Five Facts About Direct Lending to Middle-Market Buyouts

Abstract

Using a proprietary data set of private credit agreements, I document five facts about a previously unexplored segment of the US corporate debt market: nonbank direct lending to private equity (PE) middle-market buyouts. First, PE-backed middle-market firms have high cash flow, low liquidation value of tangible assets, and exhibit strong (weak) dependence of debt capacity to cash flow (liquidation value). Second, these features are stronger for those borrowing using direct loans despite their being smaller in size. Third, direct loans face markedly higher annual borrowing costs that are over 300 basis points higher than on comparable bank loans. Fourth, direct loans instead have a much more borrower-friendly covenant structure. Fifth, borrowers of direct loans find covenant violation costly, for it may constrain future borrowing. These findings suggest that small firms are not limited to asset-based bank debt and can rely heavily on cash flow-based debt. Further, direct lenders can provide more flexible solutions to PE sponsors in exchange for greater cash flow rights without compromising ex-post enforcement of contractual rights. Overall, this paper raises important questions for research in the growing literature on shadow banking.