Just as Charles Dickens’ famous novel A Tale of Two Cities highlights the distinctions between countries and classes, the corporate credit market brings two distinct market segments into relief. Larger companies, which do not need credit to effectively function, can access capital readily. Meanwhile, middle market businesses must pay a premium to access financing from illiquid markets on less favourable terms because they are, typically, privately held or not well followed by equity analysts. For the middle market, this has resulted in limited visibility and, generally, lower overall investor knowledge, even as significant capital moves into corporate bond and bank loan markets in search of higher yield.
The middle market can be defined as companies with debt outstanding of less than $750 million U.S., or whose EBITDA (earnings before interest, taxes, depreciation and amortization) is less than $100 million. However, the stress is most acute in companies whose capital structures have a debt of less than $350 million.
The middle market debt sector may be an attractive source of higher returns, but with this higher return potential comes greater risks. A range of investors, including dedicated lending funds, focuses on providing credit to the middle market, and we are now seeing sharply higher leverage profiles in many of these companies. This increases the companies’ already significant vulnerability to economic shocks.
The middle market sector also tends to be less tethered to business cycles, providing more opportunities for investors who can capture an illiquidity premium and negotiate covenants through structured investments—mechanisms now unavailable for larger companies. However, there are early signs of excess in the middle market, so expect higher defaults and distressed exchanges over the next three to five years.
Shifting markets
There has been a profound shift in the providers of middle market debt, as private lenders, increasingly, replace banks. Given losses from high default rates on loans during the crisis alongside increased regulatory capital constraints, banks have de-risked and withdrawn capital from middle market companies. Special purpose investing vehicles, such as collateralized loan obligations (CLOs) and business development companies (BDCs), are increasingly filling the void the banks have left behind, but may be less suited than commercial banks to hold stressed and distressed debt.
These specialized structures are often limited by their investment strategies, their targeted yield schemes or by the fact that the leverage they employ has strict covenants. Aggressive lending by these specialized vehicles, alongside their limited ability to hold stressed debt, creates the potential for a greater supply of distressed middle market debt than in previous times of market stress.
Middle market companies tend to experience more stress than larger companies, and we believe this trend will continue. Leverage profiles in the middle market have now exceeded 2007 (pre-crisis) and 1997 (pre-dot-com) levels, according to Leveraged Commentary & Data (LCD). Such elevated levels of leverage create the prospect of an increase in middle market defaults and distressed exchanges over the secular horizon.
Pockets of dislocation already exist today in energy, retail, restaurant, gaming, shipping and mining industry verticals, as well as in infrastructure entities that were financed in the pre-2008 era.
As investors consider distressed debt, we would caution them to focus on companies that will be able to withstand periods of economic inertia, to undertake careful valuation practices and to strictly adhere to the absolute priority rule (in which senior creditors are paid in full before junior creditors). The tale of two credit markets is an ongoing saga that could create meaningful opportunities for investors in the years ahead.
Sai S. Devabhaktuni is executive vice-president, portfolio manager, PIMCO.