Credit Solutions for the
Middle Market
Tides Begin to Turn
Observable Credit Markets
Second quarter market conditions maintained the trend of choppiness in the broader markets that began during 1Q22. Global economic concerns such as inflation, the Russian invasion of Ukraine, and oil prices continued (or escalated) through June, suppressing larger syndicated transactions compared to 2021.
The private credit markets remained open for borrowers, albeit at less favorable terms than years past. Sponsors accustomed to record low pricing have seen spreads widen as lenders began to price in recent macroeconomic risk factors as well as feeling the impact of federal reserve rate hikes. Lenders are more commonly pushing back on terms in documentation, seeking increased protection heading into what many believe is a recessionary environment.
Despite these aforementioned challenges, M&A volume remains active, but qualitative feedback suggests that assets in market are much weaker than prior quarters. Additionally, acquisition timelines are stretching as earnings erode (leading to re-trades) and sell-side bankers no longer maintaining ultimate leverage over buyers. Forward indicators, such as Quality of Earning providers’ backlog, suggest a ramp in activity post-Labor Day. A welcome sign for credit funds and sponsors alike seeking to deploy the significant amount of capital raised in recent years.
After dipping below 4.5x in Q1, average leverage jumped to 4.8x, driven in large part by deals in the upper end of the market (i.e. >$300MM in loan size).
Note that observations were limited for deals <$200MM in size.
Lenders have demonstrated conservatism with “storied” credits, however, the market remains open and aggressive for the most attractive assets in the upper middle market.
Pricing reached its highest level since 2016, a sign that lenders have begun to factor in a weaker outlook on the broader economy. Additionally, standard 100 bps LIBOR/ SOFR floor has become moot following the Fed’s historic rate hikes.
Dealmaking activity showed cooling in Q1 and decelerated further in Q2, while dividend recapitalization transactions have seemingly halted altogether.
Loan default rate steadily increased in the quarter. Differential in # vs $ outstanding suggests lower end of the market is showing earliest signs of cracking.
A Tale of Two Markets
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.
Leverage reached post-pandemic highs due in large part to sizable LBOs closed in late Q1.
Pricing has remained at a consistent level in spite of other credit flexibility. Depending on fund dynamics, many lenders demonstrate willingness to lose on structure but not price.
Dividend recapilizations held outsized share of the deal pipeline until M&A roared back late in the quarter.
Similar to direct lenders taking share in traditional BSL territory, upper middle market structuring is seeping into documents for companies with <$30MM of EBITDA.
A Tale of Two Markets
The credit markets shifted during Q2, with investors taking a more risk-off stance in general amongst market volatility. Reactionary federal reserve rate hikes caused by persistently high inflation has driven an increasing sentiment towards the probability of a near to medium term recession (40% likelihood over the next year, and 50% likelihood over the next two years), according to a recent Reuters poll of economists. This has led to an overall change in investor preference towards both sector as well as changes in dynamics related to the size of deals.
The credit markets have bifurcated between the “haves” and “have nots”. Lenders have sought to limit exposure to cyclical businesses as well as those with outsized exposure to consumer spending (the “have nots”). Inflation, rising rates, and supply chain issues all contributed to volatility experienced throughout the quarter and a more conservative stance towards assets that may perform poorly in an economic contraction. Not only have the effects of this shift been felt on typical consumer discretionary items (travel, luxury, leisure, etc.) but also in areas like food and restaurants, where consumers are cutting down on or cutting out spending entirely. The general flight to quality of the “haves” has resulted in the “have nots” losing ~1.0x leverage and ~150 bps of spread, while the strongest credits in reliable industries have only given up ~25 – 50 bps in pricing.
During the second quarter, private credit investors benefited from an increased opportunity to deploy capital as broadly syndicated loan arrangements paused. For BSL deals that did transact, larger private credit funds stepped up to finance transactions, or round out syndicates, that would normally be absorbed by the syndicated loan market. One example of private credit financing large buyouts that would typically be covered by a BSL was the $10.4 billion buyout of Anaplan, Inc. by Thoma Bravo, where Owl Rock served as administrative agent, joint lead arranger and bookrunner (other joint lead arrangers were Blackstone, Golub, Apollo, Ares, Jefferies, Stone Point, Macquarie, and Veritas), where $3.1 billion in credit facilities were provided. At the same time, a general inversion of the upper and lower ends of the middle market was observed. While larger deals typically receive favorable pricing and looser (or no) covenants, smaller deals closed with tighter pricing and even one covenant. The phenomenon can be attributed in part to the lower end of the middle market being less distracted (or, in some investors’ view, attracted) by perceived market dislocations in the liquid secondary market, where paper was available directly from syndication desks at attractive yields with OIDs often in the low 90’s. An analysis of middle market loan issuances by Pitchbook/LCD showed an average loan bid of 94.3 at Q2 2022, down from 97.6 at Q1 2022. While the aforementioned market activity primarily occurred for companies with EBITDA exceeding $50.0MM, sub-$10.0MM EBITDA company transactions were not nearly as affected, and deals were done with similar urgency and competition as prior quarters. A secondary explanation is that much of the capital for lower middle market deals is ultimately provided by SBIC funds or un-levered LP capital, which is less impacted by the vagaries of CLO issuance, leverage lines, and other market forces.
We expect investors will continue to place an outsized emphasis on non-cyclical businesses with stable and predictable cash flows over the coming months, as the Fed’s strategy for calming inflation is extended. In the context of this market tightening, Sponsors should carefully consider the amount of leverage they will be able to deploy in determining enterprise valuation and selecting which deals to pursue.