Welcome to Debt Download, Goodwin's monthly newsletter covering what you need to know in the leveraged finance market. Are the debt markets heating up as the mercury starts to drop? Read on to find out.
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In the News
- The loan market remained resilient in the third quarter of 2023, with September 2023 having the highest gross institutional loan volume since February 2022 (i.e., when the Federal Reserve started to raise benchmark interest rates and Russia invaded Ukraine), driven largely by opportunistic repayments, refinancings (including refinancings of large broadly syndicated loans (BSLs) with private credit, as discussed in more detail below), repricings, extensions and, to a lesser extent, M&A. Notwithstanding the robust loan volume overall, however, middle market loan volume was its lowest since the third quarter of 2020, at $23.6 billion, and, although September 2023 saw the highest new issue volume since early 2022, M&A-related volume on a year-to-date basis is at its lowest since 2010. Still, the loan market remained favorable to LBOs, particularly those with low leverage, with the average year-to-date pro forma adjusted debt multiples of such deals falling to 5.18x for BSLs to large corporate borrowers, the lowest levels since 2012. In addition, sponsors are providing higher equity contributions as a percentage of debt and equity capitalization, averaging over 50%, whereas the average equity contribution for ten years through 2021 was 41%. For BSLs, pricing flex continued to favor borrowers with 31 cuts to 5 increases and, as a result of competition among lenders, average loan spreads in the past four months have tightened about 100 bps, average original issue discount has tightened to 98 from 97, and average all-in clearing spreads for single-B new issuances decreased to a 22-month low of S+452 in September (down from S+484 in August). Loan default rates remain low, falling to 1.27% for the rolling twelve-month period, down almost 50 bps since July. Investors are expecting M&A-driven transactions in the fourth quarter of 2023 to remain relatively quiet given increased interest rates and 2024 recession concerns, anticipating fewer BSLs and more private credit transactions as a result of certainty of execution and absence of ratings requirements as well as the ability to provide alternative financing arrangements, such as payment-in-kind (PIK) features, as purportedly was offered to Carlyle Group in connection with its proposed buyout of Medtronic Plc.
- Private credit may now dominate the credit market, as highlighted in this recent Wall Street Journal article, with Moody's estimating that private credit funds have approximately $214 billion of dry powder in the U.S. and $450 billion globally to deploy. Moreover, PE sponsor portfolio companies are looking to private credit for more than just LBO financing; for the first three quarters of 2023, private credit funding for general corporate purposes was at 25% by deal count compared to 16% for the first three quarters of 2022, whereas funding for LBOs declined to 29% by deal count from 34% for the same periods. Portfolio companies also are seeking refinancing opportunities through private credit rather than traditional bank and institutional lenders to avoid defaults and bankruptcy filings, including KKR-owned PetVet, which is looking to refinance $3 billion of its debt with private credit, the latest in a trend of large private credit refinancings of broadly syndicated debt to address upcoming maturities. Although banks are reluctant to take on risky financings due to losses from 2022, including from the Citrix, Nielsen, Tenneco, Twitter and Brightspeed financings, they are slowly returning to the loan market, and their return will likely result in more competitive terms for stronger borrowers. Banks continue to tighten lending standards, however, notably based on concerns due to the effects of legislative changes, supervisory actions and changes in accounting standards.
- As further evidence of the rise in private credit, a recent American Investment Council report prepared by Ernst & Young notes that in 2022, private credit contributed 1.6 million jobs to the US economy, providing for $137 billion in wages and benefits and adding $224 billion toward GDP. In addition, although fundraising for private markets is down compared to 2022, debt funds are bucking the trend due to greater returns and many investors believe private credit will grow faster than private equity in the coming years.
- With interest rate increases and a slowing economy, however, there are increased concerns that private credit loans will fare worse in 2024 than traditional leveraged loans. Bank of America is predicting a default rate of 5% in 2024 for private credit loans and a default rate of only 3% for traditional broadly syndicated loans and other investors fear the default rate for private credit loans could be much higher. In addition, the Board of the International Organization of Securities Commissions (IOSCO) recently released a consultation entitled "Emerging Risks in Private Finance", in which it raised concerns that the higher leverage levels private credit supports, together with leverage at the fund level, could negatively impact the financial system as a whole. In addition, the Financial Stability Board has launched a probe to review potential risks from non-banks such as hedge funds and other private capital providers, with this Financial Times editorial noting that any fallout from private capital could have broad implications to the financial system more generally.
