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Leveraged Loans: In Lower Middle Market, Yields Likely To Rise After Friendly 1Q

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The smallest sponsored companies in the U.S. enjoyed lower interest rates and higher leverage multiples during the first quarter, but it’s unlikely that the same terms will hold in the months ahead after market conditions cooled in recent weeks.

All-in yields averaged 5.6% for loans to sponsored companies generating $25 million of EBITDA or less, according to aggregate data from Credit Estimates, a unit of Standard & Poor’s that rates borrowers privately for collateral managers. That compares to 6.9% for all of 2013.

Leverage jumped to 4.7x in the first quarter, versus the 2013 average of 4.3x. A weak LBO pipeline toughened competition for mandates. In fact, leverage across all-senior deals widened a full turn. Deals structured as all-senior (first-lien only) increased to 5.2x, from 4.2x for all of 2013, according to Credit Estimates data. By comparison, transactions with first-lien debt and subordinated debt (including second-liens) tightened to 4.5x, from 4.6x.

The two structures showed no significant difference in pricing, with both averaging about 5.6% during the first quarter.

This month’s more cautious tone will temper underwriting for all deals, the lower middle market included. Shoe retailer  R.G. Barry  is on deck with a $130 million LBO credit. Mill Road Capital announced plans last week to take the footwear company private for $215 million. Preliminary price talk is higher than the first-quarter average, an SEC filing shows. An $85 million, five-year first-lien term loan is outlined at L+500, with a 1% LIBOR floor.

S&P Capital IQ estimates annual EBITDA of $20.6 million as of March 29, although sources say that current financials and adjustments bump up that amount and put leverage at 3.4x through the first-lien term loan, and 4.5x through a $30 million, 5.5-year second-lien term loan that’s outlined at L+900, with a 1% floor. Call premiums and covenants are included in the terms, the filing shows.

Turf war

Note that Golub Capital is the underwriter for the financing for this transaction. Non-regulated finance companies like Golub are offering generous amounts of leverage to win mandates over banks, which are expected to see their share of the leveraged lending market slip further this year.

A bank would have to weigh rewards versus reserve requirements and/or potential regulatory actions for underwriting a 3.4x by 4.5x transaction under new guidelines handed down last year. The 2013 guidelines define leveraged lending for the first time: any deal leveraged at 3x senior, or 4x total. Second-liens are included in the total multiple.

Lenders will soon find out how sensitively regulators will treat the new guidelines, as Shared National Credit reviews for 2013 business are due out sometime this month or June. U.S. banks’ share of leveraged loans to middle-market companies contracted to 9% of overall middle-market volume last year, according to LCD. That’s down from 12% in 2012 and nearly 20% in 2011.

Their shrinking market share might suggest that businesses have fewer outlets to tap for financing, but that isn't the case. Separate accounts are being lured into the middle market by low default rates and higher yields, and the number of BDCs has more than doubled since the 2008 credit crisis, with more than 40 publicly traded BDCs with total assets of more than $40 billion. American Capital Senior Floating, CM Finance, Triangle Capital , and TriplePoint Venture Capital raised an aggregate of $500 million in IPOs during the first quarter.

Upmarket

In the upper middle market, where midsize credits attract institutional money and are more sensitive to moves among broadly syndicated deals, pricing rose to compete with a big slug of first-quarter M&A among large-cap loans.

Institutional yields for upper-middle-market borrowers – those that generate $25-50 million of EBITDA – ended March at 6.5%, versus 6.2% for 2013, according to LCD. The jump was not huge, but it is significant in showing a change from frothy conditions earlier.

As a result, lower-middle-market credits delivered a 96 bps premium over upper-middle-market loans during the first quarter, but the upper bucket was leveraged to the hilt: All-senior deals during the first quarter averaged 6.4x, up from 5.5x in 2013.

Compared to the broader market, upper-middle-market loans yielded a first-quarter premium of 170 bps over large-cap single B loans, which yielded 4.8%, according to LCD. But large-cap yields have increased since the end of March, and will lift middle-market pricing in tandem. Marginal accounts are shifting their dollars into better fixed-rate high-yield plays. April yields for large-cap single-B loans rose to 5.1%, and are tracking higher this month. For the last seven days, yields average 5.6%.

Covenant-lite for middle-market deals appears to be on hold for new business. Over the past three weeks, Boyd Corp.Stratus Technologies, and Emmis Communications added covenants to their initial covenant-lite proposals.

Follow Kelly Thompson on Twitter: @MMktDoyenne