Welcome to Debt Download, Goodwin's monthly newsletter covering what you need to know in the leveraged finance market. Are the debt capital markets this summer as hot as the weather? Read on to find out!
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In the News
- Global loan activity during the first half of 2023 was down 28% year-over-year (the lowest since 2012), with refinancing activity accounting for almost 70% of total global volume and M&A financing accounting for only 10%. Although private credit lenders continued funding deals in the first half of year – with volume far outpacing broadly-syndicated loans – they generally took smaller hold sizes, sought tighter terms, had a decreased appetite for unfunded debt (including revolvers and DDTLs), and required higher costs for borrowers. Lenders are keeping an eye on falling interest-coverage ratios, distress within the healthcare and software sectors, and increasing downgrades. Meanwhile, with credit conditions continuing to tighten among rising interest rates and other economic pressures, borrowers favored high-yield bonds over leveraged loans for LBO financings in 2Q23, though issuers included attractive terms for bondholders by offering up collateral and agreeing to shorter average maturity (currently 6.1 years, compared to an average of 7.4 years over the last decade). Looking at the end of the quarter, the syndicated loan market saw some increased activity in June compared to May, with the average all-in clearing spread for single-B new issuances down slightly to S+510 (compared to S+519 in May). Looking forward, a large number of CLOs are nearing the end of their reinvestment periods which may result in less demand for buying new leveraged loans.
- However, the capital markets may be starting to show signs of life again. In other positive news for the broadly syndicated loan market generally, the SEC declined to file an amicus brief in the Kirschner case for which the Court of Appeals for the Second Circuit had requested the SEC’s view as to whether the Term Loan B at issue in the case was a “security” under SEC regulations. According to the LSTA, a “holding that Term Loan Bs are securities would have a devastating effect on the leveraged loan market, both in the short and long terms”.
- Global announced M&A activity is down approximately 37% in the first half of 2023 compared to the first half of 2022, with economic headwinds, regulatory uncertainty and inflation contributing to valuation mismatches between buyers and sellers. For the deals that closed last quarter, the average pro forma adjusted debt multiple decreased to 4.0x for syndicated leveraged loans backing M&A deals (down from 4.3x in 1Q23). Although PE funds are “pumping the brakes” on both deal activity and through slower exit rates, PE firms are still transacting, though the average size of such M&A deals are smaller and add-on activity constitutes a large portion of closed transactions so far this year. Meanwhile, PE funds are increasingly marking down the value of their portfolios as we head into the second half of the year. Interestingly, middle market M&A activity is faring better than large-cap M&A in the current credit cycle, reports PitchBook LCD.
- The loan default rate has been creeping up (143 bps since last year) and is approaching the 10-year average of 1.86%. Interestingly, sponsor-backed deals fared better than non-sponsored deals, with the former sitting at 1.49% and the latter at 2.42%. The six largest U.S. banks are expected to collectively write off $5 billion in defaulted loans for 2Q23. With 2020 and 2021 having a reputation as the “golden age for dividend recapitalizations”, it is not that surprising that borrowers are now struggling to service that extra debt on their balance sheets in an increased rate environment. Moody’s warns in a recent report that private credit loans, particularly loans issued in 2021, are facing challenges as macroeconomic pressures will lead to an increase in defaults and decrease in recoveries. In examining loans issued by Ares and Owl Rock, Moody’s found that interest coverage ratios may eventually decrease by about half. Relatedly, a report by Lincoln International also highlighted the “notable and worrying” declines in fixed charge coverage ratios (FCCRs), with a large percentage of companies having less than 1.0x FCCRs in 1Q23. Borrowers are increasingly seeking flexibility in how they service their debt, including through “pay-in-kind” features, otherwise known as PIK toggles, which give borrowers the option to capitalize interest that is due and owing by adding the amount to a loan’s outstanding principal rather than paying it in cash.
- The number of liability management transactions has increased as borrowers continue to look for flexibility to incur new “priming” debt in a rising interest rate environment. In addition, a new trend has emerged, which Reorg calls “double-dip” financings, where a new-money creditor establishes multiple independent claims against the organizational structure using looser restrictions on non-guarantor entities (and the ability of such entities to receive credit support from an existing guarantor group) that ultimately benefit participating creditors at the expense of other existing creditors, such as the transactions recently announced by At Home Group and Sabre Corporation. A stylized example of “double-dipping” – illustrated below – would be where a creditor provides new money to an unrestricted subsidiary of an OpCo (a borrower under the main “senior” credit facility), the proceeds of which the unrestricted subsidiary uses to make a secured intercompany loan to the OpCo’s parent (a guarantor under such “senior” credit facility), and in return the new money creditor receives both a pari passu secured guaranty from the OpCo – i.e., sharing in the collateral with the OpCo’s existing senior creditors (the first “dip”) and an indirect secured claim against the OpCo’s parent via a pledge by the unrestricted subsidiary of its rights in the receivables in respect of the intercompany loan to the parent guarantor (the second “dip”). Of course, the example assumes sufficient flexibility for the OpCo and its parent to incur such loans and liens under the OpCo’s “senior” credit agreement.
Goodwin Insights
The collapse of industry-leading bank Silicon Valley Bank (SVB) and difficulties at other venture lenders in early 2023 led to fewer loan transactions for emerging companies in the first half of the year. As we enter the second half of 2023, the volume of new loan originations does not appear to be returning to previous levels; nevertheless, the venture debt space remains active and continues to evolve.
In the aftermath of the SVB collapse, VC investors and their portfolio company borrowers have become more successful in negotiating carveouts to the standard requirement of bank lenders that borrowers maintain all of their deposits with the lending institution. Although spreading cash over two or more banks is beneficial for borrowers from a risk management perspective, it makes the overall financial relationship less lucrative for the lenders. As such, even though sourcing venture debt term sheets remains a viable option for many tech, life sciences and other emerging companies, prospective borrowers should expect to encounter tougher standards in the underwriting process than those from 2022 and an increase in pricing, including greater warrant coverage.
Meanwhile, a number of new venture debt lenders are entering, or are planning to enter, the market in an effort to take advantage of the uncertainty left in SVB’s wake. For example, Blackrock announced plans to purchase venture debt provider Kreos; Ares purchased a $3.5 billion loan portfolio from ailing PacWest; Hercules Capital launched Hercules Adviser, a private credit lender seeking to focus on venture and growth companies; and HSBC’s U.S. unit hired over 40 former SVB bankers and signaled a desire to become a leading venture debt lender. It remains to be seen whether these entrants will provide competitive terms or otherwise will be successful at filling SVB’s enormous shoes, but their eagerness for new business may at least translate to opportunities for emerging companies – who often find it challenging to engage the attention of established lenders – to obtain credit in the face of unprecedented challenges.
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