A continuing concern among investors in direct loans is whether opportunities will continue to exist in the future if the tight bank regulations put in place after the global financial crisis (GFC) are relaxed and commercial banks try to regain market share. With their lower cost of capital and the importance of financing costs to leveraged buyout borrowers, a rewind scenario is certainly plausible. This chapter provides the results of a survey conducted in 2017 of US middle market private equity sponsors on their decision process as to whether to use bank or nonbank financing. The purpose is to see if there are factors other than price that influence what lender to use.
A telephone survey of private equity firms was conducted to better understand the growth in nonbank lending in the private equity (sponsored) market. Private equity general partners (sponsors) shared that increased bank regulation, including capital requirements and limits on types of lending, has curtailed some bank lending. Sponsors cite the flexibility of nonbank lenders to structure creative deals, their ability to take on larger portions of a loan (both senior and junior), and the speed at which they can close as attractive reasons for moving business to nonbank lenders and away from traditional banks. Despite these trends, the most important consideration continues to be the relationship between the sponsor and lender, regardless of whether it is a bank or other supplier of debt financing.
The rapid post‐2008 growth in nonbank middle market lending (defined as lending to companies with less than $100 million in EBITDA) has largely been attributed to increased bank regulation. Both the 2010 Dodd–Frank Act and the 2013 Inter‐Agency Guidance on Leveraged Lending have limited the amount of risk capital that banks can hold on their balance sheets and the amount of leverage that banks can underwrite in levered transactions.
However, our research surfaced other reasons for the success of nonbank lending, particularly in the middle market. To better understand the reasons for why private equity sponsors may utilize nonbank lenders, a broad group of 20 middle market buyout firms were sent surveys and asked to share their principal considerations when looking for debt financing.
The survey showed that the most important consideration in choosing a middle market lender was the preexisting relationship that sponsors had with their lenders, regardless of a bank or nonbank source. Every sponsor surveyed highlighted the stable, pre‐existing roster of bank and nonbank lenders that they return to for financing. These relationships are built over time based on a successful history of closed deals and positive working experiences. Each sponsor placed very high importance on cultivating lenders that participate in club financing deals. Failing to make the preferred group can effectively shut a lender out of most of the sponsor's deals.
When comparing the differences in bank versus nonbank middle market lending, some recurring themes appeared. First, middle market banks have ceded market share, primarily due to a diminished ability to hold loans on their balance sheets and the need to arrange club deals. As a result, many middle and lower middle market sponsors have turned entirely to nonbank lenders to provide solutions. Nonbank lenders have become more flexible when it comes to “out of the credit box” transactions and tend to be a bigger participant in club deals and in junior structures. Banks still participate in clubs and can remain competitive at the senior level in terms of pricing. However, for more complex deals, middle market banks generally have tougher underwriting standards, demand a heavier amortization schedule, and require extra covenants. A full comparison is provided in Exhibit 21.1.
EXHIBIT 21.1 US sponsor survey on choosing bank versus nonbank financing .
| Survey findings | |
| Underwriting flexibility | Nonbank lenders tend to have more flexibility in structuring loans (leverage multiples, covenants, etc.), although for cleaner deals, banks remain competitive, particularly at senior levels of the capital structure. |
| Pricing | Nonbanks tend to charge a premium of 25–100 bps for their flexibility. Interestingly, most sponsors have expressed low sensitivity to pricing as their higher ROE requirements leads to a preference for nonbank lenders that are able to finance very attractive deals in exchange for the premium charged. |
| Leverage restrictions | Most middle market sponsors noted that they do not participate in highly leveraged deals, though a few have noticed that banks are no longer participating in highly leveraged transactions. Where applicable, banks tend to primarily participate in senior loans, whereas nonbank lenders are brought in for unitranche, second‐lien, and mezzanine structures. |
| Capacity and deal size | Middle market banks that compete for deals below $50 mm in EBITDA have experienced eroding market share as their capacity to hold loans on their balance sheets has shrunk relative to the past. Additionally, nonbank lenders can accommodate add‐on transactions, while banks are limited by the absolute dollar amount they can lend to any credit. Notably, investment banks that compete on deals over $50 mm in EBITDA with the goal of syndication have seen only minor changes as a result of lending regulation. |
| Speed to close | Almost all sponsors have noted that nonbank lenders tend to be faster due to quicker internal processes and fewer committees. Additionally, nonbanks can move quicker in refinancing and add‐on transactions because of dedicated coverage that maintains closer familiarity with the credit and the sponsor. |
| Covenants | Banks tend to have tougher covenants than nonbank lenders. However, the differences are usually limited to one or two more covenants and are driven by the desire for nonbank lenders to be more flexible than banks. A number of sponsors also cited a requirement by banks to amortize a large amount of the deal in the loan (i.e., approximately 50% over seven years). |
| Reporting requirements | Most sponsors have reported no differences, although nonbank lenders may require more detailed reporting or board observer rights (in junior structures). |
| Industry expertise | Banks generally tend to have more industry expertise, but while it can be helpful, it does not seem to be high on the sponsor's wish list, given that a lot of nonbank finance company professionals are former bankers with some level of industry expertise. |
| Access to capital | Interestingly, a few sponsors have noted that in the late 2015 and early 2016 turbulence in credit markets, nonbank lenders dependent on capital markets for funding (particularly BDC platforms) lacked the ability to provide timely capital and saw reduced negotiation leverage. |
| Restructuring troubled deals | Many sponsors have not seen enough troubled deals over the past seven years to provide comments. The few that have had challenges pointed to the importance of lender relationships in working out a troubled loan (and as such the importance of the participants in the club) as opposed to any differences in bank versus nonbank workouts. One common theme was the dislike for bank workout groups. This is a positive for nonbank finance companies where troubled credits stay with the original coverage officer. |
When sponsors were asked about the specific impact of regulation, most sponsors noted the acceleration in the share of middle and lower middle market lending toward nonbanks. Changes in bank behavior specifically attributed to regulation included the tilt toward more conservative underwriting and tighter covenants, the diminished ability to hold loans on their balance sheets and relegation to club deals, the cap on 6x leverage, and the higher principal amortization rate.
