Credit Solutions for the
Middle Market
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Observable Credit Markets
Momentum in credit issuance has picked up as financial markets have stabilized, and both borrowers and lenders have adjusted to a new normal in the pandemic age. This adjustment was evident between the “tale of two quarters” experienced before and after Labor Day, as borrower cautiousness in seeking capital at the beginning of the quarter eventually gave way to the typical rush to complete deals by year-end. Eager to make up for a dearth of new deals, lenders’ focus has largely shifted from portfolio management to origination. Pricing moved higher and lenders adjusted structures for many; however, sectors viewed as resistant to the stress of shutdowns (such as tech, business services, and pockets of healthcare) have become, and increasingly remain, desirable to credit providers. Use of proceeds for deals closing in the quarter widened from add-on acquisitions and recapitalizations to buyouts and even dividends. Healthier borrowers continue to prefer unitranche structures and a single point of contact for execution and amendments. Alternatively, riskier credits are trending towards ABL plus junior capital and senior/junior structures in order to maximize liquidity and flexibility. Even as new issues take a more prominent role in Q3 when compared to Q2, credit teams are actively monitoring their portfolios and strategizing for weaker holdings.
Private credit funds face a choice: chase rare, highly sought-after, COVID-resistant credits for lower pricing on less favorable terms, or pursue more risk for better pricing and documentation.
Volume has significantly lagged 2019 levels and, despite activity in the observable credit markets remaining muted, Configure’s evidence suggests new issuance is accelerating as pent-up demand for new credit is apparent, particularly in recent weeks.
Unsurprisingly, lenders are wading back into the market with caution, compressing average leverage multiples to levels not seen since 2015.
Inside the Issues List: What Could Change in Your Next Credit Agreement
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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.
Lenders are seeking increased yield to compensate for the risk in an uncertain economy, which has driven up pricing ~75 bps.
Though lenders are keen to deploy capital, they are balancing eagerness with modest changes to debt service via increased amortization.
With fresh memories of sponsor support (or lack thereof) during the height of the pandemic, lenders are insiting that sponsors contribute a greater percentage of the purchase price for new deals.
Inside the Issues List: What Could Change in Your Next Credit Agreement
For borrowers who care about their capital structure, the credit agreement can be as important as—or perhaps more than—headline rate and leverage. Negotiating the best possible document both maximizes operational flexibility and minimizes management distraction once a deal has been inked.
In a welcome return to “normal”, sponsors have seen the typical post-Labor Day ramp in new deal activity. In the several months following the onset of COVID, many firms were focused on existing portfolio companies. Recently, as more deals have been completed, market evidence is making clear that lenders have the upper hand in negotiations with borrowers when compared to pre-COVID periods. Configure Partners’ data suggests this trend is as noticeable in documentation as it is in economic terms. Lenders are more strident negotiating covenant packages, reporting requirements, and other contractual terms, representing a significant shift from what was “market” earlier in 2020.
- Grace Period for Implementation of Reserves
In the early weeks of pandemic hysteria, many borrowers made pre-emptive draws on revolving lines of credit in order to ensure adequate liquidity for an uncertain future. Some companies have gained comfort with their financial profile and liquidity position, while others have not fared as well in the midst of shutdowns and social distancing measures. No sector has been hit harder than retail. From local delis to national department stores, the wave of retail distress has just begun to crest, and the ramifications are impacting new loan documents. As retailers contemplated pre-emptive drawdowns, their lenders sought to implement reserves to the borrowing base. Faced with a reduction to availability, many borrowers utilized the time between notification of a new reserve and the implementation of that reserve to draw down the entirety of their revolver. Not surprisingly, lenders have learned that lesson, and many are eliminating the grace period for implementation of reserves in new and amended credit agreements.
2. Assignment and Participation
The lender-borrower relationship is important, especially in the bilateral and small club financings pervasive in the middle market. Borrowers should seek not only the best terms, but should also consider qualitative factors such as lender industry experience, workout mentality, and fund structure, among others. Borrowers have historically sought to protect themselves by limiting a lender’s ability to assign or grant participation in all or a portion of its loan. Post-COVID, lenders are demonstrating less flexibility in notice, consent and/ or situational conditions related to assignment rights. In response, some recent borrowers have successfully implemented restrictions by introducing “disqualified” lists and modifying required lenders.
3. Collateral Monitoring and Reporting
While the cash flow market has understandably been slower to recover, asset based financings are on a tear, thanks in no small part to refinancing of “fallen angels.” Formerly performing credits have either been transitioned within institutions or shifted lending altogether to an ABL structure. Both tenured and first-time ABL borrowers are facing increased collateral monitoring requirements and stricter thresholds. Multiple annual field examinations and inventory appraisals, with increases upon default or falling below availability minimum, are now commonplace. Additionally, thresholds triggering cash dominion have tightened considerably.
4. Board Observation Rights
For years, borrowers—and specifically senior management—interacted with its lender on a relatively limited basis. Unless in default, a compliance certificate, annual projections, and the occasional MD&A were the extent of what was required as part of monitoring a credit. Lender sentiment has shifted, however, and some are now regularly requiring/ seeking a “seat at the table.” Positioned by lenders as an additional means to be a partner to its borrowers, board observation rights provide lenders enhanced protection by reducing reaction time, improving transparency, and granting a voice to lenders.