Credit Solutions for the
Summer of the Deal
Observable Credit Markets
Labor Day came and went without the usual end-of-summer slowdown, leaving professionals that sought a respite from the flurry of deal activity looking ahead to the holiday season. As the Pacific Northwest suffered through a major heatwave, the M&A markets were even hotter, which pushed ahead at record-setting levels. M&A activity—both LBO and add-on—continues to power debt issuance. Additionally, many borrowers are taking advantage of tighter spreads to refinance debt or issue dividends.
Elsewhere, lender optimism abounds. Earnings season for BDCs demonstrated non-accruals are declining, and the share of challenged credits in investment portfolios has pulled back from the heightened levels of 2020. The Proskauer Private Credit Default Index showed improving default levels of private credit loans, with the overall rate falling to 1.3% on a sequential basis in Q2 2021, from 2.4% in Q1. The rate, which tracks the defaults of senior secured and unitranche loans, hit a peak of 8.1% in Q2 2020.
Total leverage is consistent with 2020 levels. Refinancing volume is contributing to lower leverage in exchange for better pricing, terms, etc. post-COVID.
Competition for deals remains fierce and pricing tight across the spectrum. Market participants and observers are only left to ponder the generally accepted replacement to LIBOR.
In addition to M&A transactions, dividend recapitalization volume continues at a blistering pace and is on track to match levels not seen since 2014.
Note: volume may be impacted by LCD observations.
A healthy economic backdrop, ample capital/ federal assistance, and docile lenders combine to produce unusually low default rates.
A Rising Tide Lifts All Borrowers
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.
Median leverage is increasing as lenders are willing to support higher valuation multiples at consistent loan-to-value levels.
Pricing has reverted to pre-COVID median as a result of competition to deploy capital, but lenders are demanding LIBOR floor between 75 – 100 bps.
Although economics for recaps and LBOs are surprisingly similar, call protection is elevated for dividend deals. Change of control is a hot-button carveout for no-call provisions.
The market has been highly receptive to DDTLs as lenders seek to retain borrowers through easing future transaction costs/friction. As a result, DDTL terms have generally been borrower friendly.
A Rising Tide Lifts All Borrowers
Car dealerships are barren due to the semiconductor shortage. Job openings stay unfilled due to a selective workforce. Shelves sit void of tennis balls and ammunition as manufacturing and shipping can’t satisfy demand. Supply chain disruptions and pandemic-driven changes to consumer spending have caused widespread shortages. Capital available for private credit, however, remains abundant.
According to Preqin, private credit AUM surpassed $1 trillion in early 2021 and fundraising has shown no signs of slowing. Through 1H 2021, nearly $80BN of capital was raised. Despite record deal volumes, asset managers have been unable to deploy capital at the same rate they can raise it, causing dry powder to reach record levels.
To put money to work, lenders are not simply lowering rates, increasing leverage and structuring flexibility to win deals. Configure has witnessed several emerging trends as a result of the copious amounts of capital.
1. Delayed Draw Term Loans
In previous years, DDTLs were the exception. Although lenders were willing to provide them, limitations included short availability windows, specific usage, and strict incurrence tests. Furthermore, DDTL as a percentage of total commitment was relatively minor. As DDTLs have become more commonplace, recent deals have cleared with DDTLs of ~50% of total commitment, available for up to 24 months, and use of proceeds for acquisitions and/ or distributions.
2. Staying in the “Middle of the Fairway”
The torrid pace of M&A has provided ample opportunity for lenders to deploy capital. Tremendous deal volume has also allowed lenders to be more selective. Faced with new opportunities every day, lenders have shifted their focus to pursue “clean” deals or ones without a “story.” It also serves as a triage method for firms facing capacity limitations.
3. Thinning Lower Middle Market
For companies with EBITDA <$5 million and >$20 million, the financing markets are receptive and seemingly deeper than ever. SBICs offer a unique solution for companies on the smaller end of the spectrum, while larger deals are attracting more attention. Similar to the selection bias mentioned in #2, middle market credit funds are increasingly focused on larger opportunities. Potential borrowers with ~$5 – $15 million of EBITDA are discovering a shallower capital pool as compared to 2019 or early 2020.
4. “Buy it Now” Option
In addition to intense competition in a white-hot market, lenders are also facing substantial runoff. The newest strategy lenders are testing in order to differentiate themselves is a “buy it now” option, whereby a borrower and/ or sponsor forego a self-managed marketing process to consummate a recapitalization. This tactic is employed primarily by lenders with a streamlined investment committee and in situations checking specific boxes such as a) known sponsor b) familiar industry and c) modest risk/ return threshold. Though quicker, properly pairing the right lender with a situation is increasingly challenging and introduces risks of re-trading and executing on sub-optimal terms.
5. More Penal Prepay
As mentioned in #4, run-off is an important issue facing lenders. For example, deals executed during the height of COVID (with even a slight premium) are already being refinanced. In attempts to mitigate portfolio turnover, lenders are pushing for stricter prepayment penalties, including elevated year 1 prepay of 103+ or make-whole provisions, and trading call protection for other structural considerations.
The aforementioned trends are only a sample of the ways lenders have demonstrated creativity. Market chatter suggests the M&A backlog is robust and lenders must continue to adapt to win. Furthermore, investors seeking inflation-hedged assets may allocate additional funds into private credit. The combination suggests an extension of the advantageous market for sponsors and their portfolio companies.