Credit Solutions for the
Middle Market
2 0 2 3 1 ST Q U A R T E R R E P O R T
For Whom the Bank Tolls
Observable Credit Markets
In our year-end wrap up, Configure prognosticated that another bankruptcy in 2023 would top FTX as the most impactful collapse. Only 69 days into the year, the FDIC placed Silicon Valley Bank into receivership in what was (then) the second largest bank failure in U.S. history. To this point contagion has been prevented, but the impact is being felt.
Pro rata bank market activity remained low in Q1 as conservatism amidst economic uncertainty abounds. While the bank-led ABL market is still relatively healthy (albeit showing signs of pull-back), the cash flow market is not. The downfall of Silicon Valley Bank and subsequent pressure on regional banks exacerbated this trend, spurring a renewed focus on fortifying bank balance sheets.
M&A activity remains significantly depressed relative to historic levels. What activity does exist is dominated by founder / family businesses, and few sponsors are bringing businesses to market. The trend is partially attributable to depressed valuations, but another factor is a lack of debt capital availability, whether perceived or tangible. Anecdotally in the broader market, numerous transactions have been delayed or pulled as a result of unpredictable or unsuccessful financing.
With the backdrop of limited to no redemptions and a challenging fundraising environment, some private credit funds essentially ran out of dry powder. Some lenders have created liquidity by selling down participations in existing positions, while others have sidelined new investments until additional LP commitments or CLO transactions close. The details of where / how / if these transactions clear will be important to debt capital availability over the next several quarters.
Lastly, a notable development was the volume of GP-led continuation transactions. Historically, lenders have typically agreed to roll the existing credit facility in support of continuation transactions. That accommodation seems to have stalled in the most recent quarter, as lenders seek to reprice risk and reduce hold sizes. At the same time, GP-led continuation vehicles often seek to increase the size of the debt capital commitment in connection with the continuation transaction in order to reduce the necessary LP equity commitments. The result has been some level of incremental debt capital necessary to successfully complete the continuation transaction. As a result of the capital deficiency, successful close rate on these transactions has fallen from a historical level closer to 75% down to ~40%.
Leverage declined to 3.7x, the lowest level since the GFC, as lenders retreated from new activity, particularly in the lower middle market.
While standout credits and / or deals in the upper middle market can still achieve 4x+ leverage, 3x leverage or lower is becoming more common.
After widening in 2022, spreads reversed in certain parts of the market to levels more consistent with ~5 year average. Meanwhile, upfront fees remain elevated.
New issue volume has not recovered from a sluggish pace first felt in Q4’2022, and lenders are largely unwilling to allow Sponsors to return capital.
Loan default rates increased during Q1 as the effects of economic stress were felt and borrowers struggled to cover fixed charges due to higher debt costs.
Most Favored Nation Clauses – Q&A with Massumi + Consoli LLP
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.
Spreads increased during the quarter, continuing a trend felt during late 2022. All in, spreads are ~100 bps higher than their lows in late 2021.
Leverage remained low during the quarter, reflecting continued lender conservatism amidst economic uncertainty.
In a muted M&A market with depressed valuations, there are an outsized amount of recap / refinancing transactions in 2023.
Minimum liquidity and maximum capex covenants are becoming much more common as lenders heighten focus on liquidity.
Configure has noticed a decrease in term sheets received per lender contacted, reflecting continued lender conservatism.
Most Favored Nation Clauses
— Q&A with Massumi + Consoli LLP
Massumi + Consoli, founded in 2015 as a spin-out from the Private Equity and M&A group of Kirkland & Ellis, delivers market-leading counsel to private funds and other financial institutions, along with their portfolio companies, and other acquisitive private and public companies, on complex private equity, M&A and debt financing transactions and on ongoing corporate matters outside of the transactional context.
