Credit Solutions for the
Middle Market
A Private Credit Close-Up in a
Socially Distant World
Observable Credit Markets
The coronavirus pandemic froze activity until a surge of government stimulus and rising confidence began to thaw middle-market issuance. Contrary to the pre-COVID supply/demand imbalance in favor of sponsors and borrowers, the crisis has turned the tables and is testing relationships between borrowers and lenders. Covenant holidays, delayed P&I payments, and short-term amendments were doled out like PPP loans; however, lenient portfolio management is not anticipated to be the new normal, and lenders are already returning to pre-COVID credit resolution mentalities. For those lenders with the capacity and liquidity to pursue new loans, yields ticked up, covenants tightened and leverage levels declined. Additionally, sponsors show a continued preference towards one-stop private credit alternatives vs syndicated processes, which can be much simpler in amendment and workout scenarios.
While spreads remain tight, Q2 saw a reintroduction of LIBOR floors as the benchmark rate reached the lowest level since 2015.
Although there were insufficient observations from publicly-available sources, new deals gradually emerged in Q2, including transactions either negotiated before or temporarily postponed, after COVID-19. Proprietary observations indicate debt-to-equity for LBOs closer to 50/50.
A turnaround in new credit issuance occurred around the start of May, led by a reduced subset of lenders with liquidity and a willingness to wade into new deals.
The Best Defense is a Good Offense
Configure Private Credit Metrics
In order to provide you with additional insight into current middle-market lending conditions, Configure reached out to our broad array of lender relationships. We asked our accounts several questions covering a range of pertinent topics. We are pleased to share this glimpse into lender perspectives.
How has COVID-19 impacted average leverage levels (as a turn of EBITDA) for new term sheets issued?
A plurality of lenders have reduced leverage by 0.5 turns of EBITDA or more compared to prior levels.
How has COVID-19 impacted average LIBOR spreads/pricing for new term sheets issued?
A majority of lenders have increased their average pricing levels by up to 100 bps.
How would you rate your institution’s consideration of new primary/direct lending for elective transactions (acquisitions, dividend recaps, etc) and non-elective transactions (liquidity-driven, rescue, etc.)?
Most lenders have signaled either increased or static interest in both discretionary and
non-elective transactions.
With respect to portfolio companies that are encountering challenges, is your institution implementing or considering any of the following?
A majority of lenders have granted temporary debt service relief to address borrower challenges, but remain steadfast in expecting equity solutions as well.
The Best Defense is a Good Offense
Private equity funds closed 2019 with record levels of dry powder. Only three months into 2020, the opportunity to deploy that capital all but vanished. Savvy sponsors are evaluating opportunities to “play offense” in this market.
Finance professionals love a good sports reference, and in the COVID-era, “the best defense is a good offense” is a maxim being applied to sponsors’ approach to their portfolio.
Banks and private credit funds alike widely provided covenant grace periods in the wake of COVID-19 shock and dislocation. Now, more than five months since the World Health Organization declared the outbreak a pandemic, lenders are signaling a return to more traditional credit behavior. Workout approach will depend on considerations such as industry outlook, liquidity, and sponsor support.
Many sponsors are not waiting for lenders to initiate difficult conversations about portfolio company balance sheets. Instead, they are developing an offensive mindset, becoming bold, and taking affirmative steps to create value in an uncertain environment. A few recent examples are summarized below:
Assignment of Debt at a Discount
Case study: a sponsor-owned regional restaurant chain experienced declining same-store sales before COVID shutdowns forced the temporary closure of all units. Faced with negligible revenue and an impending first-lien maturity, the Company required a transaction or series of transactions to address its capital structure challenges. Through a fulsome assessment and positioning of strategic alternatives, Configure assisted the Sponsor in negotiating a purchase of 100% of the first-lien debt at a significant discount. In addition to dramatically decreasing the Sponsor’s attachment point in the company, the Sponsor addressed the Company’s liquidity needs as well as renegotiated certain leases.
Add-On Acquisitions
Health and safety procedures, overhauled supply chains, cash management, and workforce rationalization measures are the new normal under COVID-19, which has forced organizational transformations. Many companies do not have the leadership, capital, or aptitude to successfully pivot on these fronts, making them prime acquisition targets. Sponsors have begun to search for companies in need of fresh equity support. The approach is different and often initiated with the target’s lenders, who prefer to engage with a familiar sponsor or one with investments in the sector instead of a “short sale” that locks in a less than par outcome. These transactions take the shape of a new money restructuring or a debt purchase under a “loan to own” strategy.
“Re-buy” the Business
Case study: the bank group for a Sponsor-owned food products manufacturer had become fatigued and was seeking an exit. The Sponsor remained confident in the business and its original thesis. Armed with the insight of market comparables, limited investor appetite as a result of COVID-19, and liquidation estimates, Configure assisted the Sponsor in successfully negotiating a discounted payoff of its existing first-lien debt, which was funded by a combination of new senior debt and a nominal equity contribution.
Each situation is unique, but a successful offensive strategy involves executing the right plays at the right time. With these three plays in mind, sponsors can potentially capture some benefit from the chaos generated by COVID-19.