A 2025 Lending Outlook with WhiteHorse Capital

Stuart Aronson, executive managing director and CEO of WhiteHorse U.S., and Pankaj Gupta, president of WhiteHorse U.S. and global head of originations, are back with the podcast to discuss what’s next for lenders in the months ahead, how underwriting standards are developing, how portfolios will perform in 2025 and more.

This episode is brought to you by WhiteHorse Capital, the direct lending arm of H.I.G. Capital. To learn more about WhiteHorse, visit whitehorse.com. Read a transcript of the podcast below.

Middle Market Growth: Welcome to the Middle Market Growth Conversations podcast, an ACG production. I’m Katie Maloney. Today’s episode features a lending outlook for the lower and middle market in 2025. For that, I’m joined by Stuart Aronson, executive managing director and CEO of WhiteHorse U.S., and Pankaj Gupta, president of WhiteHorse U.S. and global head of originations. Stuart and Pankaj were guests on the podcast early last year, and many of their predictions for 2024 proved correct. For example, they predicted that in 2024 there would be fewer rate cuts than many in the market were expecting, that inflation would not be fully tamed, and that 2024 would be an aggressive year for lending, just to name a few of the predictions they got right. Today, I’m very much looking forward to hearing their forecast for 2025. Stuart and Pankaj, welcome back.

Stuart Aaronson: Thank you.

Pankaj Gupta: Thank you, Katie, and thanks for not mentioning the ones we didn’t get right.

MMG: Oh, I don’t know. I think you got quite a few right, so I’m looking forward to hearing your forecast this time around. Stuart, we sat down with you and Pankaj at the beginning of 2024, as I said. In the year since, what are some interesting market trends that you’ve noticed?

SA: There are a number of things going [on] in the market. It starts with the fact that 2024 was an extremely aggressive year in terms of lender behaviors. And that led starting in Q3 we saw to a partial thawing of the M&A market, and that continued into Q4 and has also continued into Q1. So interest rates are now a hundred basis points lower, at least SOFR is a hundred basis points lower, and there is an expectation that there will be some more rate cutting this year. Our predictions are that the rate cuts will be probably only one or two because there are many policies of the new administration that are feared to be inflationary, and we think the Fed is going to be cautious on that to limit the re-spark of inflation. But when you take a series of factors into account, including the fact that interest rates are lower, that they will probably be getting a little bit lower than they are right now, that spreads are at an all-time low in pretty much all sectors of the market, upper mid cap, large cap, mid cap, and lower mid cap, and that there’s a lot of pressure on private equity firms to have realizations. We think the thawing of the M&A market will continue into 2025 and will probably accelerate if the deals that are brought to market have reasonably good outcomes. We’ve also seen that for better companies, private equity firms are willing to pay up more. We’ve seen more trades occurring in the low teens to high teens EBITDA multiples, although that trend has not really continued in terms of higher multiples for companies that are more cyclical or have a more complicated credit story. For those companies, what we’ve seen is that sellers have become more realistic, and whereas they might have been expecting to get eight or 10 times for companies like that last year, we are seeing some companies now trade more in that six and a half to seven and a half times range if the companies have less growth prospects and more complexity. So overall, we expect to see an increase in M&A activity and we’re budgeting ourselves to be up about 20% on the year.

PG: You know, the one thing I’d add to what Stuart said is, in addition to rates and pressure to deploy capital, I have noticed or heard a bit of a renewed optimism coming from CEOs, CFOs, owners of businesses, et cetera, as it relates to the economic outlook, as it relates to the business environment on a go-forward basis. And again, that’s sort of just talk and it’s optimism, but I do believe that it could fuel additional M&A, or it will likely fuel additional M&A in ’25 relative to the past two years.

MMG: Thank you both for that overview of the trends that you’re seeing, and of course, market trends often also impact underwriting standards. What are some of the ways you’ve seen 2024’s economy shape underwriting standards?

