Why Buy Middle Market Loans?

A Churchill Financial Special Report

Beginning in February 2010 On The Left published a series of articles discussing the relative merits of investing in middle market senior debt and their broadly syndicated counterparts. This report consolidates those articles. Copyright 2010 Churchill Financial LLC, All Rights Reserved
"Middle market loans are just like other loans," a long-time observer of the space enjoys noting. "Only more so." Whatever the truth to that observation, investors in the loan markets have their clear opinions about the virtues of smaller deals relative to their broadly syndicated cousins. But it's also evident from the dislocation of the credit markets over the past 30 months how dysfunctionally that larger family of assets has behaved. Indeed, the supposed benefits of big deals turned out to be major stumbling blocks, leading private equity sponsors and financing sources to "go small." Suddenly, after years at the kiddie table, middle market firms were sitting with the grownups. Indeed, most of the adults were sidelined with indigestion. Institutional investors were supplanted by traditional buy-and-holders. Players like regional banks, BDC's, mid cap finance companies, and credit opportunity funds jumped up the league tables. With any real CLO creation at least a couple quarters away, the outlook is good for smaller deals to hold onto more than their fair share of the leveraged market. So it seems like an appropriate time to puncture some myths about middle market loans. Let's start with: Myth #1 - Middle market loans (MMLs) are less liquid than broadly syndicated loans (BSLs). Institutional investors traditionally eschewed MMLs, saying I Exhibit 1 Middle Market Loans (MMLs) have outperformed Broadly Syndicated Loans (BSLs) in several key metrics. can't trade out if I need to; there's no market for them.' And it was true that for years leading up to mid-2007, when every BSL was trading at par, it was easy finding buyers and sellers. But the Great Credit Crunch revealed that large, on-the-run names were liquiduntil they weren't. When hedge funds dumped Georgia Gulf to pick a name in the low 70's to meet redemptions, the fact that it had been one of the most creditworthy, highly-traded names in the LCDX didn't help. Large cap liquidity turned out to be an illusion. There's no question that MMLs are less liquid' in the sense that there aren't hundreds of accounts holding them. There are two reasons for this. First, the deals are small. If you define MML as a credit facility less than, say, $150MM, you're probably going to have only a dozen or so holders. And the majority of MMLs have only a handful. Secondly, MML names trade infrequently because lenders want to hold the paper. They've put a lot of time, effort, and resources into underwriting the credit. They've visited the company, met management, kicked tires. They like the asset, and the spread. They may even have a relationship with the issuer. You can't buy them out, even at par. After all, does the number of people at a wedding prove how long the marriage will last?

Source: S&P LCD, Credit Pro

Churchill Financial 400 Park Ave - Suite 1510 New York, NY 10022 www.churchillnet.com

Randy Schwimmer Senior Managing Director - Head of Capital Markets rschwimmer@churchillnet.com (212) 763-4646

Myth #2 Middle market companies (MMC) are riskier than large cap ones. The theory boils down to two arguments. First, smaller companies have less critical mass, thinner cushions, in case something goes wrong. If a $13MM Ebitda wing-nut manufacturer loses a key customer, it could be fatal. Small businesses can surely be wiped out by big problems. But it's all relative. As with liquidity, size can be barrier to failureuntil it's not. Toyota was the most well-regarded auto company in the worlduntil it wasn't. No need to reprise here the hero-to-zero list of big business catastrophes that weren't too big too fail. Also, mid cap management layers are flatter. Feedback from customers and suppliers to C-level execs is accelerated. CEOs get involved sooner and decisions tend to be simpler; fixes closing a plant, shutting down a line, selling a facility are less complex. The second argument against MMC's is that smaller companies don't have the same access to the broader capital markets that larger companies do. Alternative sources of liquidity, like bonds or IPO's, aren't available to that wing-nutter. But the virtue of (mostly) private-held MMC's is that they are sheltered from the vagaries of public markets. Fixed income and equity instruments are extremely sensitive to exogenous factors. Even if you manage to get an issuance off the ground, secondary prices then can get dragged down by whatever happens to be roiling markets at that moment. That wing-nutter may never be able to do an IPO, but its CEO isn't sitting around worried whether Greece can pay its debts. And with markets having shown over the past two years to be way more correlated than anyone predicted, a problem in one market can leak over to another. When equities sneeze, junk bonds catch cold. So, as we've discussed, there are pluses and minuses to liquidity and size. But how do the smaller credits actually perform when it comes to default rates, losses, and recoveries relative to larger deals? So far weve focused on the relative virtues of middle market loans and their broadly syndicated counterparts, as they relate to the issues of liquidity and business risk. Lets turn next to one of the biggest reasons many institutional investors have historically avoided MMLs: Myth #3 Broadly syndicated loans (BSLs) show better recovery rates than middle market loans (MMLs). But before we jump into statistics, let's set the stage by going behind the numbers. Default and loss/recovery metrics on high yield bonds and BSLs are based on submissions by hundreds of institutional investors

