Welcome to Debt Download, Goodwin's monthly newsletter covering what you need to know in the leveraged finance market. Along with leaves and temperatures, interest rates are finally coming down. Read on to see what the landing may look like for debt markets.
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In the News
- Setting the stage for rate cuts in September, the broadly syndicated loan (BSL) market took investors on a rollercoaster ride in August. Supply of new loans ticked up slightly to $14.4 billion, including $13.1 billion of new-issue volume net of associated repayments, according to Covenant Review. The average all-in spread of single-B loans shot up to S+444 (S+409/99 OID), from S+375 (S+367/99.8 OID) in July. Price flex turned slightly against borrowers for the month, with 11 loans tightened and four widened, for a 2.8:1 ratio, down from 6.0:1 in July. A shuffling of the loan mix caused the sharp jump in yield, as more expensive M&A loans took up a larger share. Meanwhile, loan repricings became a casualty of a fall in secondary loan trading prices in August, with only $1.2 billion repriced via amendment, the lowest such amount since June of last year. In fact, loan repricings represented only 45% of volume in August, a 15-month low and well down from July's 69%; M&A financings, meanwhile, hit a 20-month high of 39%. This rebalancing should further favor M&A financings going forward, with an expectation of "a decent pickup in acquisition-driven BSL volume between mid-September and early November," according to Covenant Review. Loan repricings showed signs of renewal in September, as the secondary market recovered somewhat; amendments were launched to reprice $17.2 billion in speculative-grade debt through the first six business days of September, compared with $8.4 billion for the comparable period in July (never mind August's rollercoaster). Even with the recent recovery, secondary trading prices remain below the levels in May, the high-water mark of loan repricings for the year. Looking forward, LCD expects this solid-but-not-stellar trend to continue, with about $56 billion in debt remaining as prime targets for loan repricings as of September 9.
- One factor that will continue to drive activity in the near term is the tactical decision by borrowers to get ahead of any news—electoral and economic—that might bring back volatility. This has lifted demand "even for risky transactions." While this approach appears to be the opposite of that taken by the equity markets, it may ultimately favor private debt as a place to park that risk. And, in fact, the BSL market has become less risky: The Morningstar LSTA US Leveraged Loan Index has seen its share of riskier borrowers (rated B-minus and below) fall to 25% as of September 6, from a recent peak of 30% in February 2023, according to PitchBook. But "the riskier deals aren't disappearing—private credit is picking up the slack." Private lenders have been adept at managing these risks and the "complicated story" of their borrowers through the use of recurring-revenue covenants, PIK options and delayed draw facilities.
- Private debt funds are therefore expecting "a busy end to 2024," according to Private Debt Investor. Broadly speaking, private funds do better in lender-friendly markets, and this market has been anything but. Intense competition, and the resulting spread compression, have kept private lenders focused on the core and lower middle markets, where spreads have been 175 to 200 basis points lower than in the upper middle market. In anticipation of that busy end, private-credit fundraising is making a comeback: after raising $46.2 billion in North America in the first half of the year, the lowest tally since the pandemic, "the private credit fundraising market is really active—it is night and day compared to last year," according to the CEO of Briarcliffe Credit Partners (as quoted in Private Debt Investor). Also experiencing a night-and-day difference are the fundraises for larger "one-stop-shops" as compared with middle-tier private credit players, according to Bloomberg Law. The scale offered by the likes of Apollo, Ares, Blackstone and Goldman Sachs allows companies to borrow across the capital structure while giving investors access to returns regardless of economic cycle. For that reason, fund managers are growing in scale, and "mid-tier fund managers are struggling to raise money for new funds."
- Another emerging trend to boost capital-raising is adoption of the open-ended private credit fund. While closed-end funds have been the standard approach, fundraising for those vehicles has "declined steadily since 2021 and is expected to stay flat." Open-ended funds, however, offer an evergreen option and are now "seen as a more efficient way to allocate capital to private credit." Among their advantages, open-ended funds do not burden investors with capital calls and recommitments, raising their allure for "new classes of investors," including wealthy individuals. Along similar lines, BlackRock has recently made Partners Group its own partner in launching a "model portfolio" to ease investments in private credit, following its recent tie-up with Preqin and establishment of a Global Direct Lending unit to catch up to PE shops already well-entrenched (and well-enriched) in private credit. And no wonder: private credit is now the driver behind private equity, with the seven largest public private equity firms spending $121.1 billion on credit strategies in the second quarter, compared with $11.3 billion on private equity, according to PitchBook.
- Quick roundup of recent new direct lender debt funds and related news:
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- Churchill raises more than USD 350m for junior capital debt fund (Debtwire)
- Benefit Street, Diameter Form Private Credit Venture With Stifel (Bloomberg Law)
- Sixth Street Buys TPG Partners' Stake at $10 Billion Value (Bloomberg Law)
- Ares expands direct lending capabilities through Riverside Credit Solutions acquisition (Private Debt Investor)
- Bregal Sagemount nets $1B in deployable capital for credit fund (Leveraged Commentary & Data)
- The payment default rate for the month slipped to 0.78%, from 0.92% in July, though these figures mask the impact of "soft defaults," which include liability management exercises (LMEs), such as distressed debt exchanges. The number of soft defaults rose to a record high 34 for the month, according to LCD. This caused the dual-track default rate—which incorporates those defaults—to rise to 4.17% for the month from 4.02% in July. Distressed exchanges are reaching new heights this year, contributing to defaults, as borrowers turn more to the practice as a restructuring tool, but those borrowers soon find themselves in default, according to Bloomberg Law and S&P Global Ratings. The year-to-date default figure stood at 87 at the end of July, which is behind last year's rate but ahead of the five-year trend. More than half of those defaults were precipitated by a distressed exchange. There were nine defaults overall in July, six of which were triggered by distressed exchanges. There were six defaults in speculative credit in July, four of which came out of distressed exchanges. Year to date, we've seen 45 distressed exchanges, the most since 2009.
