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Adapting to Change: Strategies for Lower-Middle Market Companies in the Evolving Private Credit Landscape

In the dynamic and rapidly evolving private credit landscape, lower-middle market companies face unique challenges and opportunities that require agility and informed decision-making. With the financial markets undergoing significant shifts, the insights from seasoned investment bankers are invaluable for companies looking to adapt and thrive.

Shift from Traditional Banks to Private Credit

Historically, traditional banks played a central role in providing capital to businesses. However, the last decade has seen a shift towards private credit—a change driven by the reluctance of traditional banks to engage in complex underwriting, especially for lower middle-market companies. This shift was further expedited after the collapse of Silicon Valley Bank last year. This gap has been increasingly filled by private credit funds, which offer more flexible and accessible financing options.

Growth and Importance of Private Credit

“I think the banks will likely continue to pull back on underwriting, making the direct lending community even more relevant to middle market and lower middle market borrowers going forward” as noted by James Chiarelli, Co-Head of Piper Sandler’s Debt Capital Markets Group and COO of Piper Sandler Finance. The private credit industry, valued at approximately $1.6 trillion in 2023, is projected to grow to $2.3 trillion by 2027 (Source: BlackRock), emphasizing the sector’s explosive growth. This shift is not merely about the availability of capital but also about the evolving needs of businesses that require more bespoke financing solutions than those traditionally offered by banks.

Tailored Solutions for Complex Transactions in Private Credit

Current trends underscore a deepening reliance on private credit. As banks pull back, private credit funds are stepping up, increasingly becoming the go-to for complex, lower middle-market transactions. “These funds have filled a crucial gap, offering tailored solutions that meet the nuanced needs of these businesses,” noted Matt Plooster, Founder & CEO of Bridgepoint Investment Banking. Matt also highlights a recent trend “In the last five to seven years, and especially intensively in the last two or three, we’ve seen a remarkable shift. Private credit and non-bank capital, including structured credit and equity, have significantly penetrated the lower and middle markets, particularly impacting non-sponsored, privately-owned companies. This development has been truly exciting and opened up the capital options set for family- and founder-owned companies”. This reliance is expected to continue, with robust merger and acquisition (M&A) activities forecasted to persist.

Navigating Challenges and Opportunities

Navigating this new terrain presents a myriad of challenges. Companies must adapt to higher costs and navigate the complexities of varying capital structures. Yet, these challenges are paralleled by significant opportunities, particularly in the creative structuring of deals. Investment bankers have observed an increase in innovative deal structuring that allows companies to manage risks better and secure favorable returns. The need for expert guidance is becoming more pronounced in this evolving market.

“There is almost a new fund a week and some of them can be very creative. You’re likely going to need to hire advisors to help you source this capital in the future, at least for a while until some of these (private credit) funds become more well-known household” noted James Chiarelli, emphasizing the importance of leveraging seasoned advisors to navigate these complex waters effectively.

Strategic Tool for Long-Term Goals in Private Credit

Moreover, the shift towards private credit has been accompanied by a broader change in how companies approach capital raising and financial management. There is a growing trend of companies using private credit not just for bridging gaps left by banks but as a strategic tool for achieving their long-term goals. These opportunities come with more scrutiny from the lenders, which has increased over the last 9 months, dating to mid-2023. There is an increased focus on underwriting criteria and more maintenance covenants being required by lenders. James Chiarelli highlighted the changing trend, noting that “Minimum fixed charge coverage, minimum liquidity, max leverage, and other covenants reemerging into credit docs across the lower middle market in a more meaningful way.”

Broader Economic Implications for Private Credit

The implications of these shifts are profound, not just for the companies directly involved but also for the broader economy. As lower-middle market companies employ these new strategies, they contribute to economic diversity and resilience. These companies are often at the forefront of innovation and employment, and their ability to secure appropriate financing is crucial for their growth and, by extension, for the health of the economy.

With the right strategies and insights, the evolving debt landscape can be a source of strategic advantage, enabling lower-middle market companies to thrive in an increasingly competitive environment. By understanding the trends, challenges, and opportunities within this landscape, these companies can position themselves for success in the years to come.

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By Atul Sehgal, Opus Connect
May 2024

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