Welcome to Debt Download, Goodwin's monthly newsletter covering what you need to know in the leveraged finance market. Are the debt markets cooling off as the temps keep falling? Read on to find out.
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In the News
- The loan market quieted down in October 2023 after a busy September, with net issuance of broadly syndicated loans (BSLs) down 27% to $12.7 billion from $17.3 billion in September. The trend of refinancing BSLs with direct credit loans continued, as sponsors sought more flexible terms, including delayed draw facilities and payment-in-kind (PIK) features, which can be used not only to support M&A but also to provide additional liquidity, as further discussed below. Middle market LBO volume for the third quarter of 2023 totaled $7.45 billion, 4% higher than in the second quarter of 2023 but significantly lower than 2021-2022 levels. Equity contributions as a percentage of pro forma capitalization continued to rise, averaging 54% for the trailing three months for LBOs and non-software deals, and the average unadjusted total debt multiple averages rose slightly to 5.4x in the trailing three months compared to 5.2x for the third quarter of 2023. Pricing flex for BSLs favored borrowers, but less than in prior months, with 10 cuts to 3 increases. Average loan spreads year-over-year tightened about 90 bps, with average issue price increasing to 98.7, although average all-in clearing spreads for single-B new issuances increased to S+531 (up from the 22-month low of S+452 in September). In addition, a large majority of new issue and refinanced loans are now being priced with no credit spread adjustment. Loan default rates ticked up slightly to 1.43% for the rolling twelve-month period, mainly as a result of stresses in the healthcare sector, but remain below the 10-year average of 1.86%; however, some analysts are concerned that defaults are not occurring as a result of the flurry of "amend and extend" transactions, which may mask underlying performance issues.
- A full year of increased interest rates and refinanced loans with higher all-in rates is stressing borrowers and causing interest coverage ratio (i.e., EBITDA / interest expense) levels to decline, with Fitch's portfolio expected to decline toward 1.7x in 2023, but even in S&P's worst-case scenario stress test, the median interest coverage ratio fell to 1.1x, still above the crucial 1.0x marker. Although EBITDA grew year-to-year for a twelfth straight quarter for public filers (albeit at the slowest rate (1.8%) in that twelve-quarter stretch), persistently high interest expense for public filers resulted in coverage levels dropping for a fifth straight quarter to 3.8x. The decline in interest coverage for both newly issued and existing loans, as further described in this Financial Times article, is an indicator that companies may not be earning enough to cover their rising borrowing expenses. As a result of declining interest coverage levels, many sponsors are seeking PIK payment terms, which allow borrowers to defer paying interest in cash by capitalizing interest and increasing borrowers' total debt, thereby easing cash flow concerns for companies in the short term at the expense of reducing equity investors' future returns.
- Annualized recurring revenue (ARR) loans, which became popular in the last several years in take-private transactions for software companies, for many borrowers are coming up on their mandatory deadline to convert (or "flip") from ARR-based multiples to EBITDA-based multiples, at a time when high interest rates and a challenging economy are combining to put pressure on tech companies. As a result of higher multiples paid for software companies in prior years when interest rates were low, many lenders may seek an additional capital infusion from sponsors looking to delay the upcoming conversion or to renegotiate covenant levels.
- With slower M&A and LBO activity, more private credit lenders have started providing asset-based financing (ABLs) to diversify borrowers' options. ABLs can be more appealing to borrowers during downturns because they tend to be cheaper in terms of pricing than cash-flow loans and companies aren't required to satisfy strict leverage and financial performance requirements typical for cash-flow loans. Private credit providers are entering the ABL market both through originations and purchases of loan portfolios from banks looking to streamline their business as a result of increased regulation and the regional banking crisis.
- As we covered in the October edition of Debt Download, some industry leaders are voicing concerns regarding private credit, with executives at UBS and PIMCO predicting the next financial crisis will arise from the non-banking financial industry and calling for stronger regulation. In addition, Moody's and other market participants, including the IMF, have raised concerns around the rising popularity of insurance companies partnering with private credit providers, because private credit loans "have not been tested in a prolonged economic downturn," thereby adding more risk to insurers' portfolios. Experts are also cautioning against insurance companies' increased allocations to private credit funds — e.g., 60% of insurance providers surveyed by BlackRock report that they expect to increase allocations to direct lending—citing concerns that, if default rates rise in private credit, insurance policyholders could withdraw their assets thereby causing a "run on the bank".
- Some LPs are objecting to the increased use of net asset value (NAV) financings for making distributions to LPs, as we discussed in the October editionof Debt Download. In particular, these LPs are focused on recallable distributions made with proceeds of such financings, which increase a fund's distribution to paid-in capital amount but prevents the LPs from being able to utilize the funds that are distributed. In addition to NAV facilities, private equity funds are taking advantage of manco loans, a type of financing to the fund management company that is secured by its fee streams and equity returns, the long-term risks of which are unclear since there have been no reported defaults related to these relatively new financings. Notwithstanding recent LP objections, industry participants predict NAV facilities will gain in popularity with GPs and debt providers over the next several years, with the expectation that the NAV financing market will grow to $600 billion by 2030.
With the effective date of the U.S. Department of the Treasury's Financial Crimes Enforcement Network's ("FinCEN") final beneficial ownership reporting requirements under the Corporate Transparency Act (the "CTA") fast approaching, the U.S. joins a growing number of countries in implementing a centralized register of information about companies' beneficial ownership. For a brief overview of how the CTA could affect debt transactions, please click here.
In Case You Missed It– Check out these recent Goodwin publications:
A Practical Look at OIG's New Compliance Guidance; AIFMD II (Near) Final Text Agreed: What's New?; FinCEN Finalizes Rule on Use of FinCEN Identifiers in Beneficial Ownership Information Reporting; Cross-Border Transactional Risk Insurance; "Open Banking" Promoted in New CFPB Rule.
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