PG: Well, the underwriting standards that we saw throughout the course of 2024, unfortunately, I think as lenders, we saw a gradual relaxation of those underwriting standards. And really, it depends on what part of the market we’re talking about. If you’re thinking about sponsored transactions, private equity-led LBOs for middle, upper middle market companies, given the relatively benign economic environment that we experienced in ’24 and what we’re experiencing right now with the outlook as it is right now, people have gotten pretty aggressive. People are competing to win business and the way they’re competing to win business is by relaxing their underwriting standards, doing something that we call diligence light, which is effectively desktop-level diligence done in a few days to a week. And that has become more and more accepted in the upper middle market sponsor space. You then go to the lower to middle market sponsor space, and there is more of an ability to do traditional underwriting and diligence. These businesses work with the sponsors, the bankers, the companies to underwrite these companies, to underwrite their risks and mitigants and do more traditional diligence and have a more traditional underwrite. And then in the non-sponsored space where you’re working very directly with and closely with companies, owners, entrepreneurs, management teams, there’s still a very old-fashioned level of underwriting that is acceptable where you’re spending days or multiple days on site with these companies, you’re doing a significant level of financial market work, customer work, et cetera, that lenders are still benefiting from. So again, it really depends on the segment of the market. The overall economic outlook, as we talked about, remains relatively benign, right? We will talk more about it probably as we move forward. There are certain pockets of the economy in certain business models and verticals that are less attractive right now. But on the whole, GDP continues to grow, rates have come down as Stuart said and the deal environment is pretty good. And so with that, we anticipate that underwriting standards will not change materially relative to what they were in ’24, which is to say that again, in upper middle market sponsored transactions, lenders have much less ability to do traditional underwriting relative to lower middle market, middle market and non-sponsor transactions.

SA: I would add that as the market has been developing in 2024 and into early 2025, the bankers, in an effort to get better valuations for companies, have gone back to doing adjustments and synergies and maturity adjustments that create EBITDA numbers that often do not relate to the actual reality of underlying cashflow for a company. We were looking at one deal where the actual EBITDA of the company was actually negative and was being adjusted to positive so that truly there was no cash flow at the company without those adjustments. So not that extreme, we certainly don’t see every day, but we are seeing more heavily adjusted EBITDAs and numbers that we find are harder to believe that some players in the market, especially some of the newer players that haven’t experienced what happens when bankers’ numbers are wrong, people are accepting those numbers and underwriting deals at, as Pankaj indicated, a lower standard than they were in 2023 or 2022.

MMG: We’re taping this episode two weeks into the new year, and you’ve both talked about trends that you’ve seen over the past year and in the very early days of 2025. From where we sit today, what is your outlook for the rest of 2025, Stuart?

SA: Well, as I mentioned earlier, we do think the economy is generally healthy, and we do believe that the new administration has policies which will be in many respects good for the economy, but also inflationary in nature. Those policies include potential deportation of low-cost labor, tariffs, and also tax cuts, all of which could lead to a re-sparking of inflation. So we think that the Federal Reserve is going to be cautious on the timing and the extent of cuts, but we do tend to believe that the general economy will remain benign with the most pressure being on lower income consumers who’ve been compromised by inflation over the past several years. But in general, it looks to be a pretty good market in 2025. Again, as I mentioned, there’s a lot of pressure on private equity firms to have realizations, so we think that the pull from the LPs who want the private equity firms to sell, added into the fact that there are healthy and aggressive debt markets, will lead to companies trading at valuations that worked for sellers, and we expect it to be a a pretty busy year. Pankaj, anything you’d add to that?

PG: I think you covered it, Stuart. I guess I would just say that similar I think to last year, I don’t expect rates to go down dramatically relative to where they are today. Perhaps something in the neighborhood of 50, 75 basis points maybe by the end of the year, but again, still well above the historical norms of the past 10, 15 years. And that is again going to be caused by or due to the inflationary pressures that Stuart mentioned. But that said, with SOFR today right around 4.3%, and if it goes down a little bit from here, those are manageable rates where most likely companies with normal capital structures and normal amounts of leverage can service their debt obligations, generate free cash flow after that and continue to invest in growing their businesses.

