Welcome to Debt Download, Goodwin's monthly newsletter covering what you need to know in the leveraged finance market. We hope your year is off to a good start!
Note: Some of the links in this newsletter may redirect you to a subscription-only resource.
In the News
- 2022 was a volatile year for various markets, including historic losses in the U.S. bond market and a
punishing year for equities. Covenant
Review's U.S. Loans 2022 Wrap-Up, aptly named "A Tale
of Two Markets", provides a great recap of trends in the
leveraged loan market. In sum, the year started off with strong
volume and borrower-friendly loan agreement provisions, but took a
quick turn given macro-economic and geopolitical headwinds and
ended with an increased number of liability management
transactions, a general decline of aggressive credit agreement
baskets and flexibility for borrowers, and continued fights between
borrowers and lenders over credit spread adjustments (CSAs) in
LIBOR to SOFR transition amendments (more on that below).
Debtwire's LevFin Highlights for FY22 provides a
breakdown of the drivers behind the year-over-year plummeting
volume in the U.S. and European debt markets. Despite the market
downturn, it's still worth noting that while M&A volume in
2022 paled in comparison to 2021 – a year that some view as a
high-water mark – it was still in line with pre-2021 volume and amend-and-extend volume hit new highs in 2022
as borrowers sought to push out loans maturing in 2023 and
2024.
- PitchBook/LCD's Quarterly Review notes
that, due to an uptick in refinancing activity, 4Q22 saw an
overall increase in leveraged loan issuance, though the volume of
loans backing M&A deals was at its lowest level since 2010 and
PE-backed issuance was at its lowest level since 2009. In the
syndicated loan market, pricing flex favored borrowers 14 cuts to no
increases in December and, although covenant flex was limited,
terms were generally tighter in the deals that cleared. December
also saw average all-in clearing spreads for single-B new
issuances widen slightly to S+593 (from S+582 in November, a
seven-month low).
- As we highlighted in our December Debt Download, Wall Street
banks had a tough 2022 as the credit markets dried up, forcing them
to hold large portions of would-be syndicated debt on their books
and in some cases, to ultimately sell it at huge discounts.
Relatedly,
Bloomberg estimates that banks are still holding around $40 billion
of hung debt on their balance sheets. Regulators are taking
notice – the European Central Bank has raised Deutsche Bank's capital requirements
due to the risk of leveraged loans on its books. Meanwhile,
traditional money-center banks are taking a hit to their profits due to their pullback from
underwriting deals in the leveraged finance space, which
historically has generated lucrative fees, and are bracing for additional loan losses.
- The new year brings lots of speculation about what's to
come in the debt markets (see below for Goodwin's predictions).
Respondents to the LCD Leveraged Finance Survey expect high-yield
bonds to outperform leveraged loans, and while it is anticipated
that the loan index has not yet hit cycle lows, the loan default
rate will continue to remain below historical averages. M&A is eventually expected to pick up in
2023 even though most of the economists at large financial
institutions predict a recession in 2023. Institutional and
retail investors are likewise turning bullish on bonds, at least in the
near-term as a hedge against projected continued declines in
equities. In the meantime, ample dry powder will allow private credit funds and PE
more generally to continue to transact, though credit funds are
being more selective in choosing investments and PE firms may need
to be more creative to fund their investments. For example, PE investors are increasingly taking minority
stakes in portfolio companies with the goal of becoming the
control investor when debt is not as expensive. Further, private
credit lenders are pulling back from new platform deals in the
current market and focusing on amend-and-extends and PIK options
rather than new deals with higher interest that may put borrowers
in default. The deals that are still getting completed have been at
lower leverage multiples and with higher pricing and tougher
covenants. Meanwhile, the WSJ spotlights Sixth Street as stepping in
to lead some of the more recent large LBOs, showing that the
opportunity to fill in the gaps may attract certain private credit
funds (especially with the current market's higher yields).
Still, there are signs that the syndicated slump will not be
long-lasting, as Antares, a traditional private credit lender,
steps into broadly syndicated loans. Interestingly, is this a
sign of possible further convergence between the broadly syndicated
and direct lending markets where traditional banks are also
establishing private credit arms to compete with direct
lenders?
