How do you define the middle market and how significant is it to the U.S. economy?

Jim Hudak: The way we define the middle market are the companies, mostly private, that have EBITDA of $50 million or less. The vast majority of the jobs in this country are created by these sized entities (over 100,000 companies). Our sweet spot is $15 million to $50 million of EBITDA.

Pete Connolly: You hear and see the headlines about the big Fortune 500 companies, but when we look at job creation in this country, at all of the economic indicators, real job growth is happening in the middle market companies we finance. A lot of the companies we do business with you may not have heard of, but they’re really the ones that are driving all the economic metrics.

What lessons has the sector learned from the Great Recession?

Connolly: One of the biggest changes structurally is that more equity is being required in transactions. When things got crazy and you looked at a company’s capital structure, some deals were getting done with as little as 20% equity and 80% debt financing.

So if you hit a bump in the road, there is very little financial flexibility. The deals that we’re looking at now have much more equity in the transaction, so it’s providing a lot more cushion.

Hudak: There were many companies that were financed that might have had a couple of good years but weren’t necessarily the leader in their industry—so there’s a lot more due diligence around competitive positioning.

I feel much better about downside analysis now. We’ve seen a pretty good measure of what downside analysis looks like having gone through the cycle we just did.

How have credit standards and lending practices changed since the Great Recession?

Connolly: Lenders are requiring tighter covenants, lower leverage, and more upfront equity. Lenders are also more selective when deciding what industries they will finance as they determine how to allocate capital. Lately, we have seen some pricing compression and seen leverage creep up, but that was expected as the levels from a year ago were not sustainable; they were at historically conservative levels.

Hudak: The companies that are getting deals done now, they’ve lived through the cycle. They have the best business models, and they are among the best-run companies—so in our case we look at the management of the company or a combination of management of the company and the financial sponsor. We are definitely applying a higher standard to this sponsorship. We are also spending more time stress-testing the financial and business models.

Have you seen other lenders exit or enter the market?

Connolly: We did see a lot of regional banks try to get into the middle market, and some of the Canadian banks as well. When the market got really hot back in 2006, 2007, some of the really large banks came down into middle market cash flow lending as well, but their focus has primarily shifted back to larger companies. They have not been active in the middle market since the downturn, but there are expectations they may re-enter the market again.

Not surprisingly, there were a few start-up middle market lenders that didn’t survive. A handful of them started up and got financing. That was reduced as the value of the underlying loans dropped, forcing them to sell off assets to pay down the financing. So they didn’t survive, sold off their assets and closed down the shop. The middle market is our sweet spot and has been for more than 100 years.

Hudak: We’ve seen a couple of new funds come online that want to focus on middle market senior secured lending, which is good because that’s more investors for our market and we need additional liquidity to syndicate our transactions. There is still an attractive return in this market. I don’t think some of these debt funds are there to lead deals. They’re not set up that way; they don’t want all the embedded structure that you would need. But they’re there to maximize profitability. And from my standpoint, it provides liquidity for our deals and now we have another person to call to round out a deal.

What’s your sense of current loan demand overall?

Hudak: Very little of the activity this year, in terms of loan growth, has been driven by M&A events (under 15%). Most of the loan volume has been in the form of refinancings. There was a very active bond market last year that helped pay off senior loan facilities. This cash was returned to many of the institutional investors. This excess cash has been driving these refinancings in the broadly syndicated markets. The number of new deals in the middle market has lagged. With any good economic news, I sense that this will help push loan demand again.

What about those who say banks are still not lending?

Connolly: The primary factor for why banks weren’t lending was because the demand for credit had been greatly diminished over the last 12 months. And this goes back to consumer confidence. We’re willing to provide the credit; most banks are. It might be a little bit more difficult to get, but most companies, particularly middle market companies, have really been hoarding cash and paying off their debt facilities.

There’s opportunity. We’re doing deals and have momentum. We’re picking and choosing our spots. We did substantial business in the first quarter—our new committed loan volume for the first quarter was $817 million.

Where are middle market companies finding financing today and what are they using it for?

Hudak: We’re seeing companies seek financing for working capital purposes—hiring people, building inventories. They’re using it in some cases to make small strategic acquisitions, while also investing in capital expenditures, but this has been on a limited scale. We’re also seeing growth in the service-oriented businesses, for example, healthcare. Many deals done this year have allowed for divided recaps.

Connolly: Though the economy might be down, we see deal velocity. Many middle market companies are private, and many are family owned, so it doesn’t matter to them what the economy is doing. There might be a reason for them to do a deal because it’s succession planning or estate planning.

What are middle market companies focused on in 2011?

Connolly: Companies that have made it through the downturn have shifted focus from operating efficiencies (e.g., cost cutting) to top line growth. Also, even though we may not see much of top-line growth yet, there are a lot of companies that are in need of a refinancing. All of the deals that were done from 2006 to 2008 and made it through the recession are soon maturing, so there’s a huge refinancing cliff. You really have to start the refinancing talks at least a year in advance of that debt maturing.

Are deals being structured differently today than they were a few years ago? Has there been a shift away from cash flow deals to asset-based lending?

Hudak: I think what happened in 2005, 2006, 2007 is that there were a lot of companies that got financed on a cash flow basis that probably never should have been. We do asset-based lending and cash flow lending, and are putting more emphasis on assets. Asset-based lending is really a form of financing for companies that are credit challenged yet have very good liquid collateral. The company that has the better track record and a good market position may be able to do a cash flow deal.

The asset-based market has better collectability because you’re lending against its current assets, receivables, and inventory. But it comes at a lower spread.

Connolly: There are certain things that happened in the broader markets, like covenant-lite, that never trickled down into the middle market. In the middle market you need to have tighter, stricter covenants so that you’re at the table if there’s a hiccup.

As Jim said, we are also shifting our focus to more asset-based lending versus cash flow lending. Starting at the beginning of last year, banks did much more asset-based lending than they did cash flow lending. There was a lot of pressure to say that the spigots were back open and banks were lending. And that was one of the easiest places for banks to put the first dollars.

What is the private equity community’s role in the middle market? Has it impacted M&A activity?

Connolly: Financial sponsors are sitting on over $400 billion in capital right now, and they’re looking for the ways to deploy it. I think you’re going to wind up seeing more sponsor-to-sponsor deals, which could lead to an increase in M&A activity this year.

Much of the loan volume at the end of last year was people who anticipated changes in the tax rate, in the capital gains, which is driven by private equity. They’re trying to generate some type of return so they can go back to their fund, their limited partners in the fund, and say, “We’re generating a return on this company.” So they would do a deal and recapitalize the company a little bit, and pull out some type of dividend. Three years ago, you might do a deal and the whole purpose of doing it was paying out a dividend. Now, there are a lot of dividend deals, but it’s a little bit more rational—maybe it’s a $100 million financing and $20 million of that $100 million is going to pay a dividend.

“When we look at job creation in this country, at all of the economic indicators, real job growth is happening in the middle market companies we finance.”

“The middle market is our sweet spot and has been for more than 100 years.”

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CIT Executive Spotlights are periodic interviews with CIT executives offering insights into current trends in the industries CIT serves. See Additional CIT Executive Spotlights.

Members of the press who have an interest in speaking with Mssrs. Connolly or Hudak can contact Curt Ritter at curt.ritter@cit.com