MMG: And as far as your predictions for portfolio performance in 2025, what are you predicting on that front?

SA: Well, there were a lot of very aggressive deals that were done in the latter part of 2020 and throughout the year of 2021. And we’re led to understand through conversations we’ve had in the market that there are a decent number of companies that have been sort of hanging on by their fingernails, hoping for interest rates to come down dramatically and lower their debt service costs. Obviously, based on what we’ve shared in the earlier part of this conversation, we don’t think interest rates are going to come down that much this year. And we think that some of those deals that were done in 2020 and 2021 are likely to need to be restructured this year, which was also going on, frankly, in 2024. Given it was a hot market, people were taking broken deals and tranching those deals out to bring in junior capital or to bring in preferred equity. We expect that to continue in 2025. As Pankaj and I have both said, we think the economy will be generally positive, so I don’t see a significant ramping up of default rates, but there could be some companies given some of the weakness in the consumer side that run into trouble. But overall, I would expect portfolio performance in 2025 to be more or less aligned to what we saw in 2024, maybe with a slight tick up in defaults resulting from those companies that had their structures put in place in 2020 and 2021.

MMG: You’ve both noted that conditions within the economy, for the most part, are positive. I think you’ve both used the word “benign,” but in the event of a recession or an economic downturn this year, what would be your expectations for portfolio performance then, Pankaj?

PG: Well, at a super high level, of course you would expect in a recessionary environment default rates go up. We’ve seen that over the past 30, 40 years in different types of recessionary environments. Default rates do go up and losses upon a default also go up. They go up for structures that were traditional lending with covenants, et cetera, et cetera. They go up to somewhere around, you know, 2 to 3% default rates, something like a 40 to 60% losses upon a default. So overall, your loss ratio is somewhere in the range of, let’s say, 80 to a hundred basis points; still very manageable for the types of yields and returns that direct lenders are able to generate. The one caveat to that though is over the past let’s say five to 10 years, there has been a degradation in structures relative to those past recessionary environments. So what I mean by that is, first of all, most deals going back to the GFC, covenant light was only for the largest of the companies, right? $150 million or more of EBITDA, $100 million or more of EBITDA, very big, great, scaled, good companies that will cycle and then they’ll cycle back. Covenant light, I’m sure everyone knows, has crept into the middle market where companies now with typically $50 million or more of EBITDA are candidates for covenant light deals. And sometimes in certain situations we’ve even seen that go below $50 million. So that weakens the protections for lenders. It would potentially increase default rates and or losses given default. The other thing though that keeps us alert and what we stayed away from largely, but has become a commonplace in the market, is the ability for borrowers to do what is called a liability management transaction, which is companies, and this is true for a lot of lenders with portfolios that have an average $50 million of underlying EBITDA or $60 [million] or $70 [million], but really the middle to upper middle market, the documents as structured allow for borrowers to effectively take collateral within the lender package. And rather than in a downside scenario where traditionally a sponsor would have to put equity into that transaction, the sponsor is able to raise pari-passu and/or priming debt associated with that collateral. And we’ve seen that occur multiple times in the marketplace over the past year or two years as sponsors have become more familiar with this ability to do so. And of course, if they don’t have to put equity in, they’re not going to. But what that does is in the downside event, there’s obviously more debt in the capital structure on a go-forward basis, and that debt could be priming to the existing lenders, so it creates more variability and higher loss ratios. This is, again, in portfolios that exist today. This is something that concerns me because I think it exists in a lot of people’s portfolios in real volume. And so if and when the next economic cycle occurs…again, it could be back at back end of ’25, it could be after that. But if and when it occurs, I do expect sponsors to take advantage of this, right? Because it is in their best interest and they have the ability to do so, which might create higher losses ultimately than prior economic cycles.