- Portable loan structures are on the rise in the US, according to a Covenant Review analysis of Q2 issuances in August. These provisions allow the indebtedness incurred in an LBO (for example) to remain in place even after a subsequent sale of the initial target company—all without triggering a "change of control" (as traditionally defined). Using this feature, sponsors gain additional flexibility in managing the capital structures of their portfolio companies, while lenders are able to stay in the deal even after a sale. Covenant Review found that 8.2% of private equity-backed BSL loans (excluding refinancings, repricings and add-ons) went to market with portability language; this is up from 3.8% on 2023 and the highest since Covenant Review began tracking the figure in 2017.
- Following a similar trend, the "highest watermark" treatment of EBITDA grower baskets has been fairly common in Europe but is also now starting to become more prevalent in the US, according to Covenant Review. Grower baskets typically look to the greater of a percentage of the borrower's EBITDA and a fixed dollar amount, which acts as a borrower-protective floor should EBITDA fall. The highest watermark provision locks in any increases that lift EBITDA to a new high while ignoring downturns in EBITDA. Covenant Review subsequently reported that at least six deals with highest-watermark provisions have been launched since Labor Day. Xtract Research further notes that the highest-water EBITDA treatment was found in two sponsor agreements (out of five reviewed) in August. Xtract pointed out that "two sponsor agreements encountered significant successful push-back from lenders."
- LSTA has started to track representative liability management transaction protections for private credit agreements. The linked chart includes plain English descriptions (written "with a non-lawyer in mind") of Serta, J. Crew, Pluralsight, Envision, At Home and Chewy liability management issues and protections.
Goodwin Insights – Warrants: Debt's Equity Play
For this edition of Debt Download, Goodwin partner Reid Bagwell reviews the benefits and challenges of using warrants in financings—and where this practice is heading.
No distinction in financial markets is more fundamental than the division between debt and equity investors. By conventional wisdom, the creditor wants safe returns and prefers healthy growth over assets with higher variance in returns, and the equity holder is willing to risk more for greater upside. Almost every investment or market-making institution separates debt and equity components, whether equity funds and credit funds, or equity analysts and credit analysts. The distinction between fixed income desks and equities desks has existed as long as Wall Street has.
But nothing is ever quite so simple. Lenders have long sought ways to capture a small amount of the equity upside for themselves to sweeten riskier investments. Lenders have sometimes gained equity co-invests from sponsors. In other cases, lenders have invested in equity-like debt such as preferred stock with capitalizing dividends, capturing a still bounded but higher return at a cost of a higher risk profile and uncertain repayment schedule. Debt funds have been willing to make considerable investments in structured non-cash interest capital, seeking mid-teens returns on investments (above traditional debt expectations).
In still other cases, lenders have dug deeper into the equity investor tool kit and requested warrants. While less common in the debt world, warrants have long been a tool for tailoring equity investments. Traditional warrants let investors purchase the underlying stock at a pre-determined strike price. Penny warrants, which are more typical in a private credit context, permit the investor to buy a given amount of the company's securities at a nominal (i.e. one penny) exercise price. This essentially permits the lenders to capture the full value of equity appreciation on the warrant stock.
In an indicative public transaction, Cerberus provided a $210.5 million delayed draw term loan and $105 million revolver to Eos Energy (NASDAQ: EOSE). In connection with that, Cerberus also received 43.3 million penny warrants as well as shares of preferred stock with a liquidation preference equivalent to 31.9 million shares of common stock. The warrants and preferred stock together represented value equivalent to 33% of the outstanding equity of the company.
Warrants have increased potential in current markets because they can solve challenges confronting sponsors and their lenders. With higher interest rates shutting down exit opportunities, sponsors have been forced to find ways to entice lenders to accept longer periods to repayment and to manage cash outlays on interest rate service. Penny warrants can give lenders a larger return on an ultimate sale, increasing willingness to hold credit positions past the expected sale window. Pricing warrants into returns, up to 25-30% of overall return in some cases, can also help justify a lower interest rate. Of course, not all businesses will be well suited for warrant investments. The ideal business for this approach is likely a mature business able to service material debt but still in a relatively rapid growth stage with material upside to be captured.
Despite these benefits and a recent rise in press coverage, warrants still remain relatively uncommon. A few factors drive this. Many sponsors don't want to give up equity returns that drive their own bottom line (especially if those returns are already shared with rollover investors as is often the case). In addition, lenders have been able to find structures that enhance their returns within conventional debt structures. Warrants represent a handy gadget in the lender toolkit and are likely to see more use during high rate environments but are unlikely in the near term to represent a primary financing for most lenders.
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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
