The current landscape for lower middle market companies seeking to raise capital, especially debt, has become increasingly convoluted with Dodd-Frank and Basel I, II, and III regulations. Lower middle market companies seeking to raise debt have a number of options when it comes to raising debt and each option carries its own caveats. The graphic below illustrates a general overview of the options for companies seeking to raise debt and/or equity.
Lower middle market companies seeking to raise debt can do so through local, regional, state or national banks. Current bank financing for senior debt is being priced around LIBOR + 350-500 bps. Although securing senior debt at these prices may seem attractive, bank financing has become increasingly difficult (with banks being more selective on the companies and industries they make loans to). The recent depression in commodity prices has put further scrutiny on companies even marginally affiliated with the oil and gas industry.
Heavier regulations on banks has opened the door for non-bank funds for capital that comes from pension funds, family offices and high-net-worth individuals. These funds usually operate on a 2/20 structure, earning 2% fees on assets under management and 20% on profits after a hurdle. These high fees are usually passed off to the companies they lend to, which is why typical pricing for senior debt from non-bank funds is LIBOR + 450-800 bps. The advantage for companies is that these funds will lend to borrowers who typically cannot secure loans from banks or need more capital than a bank will allow. These non-bank funds will offer additional debt in the form of second-lien debt at LIBOR + 750-1200 bps and subordinated debt at 10-14%, occasionally with warrants.
Business Development Companies (BDCs)
Business development companies are similar to non-bank funds, except BDCs’ capital is provided through public markets, traded on exchanges like the NYSE or the NASDAQ. BDCs also charge relatively high fees, ranging from 25-35% of revenue from their interest income.
Private equity funds focus primarily on equity, only occasionally lending senior or junior debt. When private equity funds do lend, they primarily do so in conjunction with equity. The loans are typically at a premium, owing to the 2/20 structure PE funds often operate under.
Commercial Marketplace Lending
Marketplace lending has been quickly adopted across a variety of lending sectors, ranging from consumer loans to real estate. Until 2016, there have not been any marketplace lenders servicing the lower middle and middle markets. The only lender currently servicing the space is CrowdOut, and with the reduced fee structure of 1-4% for loan origination (paid by the borrower) and 10% of interest received (paid by the investor), CrowdOut is able to lend to the same companies as BDCs and non-bank funds — at a lower rate. These circumstances allow for both better rates to companies seeking to raise capital as well as higher returns for investors seeking yield.
Lower middle market and middle market companies seeking to raise capital have a variety of options to choose from and it is paramount to evaluate the merits of each option before electing to move forward with one.