Navigating an Aggressive Lending Environment Amid Uncertainty
WhiteHorse Capital urges a focus on interest rates and the potential for a recession
After a sluggish lending environment last year, deal activity has ramped up in 2024 thanks to pent-up M&A volume, private equity dry powder and a surprisingly resilient economy that is driving performance of middle-market companies looking for acquisition or growth financing.
While these are welcome developments, the downside is aggressive lending practices are creeping into the market in the form of higher leverage, fewer covenants and less stringent diligence and documentation standards. We believe that to navigate this increasingly aggressive lending environment, it is critical to guard against slipping standards and keep focused on what matters most.
This section of the report is sponsored by WhiteHorse Capital and originally appeared in the Spring 2024 issue of Middle Market DealMaker.
Take the tumultuous geopolitical backdrop, with conflicts intensifying in many parts of the world. These are headline-grabbing events and deservedly so, but their financial impact on American middle-market companies will be relatively limited since these companies’ customers and supply chains are largely in the U.S. Similarly, while the presidential election will command political discourse all year, the election’s outcome will have little impact on these companies, except for sectors with exposure to regulatory shifts.
What matters, however, is the direction of interest rates and the odds of a recession. While inflation is down dramatically, the latest government figures show that it is still running hotter than the Fed’s target. That is a blow to many who hoped the Fed would soon start aggressively cutting interest rates from their 20-year highs. It is likely that rate cuts will be less dramatic than expected, impacting companies’ free cash flow and ability to service debt. Meanwhile, the U.S. has averted a recession for longer than most expected, but the possibility cannot be ruled out.
Given this backdrop, we believe lenders should avoid aggressive lending practices that can put their own capital at risk, while also imperiling the stability of the underlying companies. We look for companies in non-cyclical industries with strong, high-margin cash flows and low capital expenditures, such as business services, technology and software, healthcare and consumer staples. In terms of deal structure, we eschew covenant light loans that do not alert a lender to trouble until enterprise value is compromised. Instead, we favor deals with traditional leverage and fixed-charge coverage covenants. These ensure that if there is performance deterioration, we have time to meet with the company’s leadership and devise a strategy to get back on track.
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Sticking to one’s lending principles, not getting drawn into aggressive loan structures, and finding businesses in the right industries with the right cash flow profile is not easy. It requires a robust deal origination engine in place to see steady deal flow. We believe it is not enough to simply have offices in New York, Chicago and Los Angeles. Lenders need their ear to the ground in every corner of the country to tap into regional deal flow. This approach is the surest way to navigate today’s lending environment.
Pankaj Gupta is president of WhiteHorse, U.S. and global head of originations. WhiteHorse provides senior and second lien debt for growth capital, acquisitions, buyouts, refinancing and balance sheet recapitalizations for middle-market companies in the U.S. and Europe.
Middle Market Growth is produced by the Association for Corporate Growth. To learn more about the organization and how to become a member, visit www.acg.org.
