It looks like the Federal Reserve achieved its goal: tamp down inflation by raising its benchmark interest rate without wrecking the U.S. economy. There’s still a chance a recession will happen, but the Fed has suggested that it’s done hiking rates and that it might even cut rates this year, to the delight of equity investors.
But while public companies have recovered much of what they lost (the S&P 500 is near its all-time high), private middle-market companies are still “in crisis facing collapsing margins, surging leverage, and deteriorating solvency” due to higher inflation and interest rates, according to a report by Marblegate Asset Management, a $2.6 billion asset manager focused on corporate restructuring and other special situations.
“We are what I would call sort of classic turnaround investors. We go in, we take over a company, we have to apply force to drive an outcome, [which could include] a reorganization of both the financial structure of the company as well as the operations of a company,” Andrew Milgram, managing partner and chief investment officer at Marblegate, told Institutional Investor.
Despite what the stock market seems to indicate, Milgram's 30-person firm has been observing a different economy, one that is no longer bolstered by post-Covid government stimulus and other boosters, such as the Fed’s Main Street Lending Program.
“We appear to be in this new world order. A lot of the traditional measures of economic health that people look at — stock market leverage, loan pricing, high-yield spread — those risk factors that investors and investment allocators look at as barometers of overall health in the economy? All were flashing green. But when we looked at companies, particularly those middle-market companies that we focus on, we saw persistent trouble that didn't fit with the narrative in the broader economy,” Milgram said.
There is no good data on the middle market as a whole, according to Milgram. Much of the information that investors and others rely on are correlations and inferences. “Overwhelmingly that insight is anecdotal, it is partial, it's incomplete,” he said.
So Milgram phoned his friend James Gellert, the CEO of RapidRatings, which provides companies supply chain risk analytics. RapidRatings anonymized some of its data on the financial health of companies and gave it to Marblegate to analyze. The investment firm then published its findings in a report titled, “Rip Tide: The New Era of Acute Financial and Operating Stress in the U.S. Middle Market.”
“As we looked at the data, it was actually far more compelling, and told a far more complete picture of the kind of difficult operating environment that middle-market companies face than we expected. It is plainly true in the data that the middle-market is suffering while the broader market, the companies that have access to the public markets are surviving [and] thriving,” Milgram said.
This is happening for a couple reasons. Small and midsize companies are more dependent on government stimulus money, which there is less of now. Meanwhile, bigger, publicly traded companies have pricing power; they can control what’s on the price sticker a customer sees and pressure their suppliers to maintain margins — and those suppliers are oftentimes middle-market companies.
Using RapidRatings data, Marblegate analyzed middle-market companies’ EBITDA, margins, and net profit after tax from 2019 through 2022 to understand how changes in the economy and in monetary policy have impacted them. It then compared that to the same data for Russell 3000 companies and the differences were stark.
The firm found that from 2019 through 2022 EBITDA declined over 20 percent at middle market companies while large public companies saw their EBITDA increase nearly 20 percent.
It got worse from there. Middle-market company EBITDA margins during the same period contracted by 25 percent while those of large public companies stayed roughly flat. Profitability measured by NPAT collapsed at middle market companies, declining by almost 80 percent while public companies saw their profitability grow over 30 percent.
Out of the middle-market companies analyzed, 5,800 do not typically make their financial performance data available to anyone other than their owners and their lenders, according to the report. Marblegate focused on the approximately 1,200 private companies that have sales revenues between $100 million and $750 million.
Even if the Fed begins cutting its rate sooner rather than later this year, the amortization of many loans is happening and companies in need of capital will have to get new loans with higher interest rates, which will weigh further on more middle-market firms. “It's plainly evident and you see it in the sort of bankruptcy filings going up dramatically in the middle market that there is very, very high demand for corporate reorganization skill capital,” Milgram said.
The opportunity for Marblegate and other investors in distressed companies is expanding and the firm doesn’t see that slowing down anytime soon.
“Like the powerful currents that precede landfall in a hurricane, dangerous forces can create an economic undertow — even though conditions may still seem idyllic and the storm a distant offshore threat. These insidious currents can combine with structural instability below the surface to create the economic equivalent of a rip tide,” Marblegate’s report says.
“For trained observers who recognize the danger signs, it’s just another day at the beach. Others, like an unsuspecting swimmer being pulled out to sea, may find themselves struggling to stay afloat in these dangerous waters.”
