A recent Reuters article citing demand for second lien loans to U.S. based middle-market companies has sparked a renewed interest in second lien debt. The article speaks mainly of public issuances of second lien debt starting at $100 million that are able to tap large scale institutional investors and forego structures such as unitranche in order to obtain more leverage.

While the article presents valid points about a relatively strong economy, lack of volatility and the institutional investor’s constant search for yield, it glosses over the disconnect between middle-market borrowers who benefit from scale and access to capital markets and lower middle-market borrowers who do not. What is left unsaid is that bank activity is more critical to the lower middle-market than public investment. When banks are aggressive there are more opportunities and activity, but when bank pull back there is a dearth of activity. Banking activity    drives the ebb and flow of second-lien lending in the middle market, whereas institutional demand drives the middle market.

Those of us who work in the lower middle market (defined here as companies that generate less than $200 million in revenue and $20 million in EBITDA) see little correlation between public-market issuers and companies that are sub-$200 million in revenue and can’t tap the public markets. Lower-middle market companies generally have fewer options, including a lack of access to public markets, and many inefficiencies exist, especially with companies that generate less than $20 million in EBITDA. Not having access to capital markets creates an inefficient market by definition and gives senior lenders, mostly banks, outsized leveraged to make and take the market.

Right now banks are “taking” the lower-middle market given the economy is in relatively good health and a new political administration is signaling a roll back in regulations. Banks are primed to continue to be aggressive, especially with rate hikes on the horizon. Increased assets mean higher revenues and strong returns to bank shareholders. However, this creates a dislodging of sorts between unitranche providers -- that provide a one-stop solution -- and second lien providers. Second lien providers should see more opportunities as aggressive senior leverage from banks makes the second lien solution cheaper on a blended basis and more flexible in terms of refinancing.

Second lien capital providers have a unique market opportunity for the foreseeable future. Right now, second lien providers are able to deploy capital that on a blended basis (and when combined with a bank) is cheaper than a unitranche structure. The limitation, however, is total leverage because right now banks and asset-based lending firms are in an all-out war to book new assets. The competition clearly stems from strong economic tailwinds and recovered capital bases, with a few exceptions from regional firms that over-allocated to cash flow lending. This senior-lender leverage appetite has created a clear market opportunity for experienced second lien lenders.

Firms such as Crystal Financial, Monroe Capital, TPG and Fortress, among others, are leading lower-middle market, second lien debt players. These firms are seeing an uptick in business as increased senior leverage from banks prices out unitranche providers. The advantage is higher total leverage and lower blended costs for strong borrowers. Pricing is very attractive for these firms. That’s because their target market seems to be approximately 500-basis points higher than true public middle-market, second lien issuers, with all-in pricing coming in between 9 percent and 12 percent. This trend will not last forever, but for right now the second lien is en vogue in the lower-middle market as it pertains to companies that generate at least $10 million in EBITDA.

To that end, there will always be a need for a unitranche solution, especially when it comes to companies with a lower EBITDA, since the lack of scale prices out many of the larger second lien players who can’t write a sub-$10 million check. Firms such as Deerpath, OFS, Medley and Treeline are market leading unitranche firms that have raised large funds to provide a one-stop shop to sponsor-backed companies that are still very active in the sub-$10 million EBITDA unitranche market. These firms will continue to be active given the total leverage they can provide, and the speed with which they can deliver it. These firms usually only provide capital to sponsor-backed companies given the total leverage employed, and they have proven to be formidable competition, especially when banks pull back.

The key dynamic typically shakes out as follows: bank plus second lien lender or unitranche, which is typically around 7%-to-10% all-in. For specificity, the second lien provider could take the form of traditional mezzanine lender, which is an interest-only structure with warrants or true term loan structure. Investment bankers also play a key role since they prefer unitranche providers for the ease and certainty of closing with one debt capital provider rather than two. This is not to be taken lightly because getting deals done in the lower-middle market is not easy even for quality companies.

These options are not a clear cut case of six steps forward, six steps back as there is a clear difference between pricing and structure. Unitranche should offer less total leverage and a higher blended price, but also an easier and more seamless transaction given that there is only one lender involved. Banks are clearly at the intersection between these two options. The more aggressive banks get in terms of taking market share creates havoc for unitranche firms and opportunities for second lien players. Conversely, bank pullbacks create a dynamic that is prime for unitranche firms that are backed by private capital.

What should also be mentioned is a new crop of firms such as Super G Capital have funds dedicated to primarily serving companies that are both sponsor- and non-sponsor backed and that generate less than $5 million in EBITDA with a focus on second lien debt. The pricing and structure of this second lien debt is fairly different than some of the aforementioned capital providers as the average term of those loans are typically from three-to-five years, whereas the average term of a Super G Capital loan is two-to-three years and is fully amortizing to manage risk. The check size is also much smaller with loan sizes averaging less than $3 million. There is an additional level of risk associated with financing companies that generate less than $5 million in EBITDA, and there is a reason that most large institutional firms do not do it.

First and most importantly, these firms could not deploy large amounts of capital when dealing with smaller companies that have smaller capital needs and risks. Management, liquidity, industry and customer risks are typically much bigger when dealing with sub-$5 million EBITDA companies. One lost customer can evaporate profits and instantly create an untenable situation. The same is true of unfavorable industry dynamics that create cyclicality that smaller companies can’t finance. These are just some of the risks that keep larger funds out of the sub-$5 million EBITDA market, as it makes it harder to deploy larger amounts of capital over a long period of time. This has created opportunities for firms, like Super G, that are able to provide smaller checks at higher rates, while using a flexible structure and shorter loan terms to position these companies to obtain institutional capital whether through true second lien or unitranche structures.

What is clear is that investors set the pricing when it comes to the middle market and create a relatively efficient market in stable times due to demand. Banks, on the other hand, are prone to cycles based on trying to build assets and generate an outsized return on equity while at the same time dealing with regulations. This dynamic creates market cycles when the tide turns and sets up a dynamic for a multitude of private lenders in the lower middle market.

Investors make and take the public market, while the opposite holds true in the lower middle market -- where banks make the market. This sets the stage for a natural market cycle, whether the times are good or bad. The better the economy the more banks make the market and take market share from second lien lenders due to their increased risk appetite. Banks make and take the lower middle market and right now they are taking and creating opportunities for second lien capital providers.