- As we covered in the September edition of Debt Download, PE firms have been increasingly turning to NAV loans for fund-level financings and some investors are becoming wary that the use of such facilities and margin loans to fund distributions to investors may mask the underlying financial performance of portfolio companies and interfere with LP/GP alignment. Moreover, some investors are concerned about PE firms using such loans to help pay down the debts of struggling portfolio companies. The Institutional Limited Partners Association is evaluating PE firms' borrowing strategies and drafting recommendations, calling on the industry to provide more information regarding the costs and risks of such financings to investors. Nevertheless, private credit providers anticipate growth in NAV financings in the coming years.
- Speaking of fund financing, PNC Bank and Goldman Sachs recently acquired portions of Signature Bank's portfolio of subscription credit lines from an FDIC-established bridge bank, with PNC acquiring $16.6 billion of commitments, of which $9 billion in loans is outstanding, and Goldman acquiring $15 billion of commitments, of which $9 billion in loans is outstanding.
- Liability management transactions remain a concern for lenders, and for the quarter ending September 30, 2023, over 60% of private equity-backed loans did not include "Serta" lender voting protections against priming debt and included the "Chewy" loophole allowing for automatic release of guaranties of non-wholly owned subsidiaries; however, more than 90% of such loans included protections against the "J. Crew" loophole, restricting transfers of intellectual property to unrestricted subsidiaries. As we explained in the July edition of Debt Download, "double-dip" financings, a new type of liability management transaction that provides lenders with a direct guaranty claim against the operating company and an indirect intercompany claim, are continuing to gain traction in the debt market and more public companies, in addition to PE-owned companies, are pursuing such transactions to boost liquidity.
- California has adopted the new Article 12 of the Uniform Commercial Code (UCC) covering digital assets and cryptocurrency. For a tracker on the latest updates for introduction and enactment in each state, see this ULC tracker (note that New York has introduced legislation to pass the new amendments but they have not yet been enacted).
- Quick roundup of recent new direct lender debt funds (and
related updates):
- Centerbridge Partners and Wells Fargo are teaming up to form Overland Advisors, a $5 billion BDC that will service non-sponsor-backed middle market companies and target investments between $50-$200 million.
- King Street closed a $2.3 billion fund seeking to make debt investments in distressed companies.
- T. Rowe Price and Oak Hill Advisors have launched the T. Rowe Price OHA Select Private Credit Fund, a $1.5 billion BDC that will invest at least 80% of its assets in private credit investments.
- Vista Credit Partners raised an initial $500 million for Vista Credit Strategic Lending Corp., its new BDC that will focus on investments in enterprise software, data and tech businesses.
- Crescent Capital Group launched Crescent Private Credit Income Corp., a BDC that will provide debt financing and make equity investments in companies with EBITDA between $35-$120 million.
- Arena Investors has launched Mercatus Finance, a new cash-flow lending specialty finance company, which will focus on providing loans between $20-$75 million to middle market and lower middle market companies.
- Apax Partners closed a $750 million private credit fund, which will target investments in technology, services, healthcare and internet/consumer businesses.
Goodwin Insights
Recent years have seen significant growth and innovation in the fund finance industry and, with an increase in the number and complexity of products in the market, it has become commonplace for industry publications and participants to refer to a "fund finance toolkit". In this Goodwin Insights article, we crack open the toolkit and provide a summary of some of the fund finance tools on which Goodwin commonly advises its clients. For more information, contact the authors of this article, or any of Goodwin's Fund Finance attorneys.
In Case You Missed It – Check out these recent Goodwin publications:
FDIC Proposes Guidelines for Corporate Governance and Risk Management; Delaware ABCs (Assignments for the Benefit of Creditors): No Longer as Easy as 1-2-3; DOJ Announces Safe Harbor Policy for M&A Self-Disclosures; Supreme Court to Decide Scope of Potential Liability Based on MD&A in Annual Reports; and FTC Sues Private Equity Firm Welsh Carson and U.S. Anesthesia Partners Over Alleged Anesthesiology "Roll-Up Scheme" in Texas.
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.