Why Credit Standards Matter (Third of a Series)

In the previous two issues of our special series on the state of credit standards in the leveraged lending market, we took a deep dive on covenant trends. This week we take a step back and look at the overall picture of middle market credit fundamentals.

So much of leveraged lending is tied to the fortunes of the private equity sponsors we support. That’s why it’s easy to forget the goal of debt providers differs from that of equity investors in at least one aspect. When PE firms succeed for themselves and their LPs, they stand to gain significant upside by not only recapturing their original investment, but multiples of that investment as well.

Lenders, on the other hand, don’t benefit from outstanding borrower performance. If the company just squeaks by and still pays the loan in full, fine. That’s why experienced managers underwrite to a base case, rather than on an ethereal management case showing hockey stick growth.

But lenders and PE are aligned when examining certain deal elements that point to both debt and equity success or failure. Here are a few:

Barriers to Entry – If your borrower has a dominant market position with high margins, competitors know it. What’s preventing a larger company getting into the market, or an existing