- The WSJ analyzed the impact of interest rate increases in the past year
by asset class and included sections on syndicated loans and
private credit – interestingly, while syndicated loan
volume was down from 2021, private credit volume was up from 2021
(in each case, through Dec. 12th). Moreover, LCD anticipates that private credit will continue
to take a larger market share (and yield) in 2023. Meanwhile,
all eyes are on the Fed (and how the markets are reacting to the Fed)
as it continues to signal rate increases to combat inflation,
though perhaps at a slightly less aggressive pace as compared to
last year. Most outlooks predict the Fed will raise interest rates
in the first quarter and, if signs of inflation have sufficiently
eased, begin cutting rates in the third or fourth quarter.
Relatedly, Fintech has been hit particularly hard by the rate
increases since such firms rely on the ability to arbitrage
debt raised on favorable terms in order to then make loans to
consumers.
- Given the rapid increase in interest rates since early 2022,
borrowers are eager to reduce interest expense where possible,
including by seeking transitions of LIBOR interest rates to Term
SOFR with no (or low) CSAs. As the deadline for transitioning away
from LIBOR fast approaches (USD LIBOR will be phased out in June
2023) and amendments regarding transitions pick up pace,
lenders are increasingly objecting to borrowers requesting an
amendment switching from LIBOR to Term SOFR without a CSA
(including in the context of so called "negative consent"
amendments). Collateralized Loan Obligations (CLOs) make up a large
portion of the ultimate holders of syndicated loans and investors
in CLOs have been putting pressure on CLO managers to vote to block
amendments transitioning to Term SOFR if no CSA is
included.
- Dividend recaps are being criticized in the news
again as the proposed Albertson's pre-sale $4 billion
dividend is put under scrutiny, though this week the Washington Supreme Court declined to hear the case
challenging the dividend and therefore paved the way for its
payment (although the company is public, Cerberus owns
approximately 30% of the company).
- Quick roundup of recent new direct lender debt funds (and related updates):
Goodwin Insights
For the first edition of Debt Download in 2023, we wanted to highlight the Goodwin U.S. Debt Finance team's predictions for the coming year in leveraged finance. Here is a list of what we are expecting:
- Private credit will continue to be the overwhelming source of
capital over broadly syndicated debt for LBOs until interest rates
level off and the pricing flex built into broadly syndicated debt
narrows and stabilizes. As private credit lenders look for ways to
minimize risk in this choppy market, their check sizes will
continue to be smaller than those provided in early 2022, which
means more private credit lenders clubbing together for sponsors
for larger LBOs.
- Venture debt will continue to be an attractive option for
companies as they prefer higher-priced debt versus doing a down
equity round as a source of capital.
- Sponsors will continue to tap into (and obtain) fund-level
credit facilities in order to bridge financing and in some cases
provide additional leverage for acquisitions until pricing for LBO
loans stabilizes and becomes more predictable. Various types of
fund lines (in addition to the typical capital call loan
facilities) will continue to be considered more frequently by
sponsors, including NAV loans.
- Amend-and-extends for shorter maturities will continue to gain
steam for companies with loans where the debt will become current
in 2023. Companies will prefer to pay fees upfront in hopes that
interest rates will decline and the market will loosen in a year or
two instead of paying for higher priced long-term refinancing
options.
- Royalty financings and other structured products will continue
to remain hot in the life sciences space, and documentation and
intercreditor arrangements will continue to increase in
sophistication.
- Term Loan A structures will continue to be a popular option
among borrowers, who are increasingly turning to relationship banks
in light of market conditions.
- PE-backed companies with delayed draw term loan commitments
locked in during the first part of 2022 at lower pricing levels
will be aggressive in looking for ways to utilize these commitments
with add-on acquisitions and other investments before their
commitment period expires during the course of 2023.
- Companies will continue to look for ways to increase revolver
sizes to provide greater runway.
- Lenders will become more likely to insist on the inclusion of a
minimum interest coverage or fixed charge coverage ratio (FCCR),
particularly for companies lenders perceive to be a credit risk, as
SOFR and interest rate margins continue to climb.
- Distressed companies will continue to consider liability management transactions notwithstanding potentially adverse court rulings.
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.