and widely shared among thousands of market participants. Hard data on MMLs are not easy to come by. Those transactions tend to be clubs with less than five lenders and often only one or two. The vast majority are below-radar affairs, unreported by any news or research source. Also, mid cap lenders are notoriously secretive about disclosing detailed portfolio information. The reasons are both competitive and confidentiality-related, driven in part by the (understandable) sensitivities of their PE clients who own the equity Even when mid cap data is available, they aren't necessarily tied to traditional middle market companies. The category middle market' tends to be defined as borrowers with $50 million Ebitda or less. There is no distinction between larger mid caps ($25-50 million Ebitda) which tend to have more broadly syndicated facilities and thus whose default and loss/recovery behavior is more closely correlated to true large caps and traditional mid caps ($10-25 million Ebitda) which is a better proxy for smaller deals. It's also critical to understand the distinct investor personalities of these asset classes. Unlike MML lenders which typically buy-and-hold,' funds who purchase BSLs are structured to buy-and-sell.' Their buy or sell decisions are motivated as much by mark-to-market or collateralization tests as by credit considerations. If portfolio managers foresee a higher risk of default on one asset, they can sell it and buy another on a par-neutral' basis. Fund investors are also generally 'buy-side;' they do not 'originate-to-distribute' loans. Indeed, for tax reasons, some funds are specifically restricted from doing so. MML lenders do originate, which makes them less sensitive to 'price' and more congenitally willing to consider long-term value in sticking with a difficult loan. They also tend to be more relationship-driven with PE sponsors where loyalty on a tough credit may win you the next agency.

Relative Recoveries Our experience, and that of other players in the middle market, has been that smaller deals are easier to work out than larger deals. As we've discussed, there are several reasons for this. But the biggest advantage is that gaining consensus on financial restructuring issues is a lot easier amongst a handful of lenders who have worked with each other for years than among thirty or forty disparate funds with differing proclivities and objectives. And those big bank groups always have a few distressed buyers who would just as soon pull the plug and walk away rather than hang in there to see the company through the tough times.

Exhibit 2

facility size increases. We've discussed why this should be so; that smaller bank groups with aligned interests make it easier to negotiate tougher restructurings. But one counter argument runs like this: "Sure, middle market loans are to easier to keep from defaulting. That's because you guys just keep amending and extending these companies along until they run out of gas." Hmm. That sounds more like the exercises large corporates have been engaged in for months, with some tapping high yield and others enticing investors hungry to increase spreads in exchange for maturity. And what's the purpose of a covenite-lite structure anyway, if not to defer the day of reckoning? At least MML's start with reasonable maintenance covenants to track issuer performance, even if the bank group does decide to provide some headroom later on. As knowledgeable investors understand, the ultimate test whether lenders recover value revolves around the old formula: Loss rate = default rate x (1 recovery rate) Once again, the difference is clear: loss rates on MML's (0.57%) outperform those for BSL's (1.63%). To understand the implications of these numbers, we should see them in light of the returns and yields each asset class provides. Not only the spread differentials of MML's compared to BSL's, but the operating expenses associated with each of those platforms.

Source: S&P LCD, Credit Pro

So let's take a look at the numbers. As you can see from Exhibit 2, the facts are compelling. Measured over the last twenty years, MML's - whether as a percent of the value before ('nominal') or after ('discounted') default - demonstrated clearly better recoveries than those of larger, theoretically more liquid, BSL's. A few observations. First, this data comprises a total of 3,554 facilities, of which 913 represent the middle market segment. That's a very healthy sampling, particularly since it covers two decades through several business cycles. Secondly, several teams at S&P have been working for some time to develop support for the post-default middle market value proposition. The source for our chart comes from CreditPro, their default, ratings migration and recovery data tool. Also, we note that these data are averages. They ignore the role both experienced middle market firms and their portfolio managers play in further reducing losses and improving recoveries above the averages. Finally, Bill Chew, S&P's leveraged credit and recovery guru, observes that there is significant dispersion in the performance of both MML's and BSL's, with the upper end of middle market performing as well as any of the best large corporates. He further notes that smaller deals historically didn't experience the financial engineering excesses - high leverage, PIK toggles, and split collateral second liens - of the mega-transactions.

Exhibit 3 Down the Middle Cumulative Institutional Loan Default Rate by Deal Size, (1995 - 2009)

Relative Loss Rates All this said, one might ask, "That's great that recoveries for smaller deals are better, but what about defaults? You need default data to figure out your true loss rates." S&P/LCD provides comprehensive quarterly default statistics, of which Exhibit 3 is an extract. As you can see, cumulative default rates (these over a fifteen-year history) deteriorate as
MM Loss rate = default rate of 4.1% x (1 recovery rate of .8612%) = 57 bps LC loss rate = default rate of 8.6% x (1 - recovery rate of .8104% ) = 1.63 bps Source: S&P LCD

