Credit Solutions for the

Middle Market


A Roaring Twenty-One

2021 1st Quarter Report

Observable Credit Markets

Markets followed an extraordinary end to 2020 with another strong quarter to kick off 2021. Broader headlines introduced investors to the likes of Dogecoin, but frothiness likewise extended into private credit and direct lending. January saw a lull in new issuance, providing lenders a brief respite after the year-end closing rush. However, the pause was short-lived and attributable to the pipeline reloading. M&A activity led the way for sponsor-backed deals. Meanwhile, recapitalization and refinancing deals represented a combined ~45% of deal volume, demonstrating that the borrower-friendly environment has extended beyond terms into use of proceeds. Credit funds are fighting off a wave of repayment activity, particularly on the upper end of the middle market, where syndicated loan and SPACs provide attractive alternatives. As such, some funds have waded into the lower middle market and are transacting closer to or below historical minimum loan size. All told, the market remains in borrowers’ favor, with limited signs of pushback from eager investors.

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Fierce competition for deals has driven recent pricing to lowest levels in the post-Recession era. With almost no yield left to sacrifice, upfront fees have been compressed.

M&A activity, related to both LBO and add-ons, continues to power debt issuance. Meanwhile, sponsors are pursuing elective transactions to take advantage of receptive markets.

Leverage is remaining steady at levels similar to 2020. Lenders are showing a willingness to stretch in order to deploy capital.

Although average purchase multiples exceed 11-12x, leverage has not followed suit, resulting in sponsors and borrowers funding a greater portion of acquisition price.

New Lease Accounting Rules: How Are Companies Adapting?

Non-traditional, non-regulated lenders, that are not subject to direct scrutiny from the Fed and OCC may be willing to eliminate operating leases from the calculation of debt to avoid the perception of high leverage.

Configure Private Credit Metrics

The following information is based on Configure’s proprietary dataset, compiled based on lending conditions in the middle-market. EBITDA for borrowers ranged from less than $10 million to greater than $50 million, with an emphasis on transactions executed by operationally-focused sponsors.

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Recent clearing leverage exceeds pre-COVID levels, which is primarily attributable to LBO deals. Lenders are demonstrating less willingness to stretch to 4.0x for dividend recapitalization transactions.

Pricing continues to tighten, particularly for more sizable deals where the market is deepest and lenders can deploy significant capital.

Borrowers are demanding 1% amortization and 50% excess cash flow recapture and lenders seem accomodating as they face loan roll-off and repayments.

Required equity contribution for LBO transactions has held steady even as purchase price multiples have expanded.

New Lease Accounting Rules: How Are Companies Adapting?

Kim MacLeod is a Partner with Hunton Andrews Kurth and is based in Richmond, VA. Kim’s practice focuses on the representation of corporate borrowers in both cash-flow and asset-based financings. She joined us recently to discuss implications of the new lease accounting rules.

Configure: How prevalent is this issue in your practice and what do you expect to see in the near future?

Kim: People have been talking about changes to the lease accounting rules for a number of years. It’s been an issue that we have addressed with clients for a while and most of them have a provision in their credit agreement that freezes GAAP treatment of operating leases over the term of the agreement.

Configure: Is this change currently impacting just new public company borrowers?

Kim:  It depends on where you are in the life-cycle of your financing, but both public and private companies should be focusing on it.  It is obviously an issue for all new credit facilities but is also being addressed in amendments for existing financings.

Configure:  Where it’s already been implemented on public deals, how are borrowers and lenders dealing with it?

Kim: Some companies are still opting for the frozen GAAP concept. They don’t want to show higher leverage numbers and prefer to treat operating leases as off-balance sheet obligations.   Other companies are classifying operating leases as debt and ensuring their financial covenant levels reflect the change

Configure:  So, you are still seeing public company borrowers and their lenders utilizing the frozen GAAP concept even after this change has been implemented?

Kim: Yes, particularly in amendment deals where if it’s effectively a new deal but it’s still characterized as an amendment and restatement.

Configure: Are leverage levels going to go up as operating leases are incorporated into debt?

Kim:  Some of it will depend on the lender. Non-traditional, non-regulated lenders, that are not subject to direct scrutiny from the Fed and OCC may be willing to eliminate operating leases from the calculation of debt to avoid the perception of high leverage.

Configure:  What do you think will be the long-term solution here? Or is it too soon to tell?

Kim:  I think all companies will eventually adopt the change to be in compliance with GAAP and financial covenants will be adjusted accordingly to reflect the revision.

Configure:  With this change, do you think that EBITDA will continue to be the key governing metric, or will some other metric supplant it?

Kim:  I’m not aware of any whisperings of a move tied to changes in GAAP. For all the debate about what EBITDA really measures and how to use it contractually, it still seems to be the preferred metric. However, a lease-heavy company – think restaurant or retail – may prefer a different metric such as EBITDAR.

Configure: Do you think companies will utilize more short-term leases since operating leases under 12 months are not required to be classified as debt?

Kim: No, I don’t think so.  I think the mental gymnastics will go into how the change is incorporated into reporting and financial covenants vs changing the maturities of operating leases.