The State of Lower-Middle Market Credit: Two Major Bank Failures, Rising Interest Rates, and a Looming Recession

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To say that it’s been an active 6-18 months in the banking sector would be an understatement: Beginning as recently as January, 2022, we’ve seen the US Federal Funds rate increase from .08% to 4.83%, which, at least in part, precipitated the rapid collapse of Silicon Valley Bank, and the rescue of First Republic Bank by JPMorgan (the latter representing the second largest bank failure in the history of the United States).

Against this backdrop, CEOs and prospective acquirors of small businesses understandably have a lot of questions about their banking partners, their ability to secure loans, and the terms under which they may be able to do so.

To get us up to speed on the state of lower-middle-market credit in North America, I’m joined today by Anthony Rodriguez and Conor Tidgewell of Avidbank, who walk us through what has changed, the “new normal”, and what it all means for entrepreneurs and CEOs running (or seeking to acquire) a small business.

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The SMB Credit Markets: Bank Failures, Rising Interest Rates, and a Looming Recession In The Trenches

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Questions Asked

  • Can you take us behind the closed doors of a bank over the past two months or so, particularly after the collapse of SVB?

  • How do banks manage interest rate risk in a rapidly rising rate environment?

  • The SVB collapse was attributed to them borrowing in the short-term but lending across the long-term: But isn’t that the business model of every bank?

  • Are you expecting to see any further fallout within the banking sector over the coming six months or so? If so, what might be the “next shoe to drop”?

  • If somebody listening to this is worried about their current banking partner, what steps do you recommend they take?

  • Some SMBs are spreading their liquidity across several accounts within several different financial institutions. Does this represent prudence or paranoia?

  • How have the past two months changed your view of lending to SMBs? Is it different? Is it the same? Why?

  • Has the importance of hard assets as collateral increased over the past 2 months? Do lenders have an equal appetite for cash flow or MRR loans relative to 2 months ago?

  • What types of metrics, analyses, or model cases is your credit committee requiring of prospective borrowers that they may not have required a few months ago?

  • Should borrowers be prepared to underwrite their deals with more equity than they otherwise would have underwritten them 2 months ago? Why or why not?

  • In 2020 + 2021, banks would often offer 5-year terms and 8-10 year amortization periods. Are banks still willing to offer similar amortization schedules?

  • How about the dollar amount of EBITDA of the target company? Are $1M EBITDA companies as likely to get funded as $3M companies, all else being equal?

  • What is your view on the inclusion of seller notes? Has that view changed over the past couple of months?

  • Should prospective borrowers expect term sheets to be pulled or renegotiated that might have been initially negotiated a few months ago?

  • What impact have the past few weeks had on the covenants that you attach to any given loan, if any?

  • How should borrowers think about the merits of fixed rate vs. floating rate debt? If you were borrowing to finance the purchase of an SMB, which option would you choose?

  • If a borrower partners with a mezzanine lender (and not a bank), what are some of the major risks and considerations that they should be sure to think through?

  • How should searchers think about their lending partner asking for equity? Does it mean that they really liked the deal so they want extra participation, or does it mean that they view the deal as so risky that they need commensurate upside?

  • Many borrowers are worried about either a covenant breach or an outright default. What actually happens in both scenarios?

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