Credit Solutions for the
Middle Market
Sponsor Finance Report:
2021 Year in Review
Observable Credit Markets
Despite the emergence of omicron during the holiday season, credit markets remained active throughout the fourth quarter of 2021. M&A activity closed at a similar pace experienced throughout the year, as sponsors and sellers sought to transact before the possibility of any tax changes in 2022. Direct lenders, armed with significant dry powder from recent fund raising, competed fiercely for LBOs, dividend recapitalizations and other strategic transactions. In 2021, over 60% of middle market loan volume was used for LBO/Acquisition finance while another ~25% of volume related to refinancing and recapitalizations.
Private credit emerged as an alternative to broadly syndicated term loans and direct lenders demonstrated further competitiveness on both size and pricing. Previously unable to offer similar terms to BSL deals, private credit funds have benefited from the capital influx and shifted the competitive landscape for large acquisition financings. Several unitranche financings, such as the $2.85BN unitranche facility to support Guidehouse LLP’s acquisition of Dovel Technologies, exceeded $1BN in Q4 as more borrowers and sponsors in the upper middle market sought to capture the advantages of direct deals without sacrificing on economics. To further differentiate themselves in a crowded marketplace, private credit funds have also diversified offerings to sponsors with such products as recurring-revenue loans and multi-currency financings. In November, Blackstone led the largest recurring-revenue loan to date with a $1.8BN loan to Thomas Bravo portfolio company Medallia. Its structure is focused on revenue, rather than a typical EBITDA-based covenant package.
Total leverage slightly increased from 6-year lows experienced during the height of the pandemic. Leverage supporting M&A was slightly offset by refinancing and dividend recapitalization volume.
Pricing remained low in 2021 as lenders continued to compete to deploy capital.
Though pace and scale M&A activity has garnered widespread attention, dividend recapitalization as a percentage of total volume matched levels not seen since 2016. Note: volume may be impacted by LCD observations.
The flood of government stimulus programs drove a reduction in default rate throughout 2021 to below 0.5% as of December.
Nearly 70% of deals were consummated at leverage <5x, while only ~40% closed below the same level in 2019.
Configure Crystal Ball
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.
Loan-to-value metrics remained relatively stable, while lenders were willing to attach at a higher leverage point as valuation multiples continue to rise.
Borrowers continued to enjoy relatively favorable pricing throughout the fourth quarter as lenders competed for a finite number of opportunities. Term sheets started to include SOFR pricing, as lenders prepared for a post-LIBOR world.
As companies successfully navigated through COVID, sponsors took advantage of competitive credit markets to return capital to investors in 2021.
Configure Crystal Ball
The first annual Configure Crystal Ball endeavors to cover some of the more prevalent trends in and around middle market private equity transactions, LBO financing, and portfolio company recapitalizations. Record M&A levels and rising inflation garnered the bulk of headlines during the year, but other prevailing developments were equally as impactful to sponsors and lenders alike.
1. Return of the Dividend Recapitalization
2021 was marked by increased levels of dividend recapitalization transactions, and the extraordinary M&A volume over the past 18 months portends continued dividend recap activity in 2022. Private equity sponsors looking to return capital to investors have been able to capitalize on valuations and competitive credit markets without selling investments that have only partially seasoned. Many portfolio companies have grown significantly in the aftermath of COVID, and value creation is ahead of schedule; as evidenced by dividend recapitalization transactions launched within twelve months post initial acquisition. The credit markets remain open to dividend recaps, although lenders are keen to the “COVID bump” and the recent run up in valuations. As a result, lenders are intensely focused on the amount of cash equity remaining in the investment post-recap, hold period, fund lifecycle, and implied equity value. Proving stability of COVID and post-COVID performance can be nuanced, and each industry has its own customer, supplier, and cost structure dynamics. Furthermore, though Sponsors are tempted to pursue the “path of least resistance” and rely on existing lender for a distribution, a fresh underwrite and competitive tension often delivers value beyond what a current creditor will offer.
2. Roll-Up M&A Strategies Proliferate
Acquisitions centered around roll up strategies are on the rise. Competitive M&A markets have driven up valuations, particularly on scaled platforms. As a result, sponsors are increasingly turning to buy and build strategies in order to create value. Interestingly, many sponsors are bypassing the traditional “platform” step of the buy and build, opting instead for a series of small acquisitions that are then collapsed into a platform. While operationally focused sponsors (as a way to evade elevated multiples) were first movers in this tactic, the strategy has expanded into more traditional PE, namely with larger sponsors moving down market. The debt capital to support the traditional platform-first buy and build can be easier to manage and funded debt vs. committed debt ratio is more attractive to lenders. When the strategy involves a series of small acquisitions (rather than a larger platform followed by smaller acquisitions), the funded / committed ratio can be challenging for most lenders. Identifying the right lender partner and structuring flexibility to execute on the roll up are critical. In these situations, Configure also often includes Incremental Indebtedness provisions to allow borrowers to expand the facility in market if necessary.
3. Lenders Increasing Focus on ESG
ESG is being applied in private credit, and borrowers should expect to see increased activity on this front in 2022. The obvious application of ESG has been to avoid lending to certain industries – defense, energy, firearms, and even certain types of manufacturing. The less obvious impact has been the evaluation of borrower governance by lenders, which was previously unheard of. It is not unusual (and increasingly frequent) for lenders to require questionnaires covering critical governance topics, review of and comment to employee handbooks, and more. While lenders with insurance and pension LPs seem to be the first to apply these practices, this is an area of rapidly growing focus with ever-changing guidelines. Configure has started to track lender sensitivities to various ESG issues, and we expect that data set will grow significantly over the course of 2022.