Where can the middle market find capital?

The 1980s was a fortuitous decade for middle-market companies. They were well-positioned, because they were big enough to take advantage of the rapidly growing international marketplace, but small enough to innovate and to move quickly to take maximum business advantage of emerging opportunities. And they had sufficient clout to attract and compensate personnel with first-class technical and managerial skills. Not a bad formula for success.

Even with the U.S. economy in recession., prospects for middl-emarket companies are not dim. Middle-market companies have historically been relatively successful at surviving even the worst of economic times. Although large companies recovered faster from the recessions of 1980 to 1982 and 1985 to 1986, mid-sized companies which I define as those with assets ranging from $25 million to $500 million-sliffered less and many were profitable throughout the slowdowns.

However, the business cycle is not necessarily the key success factor for those in the middle market. Success for these firms is equally influenced by regulatory, financial, and market factors. And, Unfortunately, in the 1990s these companies may be caught in the middle. That is, they are too large to be exempt from tighter environmental., financial, labor, and social policy regulations, yet too small to spread the cost of meeting these stricter rules across a diversified revenue base. The squeeze is likely to come in the form of higher operating costs. One notable example is benefit costs, particularly health care costs, which are estimated to have risen a surprising 7 percent in 1990. As mid-sized companies were among the primary recipients of the benefits of Reaganera deregulation, the reregulation anticipated in the 1990s is quite likely to have a disproportionately negative effect on these companies.

Closed doors, open windows

One of the biggest challenges to middle-market companies in today's environment is credit availability. Capital markets in the 1980s were quite open to middle-market companies, from bank financing, the junk-bond market, and private placements to a generally booming equity market. Yet negative developments in the financial markets in recent months now leave some mid-sized companies with limited financing options.

With tighter capital standards creating havoc in the weakened banking sector and with bank regulators more zealous in the light of the savings and loan crisis, many commercial banks have had no choice but to contract loan growth. Larger companies, which generally can tap the commercial paper market, have not felt the credit crunch that middle-market companies have, as quantified in recent surveys. Sadly, this development comes at a time of falling interest rates. What good do the declining rates do a middle-market CFO who can't find a bank willing to extend credit?

In addition to limited bank funding availability, it has been evident since late 1989 that the junk market is virtually closed to new issues. New junk-bond issues shrank to a relatively low $700 million in 1990, as compared with $7.9 billion in 1989. Even 1989's volume was way below the $30 billion or so issued per annum in the mid-1980s. Admittedly, these record junk volumes were more an outgrowth of the large HLTs, or highly leveraged transactions, that were a hallmark of the 1980s than they were of middle-market companies' ongoing financial needs. However, when the junk door closed on HLTs, it also closed as an outlet for many middle-market companies.

By contrast, the private placement market, long a standby of middle-market companies, may have had more money to lend in 1990 than there were takers, with its funding volume falling to only $70 billion, from 1989's $190 billion and 1988's $175 billion. However, with interest rates declining, the 1991 forward calendar for private placements has soared recently. The private market has in the past been a favorite of middle-market borrowers because it offers rapid execution, relatively low issuance costs, limited dissemination of confidential information, and the flexibility to fund different levels of any given credit's capital structure. The private market can be used to finance senior debt, subordinated debt, asset-backed structures, credit-enhanced financings, or even equity or quasi-equity.

The disadvantage of the private placement market usually mentioned by borrowers is, of course, the necessity for covenants. But traditional covenant restrictions have been liberalized to some degree over the past few years, particularly for stronger middle-market credits and shorter-term transactions with maturities of five to seven years or less. As a general rule, private placement covenants are much less demanding than a middle-market company's bank arrangements.

However, there may be a fly developing in the ointment for middle-market issuers in today's private market. The National Association of Insurance Commissioners, the self-regulatory organization of the private placement market that analyzes the credit of potential issuers, recently revised its ratings.

The NAIC's rating system governs the percentage of reserve an insurance company must put aside each year against a private placement investment. While the Association's new ratings do not modify reserve requirements for the highest-quality credits or increase the maximum required reserves, they do classify four additional intermediate levels of credit quality and accelerate the annual required additions to reserves for placements in these categories.

Since their announcement late last year, the new classifications appear to have, in general, made issues in the private market more expensive for middle-market issuers, who are of course more likely to fall within these intermediate rating categories. At the same time, the new rules have served to lower rates and increase the attractiveness of the private market to larger issuers of high-quality paper.

I believe, though, that whatever short-term negative impact the NAIC provisions may have on private market spreads for middle-market issuers as insurance companies initially adjust to the new rules, over the longer term, higher-yielding middle-market credits are unlikely to be crowded out of the private market. With the demise of the junk market and the declining interest in real estate lending, middle-market companies offer one of the few remaining vehicles for insurance companies and pension funds to tap higher-yielding investments - investments that provide the protection of financial covenants.

