredictability of lenders, given the broader market uncertainty.

About CAPX

CAPX is an end-to-end digital marketplace that connects middle-market borrowers with bank and non-bank lenders. Our platform allows borrowers to instantly expand their lender outreach and create a national campaign for their deal, all at no cost to the borrower. Find out more at www.capx.io