Lender-on-Lender Violence in Middle-Market Private Credit: Is it Coming?
Lender-on-Lender Violence in Middle-Market Private Credit: Is it Coming?
Recent discussions with capital markets participants have brought several critical questions to the forefront. One particularly pressing issue is the growing concern surrounding liability management strategies often criticized as ‘lender-on-lender violence.” The simple question posed often to Configure is: do you think lender-on-lender violence observed in large-cap capital structures is coming to middle-market private credit?
Before summarizing our views and response, it’s worth defining this concept. A transaction meeting this description is marked by one group of lenders that are subject to the same credit agreement aggregating “Required Lenders” status and partnering with a company and its sponsor to effectuate a transaction — one that provides benefits to participating lenders while impairing the legal claims and economic value of lenders not allowed to participate in the deal.
This strategy is accomplished most frequently through one of two designs:
- Dropdowns: The borrower uses permitted investment and/or restricted payment capacity within the credit agreement to move valuable assets outside the purview of the credit group into an unrestricted and/or non-guarantor entity. The recipient of such collateral, which used to belong to lenders under the original credit agreement, is then utilized as the basis for raising new money financing.
- Non-pro-rata up-tiering: A group of lenders holding the obligatory amount of loans to qualify as required lenders forms and votes to amend certain provisions in the credit agreement. Those amended provisions will typically include the ability of the borrower to issue new super-senior loans that rank ahead of previously existing senior secured debts. The borrower can then issue new loans to the required lender group in exchange for new cash. Participating lenders may also “roll up” existing senior secured loans into the new super-senior loan structure, thereby providing enhanced economic value to participants while diluting the economic value of non-participating lenders.
With definitions put in place above, we find it appropriate to disaggregate the headline question further by asking — why wouldn’t the private credit asset universe see the same lender-on-lender violence observed in the broadly syndicated loan universe? After all, many deals are done on a bilateral basis or with small clubs. A small club (i.e., 3 – 5 lenders) serves as its own steering committee and does away with the need for a co-op agreement observed with increasing frequency in the large-cap world.
Further, direct lenders rely on one another for lending opportunities and frequently invite one another to participate in deals. Pursuing non-pro-rata financing strategies could shut off certain deal pipelines.
Lastly, private credit funds generally have more flexibility to work with borrowers than bank lenders do. This dynamic reduces the likelihood of aggressive borrower tactics to modify credit agreements when borrowers run short of liquidity. Configure’s casual conversations with multiple private credit funds — and our observations of working negotiations between those funds and their borrowers — confirm enhanced flexibility.
So, if certain key elements exist in the middle-market private credit space that provide hurdles to lender-on-lender aggression, why might it emerge anyway? Our answer is simple: lender-on-lender violence is not nascent in middle-market private credit. Rather, it has been dormant for a while. Suppose one looks back before the pandemic to Trident USA, NYDJ, Trimark, and Boardriders. In that case, the study will quickly jog memories of such activities using the same basic toolkit of dropdowns and non-pro-rata up-tiering mentioned above.
The question then becomes: what might awaken lender-on-lender violence in middle-market private credit? Putting aside the movement of interest rates and borrower business performance, we find a few issues as items worthy of consideration:
- Private credit lifecycle issues: As funds near the end of their life cycle, they are less likely to be capable of participating in financing rounds if a borrower needs incremental financing. Underperforming borrowers with sponsors looking to kick the can may create a dynamic where private credit investors lacking dry powder are exposed within their lending group and face the risk of being primed or having their economic interest diluted.
- Inter-lender group dynamics: Where (i) a borrower needs capital, (ii) a sponsor refuses to provide it, and (iii) there is a disagreement among lenders on how to address borrower needs, the chasm between opinions opens opportunity for a required lenders group to team up with the sponsor and design aggressive financing strategies that hurt non-req lenders.
- Individual credit fund strategy: A recent Bloomberg article, “Hedge Funds Smell Blood as Lenders Turn on Each Other,” noted that several asset managers have recently closed on “capital solutions” funds designed to “secure their own lending positions in emerging conflicts – and to profit from wider mayhem.”
As the early movers in the private credit AUM boom begin winding down funds and returning capital, the mix of mismatched lender preferences within a consortium, private equity sponsor desire to kick cans, and newer private credit “opportunity funds” lurking could prove to be the spark that awakens middle-market private credit aggression.
About Configure Partners
Configure Partners is a credit-oriented investment bank specializing in debt placement and credit resolution advisory services. The firm provides the highest level of client service and execution to middle-market private equity sponsors in acquisition finance, refinancing, and dividend recapitalization transactions.
Configure is one of the largest firms dedicated to debt advisory, recently named to Inc. 5000’s fastest-growing privately-held companies in the United States. We’ve developed our processes and systems to ensure execution across all types of financing transactions. Unlike other debt placement groups, we don’t treat debt advisory as a secondary service offering to M&A – debt placement is our entire business. If this article sparks any questions, please don’t hesitate to reach out to the team.
About Matt Guill
Matt joins Configure Partners from Greenhill & Co.’s Financing Advisory and Restructuring practice, where he most recently was a Principal. Prior to joining Greenhill, Matt worked on the restructuring teams at Rothschild & Co. and Millstein & Co. Matt has advised companies, lenders, sponsors, and governments on an array of complex financing and restructuring issues, M&A activity, and general strategic advisory assignments. He started his investment banking career at Cary Street Partners.
Matt graduated Phi Beta Kappa from Hampden-Sydney College where he was the captain of the basketball team. He also holds an MBA from Columbia Business School. Matt is a FINRA General Securities Representative (Series 63 & 79).