Another recent development that may have an impact on middle-market issuers in the private market is Rule 144A, which permits qualified institutional investors to trade in private placements. The rule's aim is to increase liquidity in the private market, thus over time making private yields more commensurate with those of public market transactions. But the ultimate impact of Rule 144A on private placement issuers is unclear as yet. To date, only a few large foreign issuers have taken advantage of the rule, As a result, an active secondary trading market has been slow to develop in such placements. And, until a strong trading market does develop in 144A paper, new issue yields are unlikely to be driven down. We have a bit of a chicken-and-egg problem here.

If it seems that I've ignored the public investment grade debt market, it's because only the largest, most conservatively capitalized middle-market companies with strong records have the BBB or better ratings necessary to tap this market. Fleming Companies, Inc., for example, has over the decade evolved into such a credit. (Randolph Devening, Fleming's CFO, talks about how Fleming's options have expanded on page 29. Frank Bissaillon, of La Quinta Motor Inns, discusses his firm's financing below.) But, even for credits of Fleming's ilk, the public debt market has in recent months become more name-selective and story-sensitive. Even within designated rating categories, investors are scrutinizing particular issuers' earnings, credit worthiness, and sensitivity to a recession in determining appropriate new issue spreads over treasuries.

The perception of greater risk from recession and falling profits continues to reinforce the stiffening of credit standards we first began to see last summer. Credit spreads have continued to widen even as interest rates have gone down. And investors are moving away from 20- and 30-year maturities to focus more on shorter-term, five- to 10-year, issuers. Even in the commercial paper market, we have seen a flight to quality, with much wider spreads on A2/P2 paper, as compared with A1/P1 paper, than has been the norm.

A friendly market?

The early 1990 equity market proved to be surprisingly friendly to middle-market companies, particularly in view of the depressed environment for IPOs and growth stocks that existed following the October 1987 stock market crash and continued through much of 1989. But the massive retirement of equity securities in 1988 and 1989, through LBOs, mergers, and corporate share repurchases, and the large disparity that emerged between undervalued emerging growth stocks and the broad market indices led to more receptive market conditions for smaller capitalization stocks in early to mid-1990. This receptiveness, however, was short-lived as expectations of an economic slowdown were first reflected in the decline in the Dow and S&P 500 during late July. And the Persian Gulf crisis in August brought about an even more abrupt and severe reevaluation of these stocks.

While the Dow Jones industrial Average finished 1990 clown only 4 percent, the NASDAQ, home of many middle-market companies, dropped 18 percent. Today, the market appears to be opening Lip again, but for the typical middle-market company, any comeback is still tentative, as investors await a clearer view of the state of the economy. The market at this point is obviously friendlier to issuers in less recession-sensitive industries, such as health care and environmental services.

The not-so-obvious alternatives

Over the past few years, with the increasing sophistication and globalization of world capital markets, a variety of new financing alternatives have opened up for mid-sized companies - like leasing, working with finance companies, using master limited partnerships, and asset-backed financing. One new financing technique in particular gained momentum in 1990 and could be increasingly important in the years ahead: the strategic partnership.

Strategic partnerships typically arise between a company and a major customer or supplier, or an international company in the same line of business. These ventures usually include a significant investment by one company in the other; strong antitakeover protection; and a research, production, or marketing agreement. Often, this agreement represents merely the formalization of an already existing business arrangement - for example, a supply contract.

The presence of such a business arrangement usually permits the investing company to offer an equity price above that which could be defended solely on the basis of investment economics. Such strategic ventures usually make the most sense, as compared with other funding options, when the value of the combination exceeds the sum of the two players' inputs. Under such circumstances, these partnerships can be a competitive source of financing in either good or bad markets as well as a source of business stability in economic downturns.

Two guidelines

So what are the two most basic guidelines of middle-market financing? The first is that middle-market companies, given their limited and selective access to most markets, Should in general raise funds whenever favorable terms are achievable, rather than waiting for a specific need for capital. In other words, "When the ducks quack, feed them," as the head of First Boston's equity desk is fond of saying.

Too often, middle-market companies identify promising business opportunities but then have trouble financing them, or at least doing so on acceptable terms. Having funding readily available can even create business opportunities, as intermediaries and third parties like investment bankers typically are more open to discussions with companies they know can follow through. Admittedly, this can be a difficult sell to a CEO or a board that is hesitant to do anything that will hurt short-term earnings, but such a short-term focus may ultimately act to the long-term disadvantage of a middle-market company.

Second, I believe middle-market firms shouldn't have as their chief goal financing at the lowest possible basis point or, alternatively, at the highest possible equity valuation. A mid-sized company needs investors with longer-term horizons who will be responsive as the company grows and changes. A group of well-informed and supportive long-term investors at a reasonable cost should be the top objective of middle-market companies.