SA: There is a whole generation of broadly syndicated deals and other large cap deals that have been clubbed with a large group of lenders that are exposed to this liability management structure. And when you think of prior downturns where sponsors would generally protect their companies with equity, and then the next downturn instead of equity, they may be priming their senior lenders. That could lead to a profound change in the loss given default on the broadly syndicated market and the large cap market. I want to highlight though that, to my knowledge, there have not been any liability management transactions done in the core middle market or lower middle market, where the documents and the size of the lending clubs generally prevent and prohibit those types of transactions. So that’s going to be a very interesting thing to see if there is an economic downturn primarily on the broadly syndicated deals.

MMG: And do you expect the middle market to remain somewhat insulated from that?

SA: I do, yes. In fact, if anything, after the Vista Equity-Pluralsight transaction got a lot of publicity, LPs across the world have become very aware of this dynamic and are very concerned about it, and they are now talking to their GPs about avoiding that type of risk. And so where there’s an entire generation, as I said, of deals that have been done where the documents have that risk in them we are seeing now for the first time, just in the last couple of months, that sponsors and bankers are being pushed and/or forced into putting protection against that type of transaction into some new deals. So the deals that have been done in the past, really the past five or 10 years, the protections don’t exist, but the deals that are done in 2025, I think there’ll be a decent number of them that those protections are injected into the documents.

MMG: And Pankaj, I want to return to the topic of covenants for a moment. The last time we had you on the podcast, you mentioned that you were seeing covenants loosen. I’m curious what you’re seeing now from covenants across market segments.

PG: So we did see them loosen in 2024, I think, as I alluded to last year, but really again we need to break it down into the various segments of the market. And so if you start with the larger deals, private equity-sponsored LBOs, you know, for upper middle market companies again, those are either covenant light or covenant wide, right? Where the sponsor may be buying a business for nine times and they may set their covenant, if there is one, at eight and a half times or nine times, or in certain cases even outside of the enterprise value at nine and a half times. And so the effectiveness of that covenant is less effective and useful as it relates to protecting your risk exposure relative to the enterprise value of that company. The other thing in that part of the market is, again, regardless of where the covenant is set, the underlying definitions that people are using for EBITDA in that market allow for pretty aggressive adjustments. And so with the stroke of a pen of a CFO, they could furnish a compliance certificate, which allows for unlimited add-backs to the EBITDA or prospective add-backs for revenue synergies and/or cost savings that are on the covenant that haven’t been actioned or customers haven’t been won or whatever it is. And so again, the covenants, if there are covenants, are wider and somewhat toothless, but then what goes into the calculation of that covenant really doesn’t give the lender protection as it relates to the actual level of cashflow that that company is generating.

Then you go into the lower middle market or the middle market, where I’d say probably, again, similar to what we said at the beginning of last year, we have not seen a dramatic shift in terms of the covenant levels. Said another way, they are still being set at levels that are decently inside of the enterprise value of these companies, providing some real protection, nor have we seen a meaningful shift in terms of the definitions underlying those covenant levels. There are caps to the amount of EBITDA adjustments that a company can claim, they tend to be broken out for in terms of action to cost savings relative to other buckets that are more squishy with even tighter caps. And so again, the covenants provide some real protections there. Then lastly, if you go to sort of the third market segment that we cover, which is the non-sponsored segment, there really hasn’t been any move at all, which is to say that covenant levels are appropriate, they’re tighter than they are in sponsor deals, and that’s appropriate given the fact that there’s usually not a deep-pocketed private equity sponsor backing that company, which then allows for more of an early warning signal if those companies are underperforming. And the definitions and what’s able to be added back to EBITDA is very limited and very tight. So again, providing very traditional lender protections in those situations. So at this point now going forward, we’re not seeing a worsening or a loosening of that general framework across those three market segments, but they are very different depending upon the market segment that you’re focused on.

