Cautiously Optimistic: Mixed Messages for the Middle Market
Predicting the future is hard at the best of times. If not impossible.
2024 is proving to be a year of complexity with geopolitical unrest and partisan politics across many countries. In a year when four billion people will take part in elections around the globe, it’s leading to ongoing uncertainty in capital markets – even while there is a stabilizing, albeit delayed, interest rate environment in the US. The equity markets in the US continue to climb higher. However, cracks are starting to be seen in portfolios. Consumers are stretched, and some business leaders believe we are already in a downturn with a weak Chinese economy and little to no middle market M&A activity in 2024.
Although there are ongoing predictions that the overall US corporate and private equity M&A deal volumes will see double-digit growth in 2024 (according to EY), this positive M&A outlook for corporate deals and PE activity in 2024 is not reflected in the middle market reality we are witnessing on the ground over the last six months, both the deal value and volume for middle-market public and private companies have backed off from the initial indications of recovery at the end of 2023. Values and volumes decreased by 20% and 7%, respectively, compared to the previous quarter, and fell by 13% and 12%, respectively, compared to Q1 2023 (according to Greenwich Capital Group). Ongoing uncertainty in the timing and depth of interest rate cuts combined with question marks over the strength of the economic recovery undoubtedly lies at the heart of this drop in middle market M&A activity even as the middle market posts strong results across industries and is thriving as the beating heart of the US economy.
The list of insights and takeaways goes on and on, a heady mix of confidence and cautiousness. Middle market leaders are currently evenly split between optimism, uncertainty, and pessimism about what lies ahead for the economy, their bottom lines, and their access to credit. No doubt, all of them crave some stability and foresight.
Luckily, Paladin is defined by its team of experts, who understand the need to think big and act fast. They are plugged into the middle market ecosystem at every level, so we are ready for whatever comes.
The M&A space firmly reflects a new focus on integration and refinancing – a commitment by companies to sorting out what they currently have rather than adding new business lines.
In fact, during Q1 2024, refinancing volume in the US BSL (Big Syndicated Loan) market was twice that of M&A-related loan volume to PE-backed issuers. Historically, the reverse has been true, with sponsor-backed M&A volume exceeding refinance volume by a factor of 4-to-1.
Amidst these uncertain times and trends, the US middle market might be set to take center stage this year, at least when it comes to refinancing and restructuring. Paladin operates at the heart of this dynamic sector, and a few important indicators hint at what lies ahead in the short to medium term.
Deal execution and restructuring tactics have never been more central to success. In a world where credit is more expensive, dealmakers and consultants must create more value to deliver the same return as before. Many are focusing on improving operational efficiencies and productivity. This is all very much in the Paladin wheelhouse.
One source claimed that $790 billion of corporate debt is set to mature in 2024, with $1.07 trillion of debt set to mature in 2025. Many companies have limited options to refinance due to the higher financing expense resulting from the Fed’s aggressive (and ultimately successful) interest rate hikes to bring inflation under control over the last two years. For middle-market companies with limited financing options and lower liquidity cushions, the refinancing challenge is compounded and central to their futures.
However, the impending ‘maturity wall’ of leveraged loans and high-yield bonds due for repayment within the next three to five years is also counterbalanced by record levels of private equity ‘dry powder’ (almost US$4tn ready to commit according to some estimates). Although the Fed has indicated its intention to move to lower rates, and we believe there will be cuts in the second half of 2024, for now, the sustained higher interest and economic backdrop could put pressure on some borrowers, so careful due diligence, deal structuring and underwriting will be increasingly important.
One major trend that has impacted the middle market has been the decline in bank lending in response to tighter regulations (and a general trend of migration of public, syndicated markets towards larger borrowers). Our sector has, therefore, benefited from private lenders taking an increasing share of loan issuance, with the private debt market rising from $272 billion in 2007 to $1.6 trillion in 2023 (and is projected to exceed $3.5 trillion by 2028). The primary focus in the short term for these lenders will be tailoring new private credit products to fit both investor and lender needs, as the middle market relies more and more on private credit for borrowing needs. However, all signs seem to point towards lenders seeking to grow portfolios, not just protect portfolios, even in challenging credit pricing conditions.
In March, Fitch reported that interest Paid-in-Kind (PIK) is likely to rise among private middle market loans in the US through both amendments to existing loans and as an optionality in new loan originations as the impact of higher rates fully kicks in and the credit burden builds up among borrowers. More middle market firms may find themselves with insufficient interest coverage as high rates persist against a challenging economic landscape, pressuring liquidity and potentially leading to higher loan amendments, which often incorporate full or partial PIK interest for a set period.
In another data set, commercial Chapter 11 filings rose 72% in 2023 to 6,569, up from 3,819 in 2022 (representing a 13-year peak in US corporate bankruptcy filings). Most of these 2023 filings were indeed middle-market companies that had no choice but to seek bankruptcy protection. And in 2024, we are seeing a steady and consistent number of Chapter 11 filings, again dominated by middle-market companies.
All in all, crucial to driving value creation in 2024 (and beyond) will be not only a need for speed but also a focus on talent, the willingness to be bold, and the right network of contacts in private credit and equity. Smart refinancing is the order of the day, and it’s time to get creative.
Luckily, Paladin is defined by its team of experts, who understand the need to think big and act fast. They are plugged into the middle market ecosystem at every level, so we are ready for whatever comes.
