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!

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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.

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