(Bloomberg) -- Red-hot competition in the booming $1 trillion private-credit market saw leverage levels soar in 2021, another sign of riskier lending as the fight to win business intensifies.
The number of U.S. mid-sized firms that took on debt equal to an average of seven times earnings or higher last year reached an all-time high, jumping 89% from 2020, according to investment bank Lincoln International. Higher leverage has been more prevalent in the tech sector for some time, but it's also creeping into others such as healthcare now, as lenders try to find an edge.
“For the longest period the leverage cap never saw anything above 7x. The increase is transformative for the private-credit market,” said Ron Kahn, a managing director at Chicago-based Lincoln, in an interview with Bloomberg.
One driver is the huge amounts of money pouring into direct-lending funds that's putting more pressure on lenders to deploy cash. That demand has swelled partly because private credit fared better during the pandemic than some people had predicted, and also because there's more desire for floating-rate debt in a rate-rising environment.
Private-credit lenders, of course, have typically provided loans to middle-market companies that might not have been able to borrow from banks in the first place, just because, say, they're growing and burning cash. Loans provided by Wall Street, and then syndicated to institutional investors, used to be deemed as problematic by regulators if leverage was around six times or higher -- drawing more scrutiny.
Even so, high leverage in direct lending was mostly reserved for technology companies that are sought after for two main reasons: They have a high-growth profile and much of their revenue is recurring. To that end, Lincoln saw a 62% increase in technology deals underwritten to recurring revenue last year, compared to the year prior.
Read more: PRIVATE CREDIT WRAP: Leverage Creeps Higher on Software Deals
The leverage creep across more sectors, however, reflects the recovery seen by many middle-market companies after a turbulent 2020. Enterprise values grew by 3.9% in the fourth quarter, driven by an average of 5.5% growth in revenue and 3.4% growth in Ebitda, according to Lincoln.
A surge in mergers and acquisitions activity in the fourth quarter has also led to pent-up demand from private-equity firms for loans. Higher purchase-price multiples -- which have risen to an average of 12 times a measure of earnings in 2021 from 10.4 times in 2019 -- has increased the need for more borrowing as well.
In another change from the early days of the pandemic, when lenders scaled back lending, they're now investing more heavily in individual deals -- a move that's causing some concern about concentration.
Average hold sizes, or the share of a loan that's split between a group of lenders, reached $119.8 million last year, a 62.3% increase on the $79.7 million average in 2020, according to Lincoln. Last year's average surpassed the pre-pandemic level of $97.8 million, where say a roughly $400 million loan was split four ways.
“By placing more capital into a single deal, it helps private credit firms to deploy capital. However, it is a little concerning because it is also a larger exposure to a single credit,” Kahn said.
Lincoln's findings are based on an analysis of 600 companies with less than $100 million in annual earnings.
©2022 Bloomberg L.P.
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