How Do Recessions Change the Way Lenders Lend

Posted on: July 7th, 2022

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The economy is in tough shape, with inflation rampant and economic confidence plunging. These environmental forces have a profound impact on how mezzanine debt lenders and senior lenders behave. Senior lenders, such as banks and asset-based lenders are more focused on the quality of the underlying asset collateral and how it holds it value.

Even though the company may underperform from a profit standpoint, the collateral value which the senior loan is based upon, may not be affected. The most common impairments to asset value are when customers go out of business or inventory gets stale in the warehouse. This will certainly unfold in the upcoming recession, but it takes a while for these trends to play out. Senior lenders usually only advance a percentage of the asset value to begin with so they have a margin of error, should they ever need to foreclose on the assets to collect on their senior loan.

Most senior lenders have special knowledge of the industries they lend to, which allows them to have their finger on the pulse and act accordingly. Senior debt lenders become more selective in a recession and focus their capital on industries they think will be insulated from the downturn. They charge higher pricing and are quicker to exit a deal in a recession. Mezzanine debt lenders feel the effect of a recession more suddenly and acutely than senior debt lenders do. If orders slow, they will see an immediately revenue and profit decrease. If costs increase, they may be unable to pass through the entire increase and lose margin. As cash flow lenders, mezzanine debt lenders are exposed to all factors in a recession -slowing demand, increased purchase and labor costs, and supply chain constraints.

In recessionary times, mezzanine debt lenders focus on markets minimally affected such as counter-cyclical and non-cyclical segment such as healthcare, critical business services, critical technology services and food companies. They tend to stay away from consumer products, retail, and any discretionary spending related companies. In a recession, mezzanine debt lenders are focused on steady eddie businesses that have strong market shares. They focus on straightforward acquisitions and less on complicated takeover or roll-up transactions. Mezzanine debt lenders are set up to work with their companies through tough times. They are adept at repositioning the business and preparing for an exit during the next industry upturn.

In the acquisition financing arena, capital availability is destiny as companies require reliable access to capital to grow over the long term. Unforeseen capital needs usually arise when acquirers least expect it. This can cause some concern for the acquisition financing provider, especially when covenants tighten up and that working capital availability is utilized faster than expected.

Mezzanine debt borrowing is usually a straightforward activity that many companies use for funding of transitional growth. Mezzanine debt lenders are highly transparent about their due diligence approach and their post-closing loan management making it easy for companies to engage with.

Elections have consequences and positive ones at that for the acquisition financing middle market. While much media attention is paid to the direction of the yield curve and the Fed’s likely rate cuts, scant attention is paid to the more important drivers of the acquisition financing market – business psychology and regulatory climate.