It’s clear that the world of middle-market lending is in a state of distress. The CLO market doesn’t seem ready to return as a source of capital for lenders — and therefore companies and buyouts — anytime soon. What’s a lender to do?
Some players suspect the business model will have to change. Take, for example, Churchill Financial. The middle market lender has remained largely on the sidelines since February of this year, when it laid off several members of its origination team, and several others left voluntarily. Casey Zmijeski turned up at Fifth Street Finance; Timothy Clifford and Sean McKeever started the leveraged lending arm of Amalgamated Bank, called Amalgamated Capital. Churchill’s competitors NewStar Financial, Orix Corporation, National City Madison Capital followed suit with headcount reductions. Freeport Financial laid off almost its entire staff as it liquidates assets.
Like several of its peers, Churchill has been “stuck in neutral” as an asset manager with little to no new deal activity. But that doesn’t mean it has no capital to deploy. The firm, which is 70% owned by Irving Place Capital, has a $1.25 billion 12-year facility raised in July 2007. Of the $1.25 billion, $200 million is fully committed and undrawn, in addition to the firm’s $100 million in cash. The firm also has a fully committed eight-year junior debt facility from Fortress Investment Group that matures in 2014.
The firm made the conscious decision to stray from annually renewable credit lines. Churchill would only look to extend its Fortress facility with an amendment if it were to bring in a significant amount of equity, according to a source close to the situation. However, Churchill is “under no pressure” to do anything at the moment, the source said. The firm has received and passed on takeover offers, the source said.
But Churchill is ready to get back into deal-doing and “growth” mode, looking to take advantage of attractive pricing, which is typically L+550-650, 2-2.5x senior leverage, LIBOR floors of 200-400 percent and 2 points upfront fees today. The firm will eventually need more capital to do so. Churchill will likely come to market with a middle market loan fund in the first quarter of 2010, the source said. To justify the need for a fund, demand and new issuance volume will need to increase. With pricing for secondary loans firming up, new issuances may become attractive to buyers of leveraged loans again.
Before that happens, the commercial finance industry may need to reevaluate its current business model. Players in the market basically have four options:
1. Existing commercial finance model, which has proven to be impaired.
2. Become a bank holding company, which firms like CapitalSource did. The issue with that model is that the FDIC has strict rules about small banks making leveraged loans, which is why some deals, such as Newstar Financial’s deal to buy Southern Commerce, were scrapped.
3. Retreat into asset management mode, meaning the lender manages its existing funds and exist on slower-growth, fee-based businesses with the hope of raising new funds in the future.
4. Become a BDC (business development corporation). The largest BDCs like Allied Capital and American Capital have struggled with their short-term credit facilities but a number of the smaller players like Ares Capital and Apollo Investment Corp. have managed to hang on. “If the BDCs survive mark-to-market, delever and have a pool of assets that post a dividend, they could start to raise new capital,” the source said. One firm has already found this option to be attractive-THL Partners is raising $300 million for a blind pool credit IPO.
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