Debt Download

Welcome to Debt Download, Goodwin's monthly newsletter covering what you need to know in the leveraged finance market. With private and broadly syndicated lenders squaring off and M&A eyeing a dramatic return, this is the summer blockbuster for you!

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In the News

• New issue volume of broadly syndicated loans (BSLs) ticked down slightly in June, with a corresponding spread increase, according to Covenant Review. Priced new-issue volume net of associated repayments was $19.3 billion for the month, down from $20.5 billion in May. The average all-in clearing spread for single-B loans rose to S+365 (S+355/99.7 OID), from S+359 (S+354/99.8 OID) in May, which was a 52-month low. Price flex remained strongly in favor of borrowers, with 39 loans tightened during syndication against only one loosened, doubling last month's 19.3:1 ratio. The first half of the year also saw gains in proceeds deployed outside of refinancing and repricing: M&A volume reached $49.3 billion, well up from the first half of 2023's $24.1 billion and the highest six-month total since April-September 2022. Dividends accounted for $28.9 billion, up from $5.7 billion last year and a 28-month high. Even with those increases, M&A and dividends comprised only 11% of total BSL volume, from 21% last year (noting, however, that volume is way up this year). Deal activity has been growing at a record pace, reaching $736 billion through June, compared with $141 billion for the same period in 2023, with repricing accounting for 52% of this year's total. The trailing 12-month dual-track default rate for syndicated loans dipped slightly in June to 4.31%, from 4.35% in May. The dual-track includes out-of-court liability management transactions (LMTs) in addition to payment defaults. The straight payment default by volume was 0.92% and by issuer was 1.55%.
• One casualty of these robust repricing transactions has been junior debt, with $7.6 billion in second-lien (2L) tranches paid off year-to-date through June 21. In fact, lenders have entirely given up their spread premium for lending into loan-only structures, as opposed to those that also include junior debt cushions, such as 2L. Over the last 10 years loan-only term loan B deals had a 40 bps premium; in 2023 it was 20 bps; this year it's gone. Another sign of the mismatch between strong investor demand with limited supply is that for the first time since 2021 the volume of new leveraged loans in the Americas, at $1.05 trillion, overtook investment grade. In fact, volume of leveraged loans in the first half of the year nearly matches that for all of 2023 ($1.16 trillion).
• With the BSL market accounting for the "lion's share of refinancing volume," private markets have been fighting back on price and with "creative wizardry," such as payment in kind (PIK) and net asset value (NAV) loans—in addition to muscling into territory traditionally dominated by BSLs.
  • On pricing, private lenders became more aggressive in Q2,according to PitchBook. The previously common higher spreads of S+600 became rare in the first half, with well-positioned borrowers obtaining "eyewatering" savings of 300 bps, and easily winning more modest savings of 175 to 250 bps, with most of the savings squeezed out of 2L and unitranche deals.
  • Wizardry or not, NAV and PIK—areas of comparative advantage for private lenders—are coming under criticism. While PIK "is becoming more popular by the day," some analysts voice a concern that it can cause a borrower's debt "to snowball to a size that eats into the equity of the business," at which point liability management transactions become tempting, putting even senior debt at risk. (Or, if you can't relate to a snowball simile right now, "PIKs are like a Pacman that eats away at the equity.") Nevertheless, recent use of PIK has become even more pervasive, including its appearance in senior debt and at the holding company level. PIK interest rates have also soared, to 9.0% in Q1 compared with 6.8% in 2020 and 3.6% in 2019, raising concerns by some that PIK is masking potential defaults that will have to be addressed eventually. Similarly, according to KKR's cohead of global private equity, NAV is "just additional leverage and if things go against you, you have a problem." Whatever the impetus, certain private equity firms have "sharply curtailed" their use of NAV loans, with their use plummeting by 90% in the second half of 2023. This came on the heels of strong pushback from their institutional investors, and the pullback is expected to continue as M&A picks up (see below).
  • Finally, private lenders are trying to expand into BSL turf, including investment grade and rated facilities and funding for ESG goals, according to recent reports. A white paper by Apollo estimates the "total addressable market" for private credit may be as high as $40 trillion (the private debt market is now valued around $1.7 trillion assets under management), according to LCD. Most of the potential value here is in investment grade paper, and includes debt products such as music royalties, auto loans, residential mortgages, franchise finance and infrastructure debt. This effort is contingent upon establishing credit ratings, a costly and time-consuming process that private lenders have avoided. A streamlined version of this may be in using lenders' own internal risk ratings, something that Citigroup is currently working on to make private debt "more of a syndicated market," according to IFR. Another area of potential growth is in funding for ESG, according to Bloomberg Law. Private credit funds deployed 16% of the $156 billion raised in 2023 toward ESG.
• Quick roundup of recent new direct lender debt funds and related news:
  • Stifel, Lord Abbett Form Latest Private Credit Partnership (Bloomberg Law)
  • MidOcean Partners raises $765m for opportunistic credit fund (Private Debt Investor)
  • HPS closes fund with $21.1bn of investable capital (Private Debt Investor)
  • Marathon Asset Management, Webster Bank partner on private credit (Leveraged Commentary & Data)
  • Pemberton secures $1bn for NAV finance first close (Private Debt Investor)
  • Calstrs Puts $200 Million Into Private-Credit Venture (Wall Street Journal)
  • Blue Owl acquires Atalaya for ABF expansion in $450M deal (Leveraged Commentary & Data)
  • Oak Hill, OneIM Strike $5 Billion Private Credit Partnership (Bloomberg Law)
• Private and BSL lenders are hoping to carry their ongoing competition into new-money issuances, which may be on the table after earnings reports from Wall Street banks teased a resumption of deal activity. JPMorgan Chase, Citigroup,Goldman Sachs, Morgan Stanley and Wells Fargo all reported very large gains in investment banking fees and expect lower base rates to bring in a wave of M&A activity. In fact, the last week of June saw $30 billion in M&A activity, "raising hopes for a recovery in mergers and acquisitions." Overall M&A deal activity is well behind the 10-year average, according to Bloomberg Law, but up 14% through the first half of the year. And the second half appears promising, as sponsors have already started "early work on transactions," with $44 billion of BSLs having been priced through May 16, well ahead of last year's pace, according to PitchBook. The private credit markets tracked BSLs in the first half of the year, with a "steady increase" of M&A driving this activity, according to Debtwire. Finally, volume of M&A-related loans has been steadily growing in Europe, reaching €6.1 billion in June, from €3.1 billion in May and €1.8 billion in April. LBOs accounted for €6.4 billion in Q2, the highest tally since Q1 2022. British companies represent the majority of M&A targets in Europe.
• Ahead of any gains in M&A activity, creditors have a "renewed focus" in tightening their documentation against unwanted LMTs. They may have a way to go, as covenants in BSL documentation loosened slightly in Q2, according to Covenant Review. This largely reflects lenders' accommodations to lure highly desirable new-money issue, in addition to the refinancing of debt facilities governed by older, more protective documentation. These conditions are expected to continue through Q3. Digging into the details, Covenant Review has provided a Q2 breakdown of specific blockers:
  • a Serta blocker—i.e., those that require unanimity for certain sacred rights consents—accounts for 54% of all the Credit Suisse Leveraged Loan Index;
  • the PetSmart/Chewy loophole—i.e., the automatic release of guarantees for excluded (i.e., non-wholly-owned) subsidiaries—is found in 85.4% of the index;
  • the J. Crew "trapdoor"—the pass-through investment basket—is fairly tightened up at this point, found in only 6.6% of the index; and
  • the Envision loophole—a complex of investment allowances—is found in 17.2% of the index.

