by Benjiman Godbout, Director at Carl Marks Advisors
As we continue to emerge from the pandemic,
albeit in fits and starts, several new studies have shown that though middle market companies have demonstrated some resilience in riding out the unprecedented economic challenges of the last few years, many are continuing to struggle to navigate the economic impacts and disruptions of COVID-19. Research from the World Bank Group and others indicate a significant wave of balance sheet restructurings and bankruptcies have not yet materialized, primarily because of a combination of unprecedented financial assistance via legislation and lender patience.
And yet we see many mid-sized organizations continuing to struggle, whether due to operating in industries deeply impacted by the pandemic that were already under financial stress before COVID reared its head, or simply being on the wrong side of history. Two years into the pandemic and months after governments have turned off the spigot of support, these businesses are seeing shrinking revenues due to supply chain shortages, eroding margins due to inflationary pressures, rising labor costs, and more. They also face significant challenges in right sizing their capital structures after absorbing the changes to operations in both revenue and margin. The forces impacting these middle market businesses are felt over a wide array of industries, from hospitality to industrials.
A survey conducted by Carl Marks Advisors last year indicated that as the calendar flipped to 2022,
lenders would get more proactive with middle market businesses that were underperforming or at risk of default, and we are starting to see this bear out. Companies that are carrying significant debt are in particular peril now in the face of forthcoming interest rate increases, inflation and operating costs continue to rise, and lender patience wears thin. In this environment, we believe lenders will be less inclined to “kick the can” down the road for struggling middle market companies.
At the same time current circumstances offer a unique opportunity for a growing array of hedge funds, distressed credit funds, opportunistic private equity funds and other alternative lenders with ample capital to deploy and pressure to put it to work. According to Eaton Square, 2021 saw record-setting private debt transaction volume, with U.S. leverage issuance topping $1.8 trillion in 2021 and middle-market syndicated loan M&A volume posting a record of approximately $43 billion, driven in no small part by the explosion in non-bank lending.
Many of these firms have spent the last several years building their positions in the capital structures of middle market companies as second lien, mezzanine, or convertible debt investors. Now they are well positioned to benefit from today’s environment by establishing more strategic fulcrum positions and playing an active role in driving the direction of the business. This can include providing additional capital with aggressive term and filling board positions that enable them to influence decisions around restructuring or bankruptcy.
These investors also have the advantage of being able to invest into situations, and under terms, that traditional banks cannot due to regulations, and due to differing strategies and ROIC thresholds. For many traditional banks holding distressed debt, selling and exiting, in-part or in-full, may be the most attractive option at different points in time. This may be the case especially when you consider that in many cases the existing debt has matured or is close to maturing and was likely underwritten under conditions that are materially different than today.
To best seize this opportunity, investors will need to think and act strategically in how they choose to invest into the capital structure.
Valuation and timing considerations are key to a successful outcome, along with a well-defined and value-maximizing pathway forward that is best determined via a comprehensive strategic alternatives analysis. This type of investment strategy also requires significant due diligence around the situation. To maximize the potential of the investment, it is essential to better understand, navigate, and address the motivations of other players in the capital structure in addition to leveraging the necessary external operational expertise.
Looking Forward
We have entered a new era of debt investing that presents some exciting new potential avenues for investors who are able to roll up their sleeves, get strategic about marshaling outside resources, and think carefully about how to optimize the pathway forward for struggling companies. With a sizable portion of the middle market unsteadily emerging from a two-year hangover and heading into more uncertainty in 2022, thoughtful investors can play a critical role in getting organizations back on their feet while generating attractive fund returns.
