Credit Solutions for the
2 0 2 2 4 T H Q U A R T E R R E P O R T
Sponsor Finance Report
F E A T U R I N G L E N D E R S U R V E Y
Observable Credit Markets
Market participants maintained a cautionary stance during the fourth quarter. The Fed’s battle to fight inflation while simultaneously engineering a soft landing waged on, as it implemented rate hikes of 75 and 50 basis points, respectively, at the November and December meetings. Some signs of success at abating inflation have been observed, with the December reading rising at the slowest 12-month pace since December 2021. Market participants are concurrently weighing the positive inflation data against data suggesting lower consumer and business demand towards the end of the year.
The impact of the current economic conditions on borrowers pervades throughout the middle market. Weakened corporate fundamentals and similarly lacking credit quality have resulted in reduced leverage and hold sizes (larger deals previously completed with one lender now require a club), and increased pricing. Of notable impact is the combination of a higher risk-free rate, increased pricing, and higher amortization on borrowers’ ability to cover fixed charges. Fixed Charge Coverage Ratio cushions have effectively been cut in half, putting pressure on free cash flow generating ability of portfolio companies.
Despite current economic challenges, private credit has maintained its role as the primary source of debt capital in the middle market, with volume outpacing deals completed in the syndicated loan market, which is essentially shut down. Looking forward, a combination of factors including the Fed’s ability to engineer a soft landing and the resilience of consumer and business demand will determine whether harsher conditions for borrowers persist.
Leverage declined to 3.9x on average from 4.5x at Q3, driven by lower observed leverage levels at the bottom end of the market.
Note that observations were limited for deals <$200M in size.
Nearly 50% of deals in 2022 closed at leverage <4.0x, as compared to only ~30% a year prior.
Spreads stabilized during Q4 after a run-up in Q3. Still, pricing is at its highest level since 2015.
Dealmaking activity ground to a halt in Q4. No new issue LBO volume was observed during the quarter in the syndicated market. Lenders demonstrate minimal appetite in the current environment to fund distributions.
Loan default rates stabilized in Q4 after a steady rise in prior quarters.
2022 Lender Survey
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.
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.
Heightened leverage in 1H was partially offset by more conservative capital structures in 2H.
LBO transactions drove the vast majority of deal flow in 2022. Early-stage refinancing activity appeared in Q4.
In addition to max leverage and FCCR, many lenders are requiring an additional covenant such as minimum liquidity or maximum CapEx.
Since peaking in early 2022, Configure has noticed a decrease in term sheets received per lender contacted on various acquisition financings and recapitalizations.
2022 Debt Placement Stat Sheet
Configure Crystal Ball
The 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.
1. More Lenders or No Lenders
Through the second half of 2022, the average hold size decreased across almost all lenders. Previously, a $400M financing would have required a 1-2 member club. At current, that same financing likely requires 4-6 lenders, which significantly complicates the process of sourcing financing. Designing financing processes to ensure maximum optionality and competitive tension requires increased management in the context of a 4-6 member club deal to ensure that options don’t “collapse” into each other too early in the process. We also expect that documentation will be more difficult in this context as each lender will require some level of review / input. Furthermore—and perhaps in reaction to the aforementioned phenomenon—we envision an increasing number of all-cash transactions.
2. Prevalence of Senior / Junior Structure
As this report noted in previous quarters, unitranche loans have been the favored structure within middle market sponsored finance for several years. Competitive rates, ease and surety of execution, and documentation flexibility provided by unitranche deals attracted sponsors to the structure as compared to split lien or senior / junior financing solutions. With the relative advantage of unitranche diminishing, Configure anticipates senior / junior structures to come back en vogue. Rising SOFR / LIBOR has led most loans to increase by more than 3.0%. Further, average spreads have widened to price in economic risk. The combination results in even top-quality unitranche loans pricing at an all-in rate well exceeding 10%. Although junior loan pricing generally exceeds that of unitranche loans, 2.0 – 5.0% lower spread on the senior debt provides significant debt service relief. Additionally, the All-In Rate on junior capital has not moved in lockstep with unitranche loans through the 2H 2022 period of restrictive monetary policy from the fed, which has led to benefits from a rate perspective for the structure. The flip side of proliferating senior / junior deals (and the pursuit thereof) is commercial bank skittishness and possible elevated amortization.
The post-COVID confluence of labor issues, supply chain disruption, inflation, and recession-driven revenue softening has been tremendously disruptive. An increasing number of Configure’s engagements involve assisting in an amendment or waiver of some sort, often within the construct of bridging to a refinancing. In exchange for sponsor support (incremental capital), lenders are being asked to revise covenant packages to allow the Company to recover to the point of a refinancing in the next 12-18 months. The “market” level of relief is difficult to assess, as each of these situations are relatively unique and, as such, sponsors are keenly focused on how much relief should be expected in exchange for the incremental capital support.
4. Divergence between Deal Team and Investment Committee
Abundant capital allocated by eager dealmakers supported record M&A – and around the cycle went. The music hasn’t stopped, but internal credit professionals are singing in different keys. Committee members and originators have long approached the market with a similar mindset and the harmony benefited sponsors via trustworthy reads, IOIs, commitments, etc. Ample dry powder remains but questions surrounding how to deploy it abound. In addition to overcoming a greater percentage of declined deals, originators / underwriters will chase a moving target on commitment level, leverage, rate, and other terms. As a result, the process of managing debt placement becomes more involved and uncertain, particularly for larger private deals. Configure does not anticipate the disconnect to subside until there is clarity with regards to the economic outlook and depths of a potential recession.
5. FTX Won’t Take the (Bankruptcy) Cake
The fraud and fallout caused by FTX’s collapse will undoubtedly generate a must-watch Netflix docuseries. More chips will fall and Configure expects one (or more) bankruptcy filings to be far more impactful to the middle market sponsor universe–although unlikely to match the theater provided by SBF & Co.