A survey of trends in U.S. middle market lending revealed substantial and growing concern about the higher amounts of debt leverage carried by middle-market companies heading into 2018, and found that less restrictive loan documents are a significant source of worry for traditional and alternative lenders and their professional advisors.  Conducted by Carl Marks Advisors, a leading corporate restructuring and investment banking firm, the survey also concluded that alternative sources of capital like mezzanine lenders and business development companies (BDCs) may experience the greatest challenges in their loan portfolios this year versus traditional banks and asset-based lenders.

Other key findings in the Carl Marks Advisors survey were:

• 76 percent of respondents are more concerned now than they were at the start of 2017 about the level of debt leverage at U.S. middle market companies.  Respondents also said that macroeconomic and geopolitical issues pose the greatest downside risk for leveraged loan portfolios in 2018.
• The majority of respondents (48 percent) said they believe that loan documents executed in 2017 are less restrictive to borrowers than loan documents that were executed immediately prior to the financial crisis of 2007/2008. 
• The loan document concessions that present the greatest concern for lenders in 2018 are covenant-lite or springing covenants with lower triggers and the allowance of add backs to EBITDA calculations.

Mezzanine and BDC Lenders Most Likely to Face Challenges

The survey also polled industry professionals’ views on which types of lenders are most likely to experience the greatest challenges in their loan portfolios in 2018. The largest group of respondents, 26 percent, indicated that mezzanine lenders are most likely to face problems in their portfolios, followed by 23 percent cited BDCs, 18 percent selected distressed investors, and 14 percent listed traditional bank lenders. Bank ABL lenders and equipment finance companies were seen as least likely to encounter portfolio troubles.

“Our survey revealed a split view on the likelihood of technical and payment defaults at middle market companies in 2018,” said Patrick Flynn, Managing Director at Carl Marks Advisors. “43 percent of respondents said defaults will increase while 43 percent said they will remain the same. While there are well-founded concerns about the impact of less restrictive loan documents, the survey results suggest that these concerns will not significantly alter the willingness to continue to lend on borrower-friendly terms.”

Response of Private Equity to Potential Defaults

The Carl Marks Advisors survey also shed light on differing perspectives between lenders and private equity/hedge fund sponsors in default situations. When asked how private equity firms are most likely to respond in 2018 when a portfolio company is facing a potential default, 59 percent of all non-private equity/hedge fund respondents said they would expect the firms to make no further investment, but rather to negotiate for additional time. Conversely, about half of private equity/hedge fund executives responding to the survey indicated that their firms would support their portfolio companies with further investment in the hopes of making a higher return in the long term.

“Based on the survey results, we believe that lenders will continue to be more prone to work out issues in their portfolios in 2018,” added Carl Marks Advisors Partner Joseph D’Angelo. Only 17 percent of all respondents said that lenders would be likely to sell their debt and move on. In terms of policy issues, half of the respondents named tax reform as the policy development most likely to positively impact middle market company performance in 2018. Reduced regulation was cited by 29 percent of respondents, while international trade deals and immigration policies were listed as positive contributors by only 17 and 3 percent respectively.

Carl Marks Advisors compiled these findings through a national online survey taken in December, 2017  by 190 participants from U.S. middle market lending-related fields, including traditional bank lenders, alternative lenders, legal and accounting advisors, restructuring advisors, private equity and hedge fund investors, and other financial and business consultants.