A wind of change is blowing through the leveraged finance market.
The turmoil sweeping the markets is putting pressure on corporate borrowers who have taken on high levels of floating rate debt in recent years. As rates rise, they will face higher interest costs and pressure on cash flow, a sharp reversal after years of cheap borrowing.
As companies benefited from higher valuations and relatively easy lending terms, the pendulum is swinging and debt investors are becoming cautious about borrowers’ ability to repay their loans in the face of deteriorating economic conditions.
The change led to a slowdown in the issuance of new loans in the private debt market, as well as tighter covenants and higher borrowing costs, several investors said.
Even as lenders face more uncertainty, some are looking to take advantage of the new situation, which should lead to more deals offering higher spreads, investor-friendly structures and a potential resumption of trading. private debt for companies not supported by sponsors.
“What happened at the macro level made the syndicated loan market very difficult to navigate, and we saw very little activity on the syndicated side. [in recent weeks]because of the difficulty in pricing transactions,” said Jake Mincemoyer, head of US leveraged finance at Allen & Overy. had fewer transactions to fund.”
US companies issued $132.7 billion in leveraged loans this year through May 18, while in the first quarter of 2021 alone, leveraged loans totaled more than $167.8 billion, according to Leveraged Commentary & Data.
Other investors said they still see a pipeline full of pending deals as cash-rich private investors take advantage of lower valuations to make new acquisitions. Even so, these investors acknowledged that borrowers’ cash flows will come under pressure in the coming months, which could affect their ability to meet debt repayments.
As market dynamics have changed in recent weeks, policy rates have risen. The three-month Libor rose above 1.5% on May 19, the highest since March 2020. The Secured Overnight Funding Rate, or SOFR, also hovered around a two-year high over the past two last weeks.
As the Federal Reserve raises interest rates, borrowers will bear the brunt of the rising cost of capital, especially companies in sectors such as consumer products, media and entertainment, where it has traditionally been difficult to pass the costs on to customers, said Ramki Muthukrishnan, who leads the United States. leveraged finance team for S&P Global Ratings.
Meanwhile, inflationary pressures are likely to persist for some time, crushing businesses in cyclical sectors.
Last-12-month EBITDA growth reported by speculative-grade companies in North America has slowed across most sectors since the third quarter of 2021 and will continue to slow this year, said S&P analyst Hanna Zhang.
Some analysts predict a slight increase in the number of corporate borrowers defaulting on their debts.
Default rates among high-risk companies could reach 3% for the 12 months ending in March 2023, compared to a default rate of 1.4% through March 2022, according to S&P’s latest debt outlook. speculative grade business. Even with this increase, however, the rate would still be lower than some previous downturns such as the 2008 financial crisis, when the rate soared into the double digits.
Higher debt load
As corporate valuations have climbed in recent years, private equity buyout firms have been able to load their acquisition targets with more debt. While the debt-to-equity ratio has remained stable in many cases, the higher absolute amount of debt is likely to put additional pressure on highly indebted borrowers when the debt becomes more expensive to repay, Chris said. Lund, Managing Director and Portfolio Manager. at Monroe Capital.
“There could be a double whammy of rising interest charges at the same time as inflationary pressures put pressure on margins,” Lund said. “While higher interest charges should lead to higher credit yields, lenders need to be above their existing agreements and ensure borrowers are able to generate adequate cash flow.”
Lund added that if the economy weakens further, the pendulum could swing further in favor of lenders. Bond investors will see more opportunities in less active areas when valuations are high, such as deals that don’t involve a PE sponsor.
“In a recessionary environment, private equity firms may focus more on existing portfolio companies and less on acquiring new platforms,” he said. “In our historical experience, in more volatile markets, we see an increase in the flow of attractive non-sponsor-backed deals, which typically offer higher returns than sponsor-backed deals, because this market is less competitive and the Direct lenders can typically raise equity through warrants or co-investment opportunities on senior secured positions.”
Monroe Capital, a private debt-focused asset manager with approximately $14 billion in assets under management, currently invests 80-90% of its direct lending portfolio in loans that support fund buyouts. investment capital. But Lund said the company’s unsponsored deals are likely to increase if the current volatility leads to a slowdown in mergers and general capital markets activity.
In recent weeks, some private lenders have negotiated a higher risk premium and reduced so-called covenant-lite, or borrower-friendly, transactions in the middle market, according to Marcel Schindler, who heads the debt business. private at StepStone.
“We’ve recently seen prices adjust, which means the spread that investors demand to hold private loans over the risk-free rate has increased,” Schindler said. “We also saw, in a few transactions, people reconsidering the valuation and becoming more cautious about EBITDA adjustments.”
It may be too early to tell whether these adjustments to deals signal a broader shift in the market for private debt deals, Schindler added, but if market turmoil persists, lenders may use their increased bargaining power to demand better prices and more protective terms.
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