SA: Yeah, I would say in the upper mid cap and large cap segment, pretty much all deals are either covenant light or covenant wide. And the covenant wide, as Pankaj correctly described it, will lead to a payment default before covenant default. So what’s the use of having a covenant if you have a payment default before you have a covenant default that really has no use at all? So that market is pretty much all not covenant-protected anymore, which is one of the reasons why we and many of our investors favor the middle market and the lower middle market.

MMG: Stuart, I also want to revisit a comment that you made on the podcast last year. I recall you had some interesting observations about credit structure changes in the lower and middle market. As you look back over the last 12 months since that conversation, have you noted any further shifts in credit structures and terms in that space?

SA: Well, I’d say the most dramatic thing that I’ve seen happen in the lower middle market is that there has been a group of new lenders that have come into that market, and they don’t have historical relationships in either the private equity side or the non-sponsored side. And in order to win business, they’ve had to do unnatural acts, which would be in some cases going to higher loan-to-value, in some cases putting more leverage on a cyclical than traditional market players are willing to do. We’ve also seen people take deals where the cash flows don’t work and inject a significant amount of PIK interest into the structure. So there is some disruption in the midmarket or really more the lower midmarket from the smaller shops that have started up that don’t have a natural way to win, that have to bend the credit rules in order to win their transactions. When we see that happening, we just move on from those deals and we think most cautious lenders do the same across the market, but there definitely has been a shift in that part of the market over the past 24 months on some of the deals that are getting done.

MMG: And then finally, Pankaj, are you seeing any shifts in those credit structures in terms in the sponsor market versus the non-sponsored market?

PG: In the sponsor market, we are seeing people, as we’ve talked about already, get more aggressive, but that’s primarily not necessarily in terms of structure, it really is in terms of underwriting and diligence. The diligence light phenomenon that I mentioned I think sort of early in this conversation is a real thing, where people are taking effectively a sponsor’s word for how they’re representing a business or its financials or its trends rather than doing kind of their own organic diligence. And that is a real change in terms of the prevalence of that relative to what it was a year ago. Leverage multiples and loan-to-values have also crept up. They’re probably, I’d say about half a turn higher and five to, in certain cases, 10 percentage points higher from a loan-to-value perspective in the sponsor space. So now deals are getting done in the upper middle market at five to seven times the EBITDA and up to 65% LTV which again is a shift relative to what it was a year ago. In the lower middle market, as we’ve talked about, we haven’t necessarily seen those structures change. Leverage multiples are still pretty consistently four to five and a half times debt to EBITDA. LTVs are consistently 55% or less. Sometimes they stretch up to 60%, but you still have pretty good equity cushion and sponsor support in those transactions. We have seen spreads tighten, right? We saw that all throughout 2024 across the upper middle market and the lower middle market sponsor space. Spreads tightened, but the risk profile and the credit structures in the lower middle market sponsor space did not move dramatically. And then the non-sponsored space, again, given how hard it is and how difficult it is to originate these transactions to cover all sorts of intermediaries and boutique investment bankers and advisors and companies directly all around the U.S., it does not move up or down nearly as much as the sponsors face. And so credit structures, diligence processes, spreads have all been pretty consistent. Multiples are two and a half to four and a half times debt to EBITDA. LTVs are typically 50% or less, and spreads are 600 to 800 in the non-sponsor space with real structures and real diligence. And so we haven’t seen much movement in the non-sponsor space, nor do I anticipate it.

SA: And as a result of the market conditions that we saw in 2024 and that we expect to see in 2025, we actually have done more non-sponsor lending in 2024 than we have done in a typical year. And so we do pivot our attention to the sectors of the market where we think the best risk return exists and that has favored the non-sponsored market to some extent over the past year or so.

MMG: Okay, we’ll wrap it up there. Pankaj and Stuart, thank you so much for joining me on the podcast and hope to have you both back on at the start of 2026 where we can look back on these predictions and see how they’ve panned out.

PG: Thank you, Katie. Appreciate it.

SA: Thank you so much.

This transcript was prepared by a transcription service. This version may not be in its final form and may be updated.

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