The last of the Great Myths surrounding middle market loans (MML's) is: Myth #4: Higher middle market spreads represent illiquidity premiums vs. large caps. It is a truism in leveraged lending that middle market loans (MML's) not only have higher spreads than those of broadly syndicated loans (BSL's), but that they should carry higher spreads. The reasons investors typically give for this are: 1. MML's are less liquid than BSL's. 2. Middle market companies are smaller, therefore riskier, than larger companies 3. MML's carry higher default and loss rates, and lower recoveries, than BSL's. As weve discussed, the evidence does not support these three notions as resoundingly as previously supposed. So, what's behind the numbers? Take a look at Exhibit 4. As you can see, new issue spreads for MML's have consistently been higher than those for large-cap deals, with the so-called middle market "premium" reaching record levels this year. But this isn't always true for comparable secondary spreads. During periods of market dislocation, BSL's yields often spike above MML's; in 4Q 2008, large-caps rose five percent above mid-caps before settling back to more normal levels (see Exhibit 5). This was clearly a technical issue: the supply/demand imbalance Exhibit 4 Technical Difficulty Leveraged Loan CLO Activity is the real key to mid and large cap spreads

Exhibit 5 Middle market secondary yields still at a premium to the broader market

SMi100: 100 most liquid loans; Yield based on 4 year term to repayment MM: Sales less than $500M, deal size $100-$300M
Source: LSTA/LPC MTM Pricing, Thomson Reuters LPC

caused by the absence of new CLO formation the traditional driver of leveraged lending. So buyers of existing paper during the credit crunch had to pay an illiquidity premium for largecaps! As weve noted, big deal liquidity isn't always there when you need it. The relationship between large-cap spreads and the evaporation of new securitization in 2008 and 2009 also shows nicely in Exhibit 4. And, of course, mid-cap spreads rose sympathetically; why offer lower yields when there are few alternatives? Then last year secondary spreads for BSL's dropped below MML's, again for technical reasons. This time, the booming high yield market pushed cash back into the hands of fund managers, who redeployed that cash back into other BSL's. If large-cap liquidity is over-rated, defaults and losses are higher, and recoveries lower, why does the middle market pricing premium exist? Perception is a big factor; myths can be enduring. But even though BSL yields are more sensitive to technicals, and thus more volatile, most of the time liquidity is "normal." It's all about timing. Middle market loans can be subject to their own kind of technicals. Regional banks, subsidized by low-cost demand deposits, have been known to offer smaller borrowers quasi-investment grade pricing. There just aren't enough of them consistently lending, compared to institutional investors, and they tend to be cautious regarding leverage. So to give middle market loans their due, rather than think of a middle market illiquidity or risk premium, maybe we should call it the large-cap hyper-liquidity discount.

Source: S&P LCD

Summary
A long-time practitioner of middle market lending has told us, "I've really enjoyed your series on middle market loans," she said. "So what does it all mean?" We understand the confusion. There seems to be a disconnect between the historic investor bias against smaller companies and deals, and evidence we've summarized in this space suggesting that expected losses for middle market loans are lower than for large, liquid ones. Lets review the four major misconceptions around the relative 'large versus small' value proposition: Myth #1: Middle market loans (MML's) are less liquid than broadly syndicated loans (BSL's). This is the case only during times of 'normal' liquidity, but often because middle market lenders are more 'buy-and-holders' than traders. Myth #2: Middle market companies are riskier than large cap ones. The problems of smaller companies are often easier to fix, and require less capital than mega-firm meltdowns. The loans themselves are less levered, and more 'constructively' structured. And issuers often have tighter 'borrower/lender' relationships. Myth #3: Broadly syndicated loans show better recovery rates than middle market loans. In fact, S&P data shows default, loss, and recovery performance is better for middle market loans Myth #4: Higher middle market spreads represent illiquidity premiums versus large caps. Institutional loan pricing and spreads are driven more by technical supply/demand issues such as high yield repayments and funds flows. Larger loans may alternatively be cheaper or dearer at times than middle market loans, depending on whether the market is extremely liquid or illiquid. What this white paper is trying to demonstrate is not that middle market loans are always better investments than broadly syndicated loans, or that the default, loss, and recovery data we have presented are inarguable. Rather, we believe that middle market loans are often dismissed by otherwise savvy investors for reasons not always objectively examined and offer compelling risk/return dynamics when compared to liquid loans if managed correctly. What is indisputable is that middle market credits as a class are not as transparent as those whose loans and bonds have been distributed to hundreds of institutional investors over many years.

Exhibit 6 Premium Rewards Today's average spreads favor middle market loans, with higher recoveries

Source: S&P LCD, Credit Pro

The level of tire-kicking required for an investor to appropriately assess the $13 million EBITDA wing-nut manufacturer we discussed earlier is several levels of magnitude deeper than someone looking to trade paper in Georgia Pacific. But once that due diligence is done, augmented with focused, on-going credit monitoring, lenders are confident that a good middle market loan will perform as well as (or better!), be structured more conservatively, and priced better for the risk, than any broadly syndicated loan.

That's what it all means.

The Churchill Financial Group, headquartered in New York, is a leading commercial finance and asset management company with over $2 billion of committed capital to support its financing activities and over $3.5 billion of assets under management. Established February 2006 with the goal of building and developing a preeminent commercial finance business, Churchill Financial focuses on lending to and investing in middle market companies that are backed by leading private equity firms and other investors. Churchill Financial is comprised of two complementary operating businesses: Churchill Financial Middle Market Finance and Churchill Pacific Asset Management. www.churchillnet.com