1. Configure: How common is the inclusion of a DDTL in recent deals? How does that compare to 2020 – 2022?
M + C: While there has been a decrease in the number of lenders willing or able to provide DDTLs (beginning in the second half of 2022), we are still seeing new platform deals with a DDTL more often than not. Looking ahead, we’d expect to see the rate of DDTL inclusion remain consistent. Even in a higher interest rate environment and temporarily lower M&A activity, having committed financing available for tuck-in acquisitions in exchange for a modest ticking fee remains a very attractive feature for private equity sponsors. However, if we reach a point where a decreasing interest rate environment becomes more likely, or with respect to platform acquisitions that are not premised on near-term add-on acquisitions, then a DDTL would be less attractive.
2. Configure: Currently, what is the greatest disconnect between borrowers and lenders with respect to MFN?
M + C: Historically, MFN negotiations have focused primarily on the existence and length of any sunset, the scope of the MFN (i.e., to what types of incremental debt would an MFN apply and under what circumstances) and the amount of the MFN. We don’t see that changing.
3. Configure: What term or provision has recently shifted most in favor of the lender?
M + C: Probably MFN sunsets—both whether the MFN sunsets at all, and if so, the length of the sunset. Other MFN terms are being driven more by precedent and/or where the borrower and particular facility are situated in the overall market.
4. Configure: Senior / Junior structures are increasingly common given relative pricing of mezzanine capital. What hurdles are you facing with regards to MFN in these deals?
M + C: We haven’t seen any MFN-related hurdles in true senior / junior structures; the differences between the tranches seem to still be respected when it comes to MFN terms. That said, the use of increasingly creative multi-tranche structures in acquisition facilities could lead to novel issues regarding MFNs. For example, if a borrower were to obtain pari term loan A and term loan B facilities from different lenders groups, you could conceive of a situation in which a term loan A lender would try to get at least some MFN protection if the borrower obtained incremental term loan B debt. However, any incremental term loan B debt wouldn’t affect the trading market for the term loan A, so it’s hard to say how much weight the term loan A lender’s argument would carry. Additionally, in the top regions of the market, MFN protection is often only applicable to “qualifying” term loans, which usually only applies to syndicated term loans (which in turn exempts customary bridge loans and term A loans).
5. Configure: Have any of your clients faced a situation whereby the existing lender couldn’t fund additional capital within the MFN window? How was it dealt with?
M + C: We actually haven’t seen this particular problem arise. For example, in one recent deal the incumbent bank lender in a platform facility was providing a fairly sizeable incremental to fund an add-on acquisition. The pricing for the incremental triggered the MFN, which the borrower accepted. There wasn’t a major effort to find a workaround or look for alternative capital that might’ve been inside the MFN. While this is just one data point, it’s illustrative of the acceptance of the current environment by at least some existing platform borrowers. In another example, a portfolio company needed incremental debt to fund an acquisition and the lead left lender was tapped out. The remaining lenders in the club stepped up and provided the debt at an agreed level of economics that did not impact the all-in yield for the debt.
6. Configure: Do you normally see MFN pricing applicable over life of facility or only for first 18-24 months?
M + C: We see a range of terms for MFN sunsets, ranging from no sunset at all (i.e., MFN for life) to as short as six months. This is a highly negotiated point.
7. Configure: To avoid repricing the entire facility, what workaround are lenders most receptive to?
M + C: Every situation is different, so it’s important for parties to consider the full array of options – obtaining new junior or unsecured debt, obtaining a sidecar facility, structuring financing as preferred equity, a 144A-for-life bond offering, fixed interest rates, using baskets not subject to an MFN (including using reclassification provisions to free up basket capacity), and structuring increased interest as a fee are some of the more common approaches. That said, structuring new debt as junior secured (including 1.5 lien) or unsecured debt is often appealing to incumbent lenders. We’ve also had success in structuring an incoming lender’s return as a fee outside the scope of the all-in yield, such that it does not trigger the MFN.
8. Configure: In a senior / junior deal, does junior debt get benefit of any senior MFN pricing (e.g. maintaining closing pricing differential)?
M + C: This is not something we have seen. To the extent it came up, we’d resist such an arrangement. Among other things, it doesn’t address the two concerns that an MFN is meant to solve, namely, adverse effects on the trading market for existing debt and perceived unfair treatment of existing lenders who hold otherwise similar debt.