Goodwin Insights – Considerations for Interest Rate Swap Arrangements

As a result of the higher-for-longer interest rates and uncertainty over when the Fed will reduce them, more companies are taking advantage of interest-rate swaps to protect against interest-rate risk and reduce debt costs. Companies use these products to lock in fixed rates on their floating-rate debt, such as term loans or revolving lines of credit, which can result in significant savings on interest expense over time. In this edition of Debt Download, Goodwin partner John Servidio highlights key issues and outlines important negotiation points for companies to consider when creating a hedging program to mitigate interest-rate risks in today's financing environment.

Prior to engaging in any over-the-counter (OTC) derivatives transactions, a company must review its credit documentation, obtain necessary authorizations, negotiate trading relationship agreements with its bank and dealer counterparties, and understand the accounting treatment for the proposed hedging transaction. It is critical to analyze the relevant trading, documentation, credit and operational risks raised when evaluating a hedging program using OTC derivatives and consult with internal and external counsel and other professional advisors.

Before executing an OTC derivatives transaction, a company must first ensure the necessary authorizations and internal approvals are in place. In general, the necessary approvals for a corporation will consist of resolutions by the board of directors or an appropriate sub-committee of the board, such as the risk management committee. The board (or sub-committee) generally must approve resolutions authorizing the company to use OTC derivatives for the purpose of hedging or mitigating its interest rate risk.

In addition, before negotiating any trading documentation, a company must determine whether it is subject to any existing contractual obligations or restrictions preventing entry into the specific contemplated derivatives transactions. Typically, a company's financing documentation will include negative covenants restricting the incurrence or existence of certain indebtedness and liens. Often the financing documentation also will contain a covenant limiting a company's ability to enter into derivatives transactions. Although most financing documents permit derivatives transactions for hedging purposes (as opposed to speculative purposes), it is important to review for any more specific restrictions, for example, language:

• Permitting only hedging of particular risks.
• Limiting the maximum amount of indebtedness permitted to be incurred in connection with hedging transactions.
• Permitting only use of particular transaction types for hedging transactions.

If the company's obligations to its swap dealer counterparty under the ISDA Master are secured and/or guaranteed, as is often the case, the company also must consider whether the relevant credit documentation contains any restrictions on the providers of such derivatives. For example, some credit agreements may limit the company's granting of security to:

• Hedges with prescribed bank counterparties (usually the lenders under the credit documentation or their affiliates).
• Hedge counterparties with minimum credit ratings.
• Instances in which notice to or prior approval of the intended hedge counterparty has been obtained (for example, from the administrative agent under the credit documentation).

For other considerations and specific negotiating tips, you can refer to this full article written byJohn Servidio.

In Case You Missed It – Check out these other recent Goodwin publications: 10 Considerations for Fintechs Partnering with Community Banks; Bankruptcy Court Rejects Settlement "Lockup" Provision; CFPB Issues New Rule on Use of Artificial Intelligence Models in Mortgage Lending; U.S. Supreme Court Significantly Curtails SEC Enforcement Forum Discretion; A Look Ahead in Life Sciences: What We Are Tracking in the Third Quarter of 2024 and Beyond; The U.S. Department Of Labor's New Definition of Fiduciary Investment Advice Is Finalized (Again)

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.