Second Lien Debt Opportunities in the Lower Middle Market
Lower middle-market second lien debt fills a much needed capital void by providing a product that is subordinated to an ABL or senior cash flow loan and that is subject to an inter-creditor agreement and traditionally in the form of an amortizing loan with a term that ranges from 12 to 36 months. This lending product intersects where ABLs and senior cash-flow lenders fall short when it comes to providing additional availability and leverage multiples and where traditional mezzanine lenders either can’t deploy enough capital on a per deal basis or can’t get comfortable with a lower level EBITDA threshold.
The lower middle-market second lien market is still in the second inning of a proverbial double header given the inherent business risks, liquidity pressures and resources needed to serve this asset class. For clarity and differentiation, lower middle-market second lien debt is typically defined by companies generating less than $5 million in EBITDA. For good reason, this is not a market targeted or served by capital providers such as institutional second lien funds and the numerous BDCs and traditional SBIC mezzanine funds.
On average, these funds typically have at least $300 million in assets under management and much larger and longer term hold limits. Large capital bases and commensurate infrastructure preclude many firms from writing a sub-$5 million check, which is the key need when providing second lien capital to the lower middle market. We have a saying at Super G that anyone can have a big fund, but very few can manage a small fund and serve the needs of the many companies in this country that don’t need or are unable to obtain subordinated capital from larger funds.
The bar is high for companies looking for traditional mezzanine capital that typically matures in three-to-five years and on average needs to be able to support $5 million + of subordinated debt. This is compared to our target second lien borrower that generates less than $5 million in EBITDA and has subordinated capital needs less than $5 million. Companies can solve large capital needs due to market efficiencies, but there is a void when it comes to solving for smaller subordinated capital needs (less than $5 million). This capital is not meant to be long term nor is it meant to be competitive to traditional mezzanine, which is long-term capital and usually accompanied by a financial sponsor.
In order to succeed in the lower middle-market second lien arena, a lender must have a unique and flexible private capital base that in turn provides flexibility to solve for lower middle-market needs. This market strategy requires filling the void where senior lenders stop and institutional mezzanine starts. At Super G, we cover numerous industries and over the years have used experience and portfolio data to drive our lending strategy and criteria. Our lending criteria and strategy vary by industry with some industries such as niche manufacturing, which is asset heavy and working capital challenged compared to software, which is asset light, and getting better terms based on the recurring revenue nature.
The opportunity to provide second lien capital remains the same, but the challenges and risks vary by industry. The following paragraphs provide our views on completing second lien transactions in three distinct verticals – niche manufacturing, consumer products and software.
Niche manufacturing represents the cornerstone of the American workforce and is a vital part of the economy due to the fact that many essential industries such as aerospace, automotive and consumer durable goods have vast and desegregated supply chains with many being key suppliers. From helicopter parts to refrigerator door handles, niche manufacturing continues to comprise a valuable service to large industrial companies. We see tremendous opportunity in continuing to finance niche manufacturing, but many face severe working capital pressure as they have limited terms from their suppliers and are forced to sit on more inventory by their customers all of which constrains cash. There are thousands of niche manufacturers that generate less than $50 million and $5 million in revenue and EBITDA, respectively. These are strong businesses, but they lack sufficient liquidity to manage a longer working capital cycle than ever before. Partnering with ABLs and commercial banks to provide over-advances and subordinated working capital lines to provide additional working capital beyond a borrowing base is critical from our perspective. By structuring a cash-flow loan tailored around a working capital cycle, the niche manufacturer can properly finance its needs and ensure a payback that still meets fixed charge ratios.
Consumer goods, whether staples or luxury items, represent a significant portion of not only GDP, but trade finance given the supply chain (both domestic and international) necessary to meet the demands of American households. While there are oligopolies in each aisle of a supermarket (i.e. Coke and Pepsi), department stores and other channels, each consumer vertical market is large and ripe for constant innovation. On average, these companies are high gross margin sales and marketing companies that outsource all manufacturing, but still need to finance and hold inventory. Most senior lenders take a cautious and conservative view towards lending against inventory with many even opting not to. The combination of high growth consumer companies with large or seasonal inventory builds and lengthening cash cycles provides ample opportunity to provide second-lien capital.
Many of companies simply plan wrong and any meaningful change to inventory could trigger a borrowing base issue with inventory borrowing outpacing accounts receivable. Second lien capital enables clients to obtain additional capital to pay down payables and work through inventory over time to generate cash flow and hold margins constant rather than be forced to dump inventory at any cost to raise cash. Seasonality is also a tremendous source of deal flow. Super G has now financed ice cream in the winter and candles in the summer, which reflected the lowest working capital points that prompted a need for second lien capital as both companies were not able to obtain over-advances.
Collateral always comes in the form of a blanket second lien behind a senior lender, but often times there is good asset coverages with lenders lending low availability percentages against inventory and the underlying IP or trademark typically available. This especially comes into play once a consumer brand reaches at least $10 million in wholesale sales, which at a keystone margin implies $20 million in retail sales, and would provide enough scale for a potential acquirer to get interested. As with other industries mentioned, there is no shortage of senior debt capital providers as well as equity providers given the value associated with consumer brands.
Software — Specifically SaaS
SaaS companies create an interesting paradigm as there are no tangible accounts receivable as in the other industry verticals mentioned. However in return, there is recurring revenue, which can be valued based on the net churn of a company’s customer base. There is just as big a void in the SaaS sector as in niche manufacturing and many senior lenders focus on SaaS companies including venture debt firms, but there are very few second-lien players who will write a $1 million to $3 million check to the SaaS company that has yet to become eligible for subordinated venture debt. Lending to this sector presents challenges as many of these firms are breakeven-to-a-slight loss on purpose in order to re-invest all cash into sales and marketing. Second-lien capital provides a non-dilutive means to grow with the assumption that management would have to scale back sales and marketing and become profitable if projections are missed. Other criteria include major customer wins and proven product, but the key metric would be recurring revenue that is spread out over a non-concentrated client base as that MRR (monthly recurring revenue) can be valued and lent against. Super G has been successful lending to SaaS companies in a second lien position and recently created a new division just for SaaS and tech clients calledwww.saasfunding.com. This is a wholly owned division of Super G dedicated to tech entrepreneurs.
The lower middle-market second lien market is only going to expand over time as the multitude of small committed and independent sponsors try to institutionalize this market. These smaller equity providers will not be able to obtain traditional mezzanine capital for all deals and second lien debt should serve as a bridge to get deals done and enable a path to obtaining traditional mezzanine debt that is more patient. Small private equity funds are just a subset of the provider opportunity to work with owner-operated businesses that are not backed by private equity.
To date, 80% of our transactions have been completed with entrepreneurs and 20% with small private equity funds. Most companies in America are non-sponsor backed and generate less than $5 million in EBITDA. Both the market and the corresponding need are quite large. The need remains the same regardless of whether a company is owned by an entrepreneur or is private equity owned, as large funds cannot afford to write small checks to a riskier asset class. We anticipate the need for second lien capital to continue to grow and be more widely utilized as more banks consolidate independent ABL groups and traditional mezzanine firms continue to raise larger funds.