The speed by which US sponsors have embraced the nonbank lending market has not been echoed consistently in Europe. Therefore, to understand the reasons why private equity sponsors utilize nonbank lenders and their possible hesitancy to embrace nonbank lending in Europe, a telephone survey of about 20 European middle market buyout firms was conducted in 2018. In this survey, nonbank lenders were cited by sponsors as being less reliable and more likely to retrade a negotiated deal. Nonetheless, several middle market sponsors noted that they work with nonbank lenders where they can obtain better covenants and more covenant headroom, with less equity in the deal. The spread in the cost of financing between bank lenders and alternative direct lenders for unitranche debt is approximately two to four percentage points on an all‐in basis (Exhibit 21.2).
EXHIBIT 21.2 European sponsor survey on choosing bank versus nonbank financing .
| European sponsor survey findings | |
| Most important considerations | Sponsors noted that the choice of using a bank versus nonbank lender was deal specific. Banks are still active and willing to provide low‐cost financing for straightforward deals and therefore remain the preferred choice. If a deal is more complicated or has a more aggressive growth plan, sponsors value nonbank lenders' ability to be flexible on leverage, sponsor equity contribution, covenants, and speed to close. However, many sponsors value existing relationships with their bank lenders and initially were reluctant to adopt the nonbank lending model. |
| Underwriting flexibility | Nonbank lenders tend to have more flexibility in structuring loans (leverage multiples, covenants, etc.), although for cleaner deals, banks remain competitive, particularly at senior levels of the capital structure. |
| Pricing | Generally, nonbank lenders charge a premium of two to four percentage points more than bank lenders in exchange for being more flexible. Bank financing is cheaper unless there is a need for mezzanine debt, in which case a unitranche loan can provide a competitive all‐in cost. However, some sponsors are seeing banks partner with mezzanine lenders to compete with nonbank lenders by providing a synthetic unitranche product. |
| Leverage restrictions | Most banks are limited on leverage to 5.0 times net debt to EBITDA. Furthermore, banks tend to primarily participate in senior loans, whereas nonbank lenders are brought in for unitranche, second‐lien and mezzanine structures. Nonbank lenders are generally willing to provide leverage of up to 6.0 times net debt to EBITDA or more in some situations. |
| Capacity and deal size | Responses from sponsors were mixed on the capacity and deal size targets depending on the region. For example, banks in the Nordic region are able to take down relatively larger deals. Generally, banks and nonbank lenders have strong appetites for providing financing. Larger nonbank lenders may have an advantage when the syndicated market is less accessible. While most sponsors prefer to work with one counterparty, they will typically arrange a club when needed for larger deals. |
| Speed to close | Some sponsors have noted that nonbank lenders tend to be faster due to quicker internal processes and fewer committees. Additionally, nonbanks can move quicker in refinancing and add‐on transactions because of dedicated coverage that maintains closer familiarity with the credit and the sponsor. However, other sponsors noted that newer lenders were slower at times most likely due to newly formed teams and processes. |
| Covenants | Covenant packages don't seem to be uniform across Europe and are dependent on size and geography. For middle market deals, nonbank lenders on average require a leverage covenant whereas banks may require additional financial covenants such as cash flow covenants. Sponsors noted that nonbank lenders tend to provide more headroom in the covenants. Smaller deals may require additional covenants for both bank and nonbank lenders whereas larger deals may be covenant lite. The most consistent difference between banks and nonbank lenders cited by sponsors was that banks have higher amortization requirements over the life of the loan. |
| Industry expertise | Banks generally tend to have more industry expertise relative to nonbank lenders. Some sponsors noted that a nonbank lender's lack of industry knowledge may prevent them from moving quickly on a deal or cause them to back out. |
| Geographic considerations | Given different cultural and business relationships across Europe, as well as different bankruptcy and creditors' rights regimes across different European countries, there tends to be meaningful country‐specific debt financing in Europe. Regional and country‐specific banks want to retain their local relationships. In addition, a number of the alternative lenders also are country specific in their lending. This dynamic is much less pronounced in the United States, where the legal framework is uniform, and where lenders (both bank and nonbank) have operated across geographic markets for years. |
Perhaps the most important takeaway from both the US and European surveys is the importance of preexisting lender–borrower relationships. This is an important finding because it puts significant value on the origination process used by direct lenders. It also highlights the similarities between private equity and private debt. Both require bespoke expertise and solutions executed by experienced professionals who understand that a major asset is the relationships they maintain.