Credit Solutions for the
Soft Commitments, Soft Demand, and a Soft Landing
Observable Credit Markets
Market conditions during the third quarter were mixed and reflected a continuing trend towards more cautionary stance. In an ongoing effort to tame inflation, the Federal Reserve enacted 75 bps rate hikes at both the July and September meetings. Recent readings suggest early success, as the September consumer price index eased slightly. Fed officials remain split on the pace and ultimate rate target, while markets are uncertain if the Fed can engineer a soft landing.
What cannot be disputed is the impact that rate hikes have had on credit markets, most of which has inured to the benefit of private lenders. Dislocation in broadly syndicated deals has driven borrowers to private credit. Meanwhile, pricing trends that first emerged in the syndicated market have expanded into private credit transactions, resulting in spreads widening 50 to 100 bps, in addition to base rate increases. Furthermore, lenders are becoming less lenient in documentation by tightening definitions, covenant cushions, etc. All told, lenders are being compensated for risk taking in this choppy environment.
However, not all trends are positive for private credit funds. M&A volume has slowed significantly, and participants admit that credit quality is similarly lacking. Additionally, lenders are downsizing check sizes and one-stop deals are now being completed via clubs. Lastly, after years of record fundraising, fund managers represent that interest is waning and fundraising has become significantly more challenging of late.
After rising above 4.8x in Q2, average leverage declined to 4.5x, 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.
An outsized number of deals are clearing at leverage levels of <3.0x, reflecting lender’s conservatism during a period of economic uncertainty.
The increase in spreads continued during Q3, as pricing reached its highest level since 2016 and upfront fees starting to tick over 2.0%, a sign that lenders continue to factor in a weaker outlook on the broader economy. Additionally, with SOFR now rising to over 4.0%, the standard 100 bps LIBOR/ SOFR floor has become moot.
Dealmaking activity continued at a sluggish pace during Q3, with the only material activity happening at the upper end of the middle market (>$300mm in transaction size). Lenders have little appetite in the current environment to fund dividend recapitalizations.
The effects of current macroeconomic conditions on the earnings of middle-market issuers are starting to be observed. Loan default rates steadily increased in the quarter, both in number and dollar amount outstanding.
Fixed Charge Coverage Ratio No Longer a Trivial Test
Except for the most capital intensive businesses, fixed charge coverage ratio (FCCR) was considered a throwaway covenant, if required at all. Due to low rates and high free cash flow, a borrower would almost certainly default on a leverage test prior to or simultaneous with an FCCR test. However, under the new reference rate regime, all-in pricing has reached double digits, which has re-introduced the importance for this secondary covenant. As illustrated in the example below, the pricing shift has nearly halved the effective cushion.