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Private Debt


LENDERS FLEX THEIR POWER IN PRIVATE DEBT DEALS IN FACE OF GROWING MARKET RISKS

By Madeline Shi
May 25, 2022
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Winds of change are blowing through the leveraged finance market.

The turmoil sweeping markets is squeezing corporate borrowers that took on high
levels of floating-rate debt in recent years. As rates rise, they will face
higher interest expense and pressure on cash flows, a sharp reversal after years
of inexpensive borrowing.

While companies had been enjoying the fruits of higher valuations and relatively
easy lending terms, the pendulum is swinging and debt investors are turning
cautious about borrowers' ability to pay off loans in the face of souring
economic conditions. 

The shift has resulted in a slowdown in issuance of new loans in the private
debt market, along with stricter covenants and higher credit costs, several
investors said.

Even as lenders face more uncertainty, some are looking to capitalize on the new
situation, which is likely to lead to more deals that offer higher spreads,
investor-friendly structures and a potential pickup in private debt transactions
for non-sponsor-backed companies.

"What happened on the macro level has made the syndicated loan market very
difficult to navigate, and we have seen very little activity on the syndicated
side [in recent weeks], due to the difficulty to price deals," said Jake
Mincemoyer, head of US leveraged finance at Allen & Overy. "The direct lending
market has also slowed up a bit, as matching equity valuations has been
challenging on the M&A side and there have been fewer deals to finance."

US companies have issued $132.7 billion of leveraged loans this year through May
18, while in the first quarter of 2021 alone, leveraged lending totaled over
$167.8 billion, according to Leveraged Commentary & Data.

Other investors said they still see a pipeline stuffed with pending deals, as
cash-rich private investors are taking advantage of lower valuations to make new
acquisitions. Even so, these investors acknowledged that borrowers' cash flows
face pressure in the coming months, which could affect their ability to keep up
with debt payments.

As market dynamics have shifted in recent weeks, key lending rates have risen.
Three-month Libor topped 1.5% on May 19, the highest since March 2020. The
Secured Overnight Financing Rate, or SOFR, has also hovered around a two-year
high in the last two weeks.

As the Federal Reserve raises interest rates, borrowers will bear the brunt of
higher cost of capital, especially companies in industries like consumer
products and media and entertainment, where it's traditionally difficult to pass
along costs to customers, said Ramki Muthukrishnan, who heads the US corporate
leveraged finance team for S&P Global Ratings.

Meanwhile, inflationary pressures are expected to persist for some time,
squeezing companies in cyclical sectors.

Last-12-month EBITDA growth reported by speculative-grade companies in North
America has decelerated across most sectors since the third quarter of 2021, and
will continue to slow this year, said Hanna Zhang, an S&P analyst.

Some analysts have forecast a slight increase in corporate borrowers defaulting
on their debt obligations.

Default rates among higher-risk companies could reach 3% for the 12 months
ending March 2023, compared with the 1.4% default rate through March 2022,
according to S&P's most recent outlook for speculative-grade corporate debt.
Even with that increase, however, the rate would still be lower than in some
previous downturns such as the 2008 financial crisis, when the rate soared into
the double digits.


HIGHER DEBT LOADS


As company valuations climbed in recent years, private equity buyout firms were
able to load up their acquisition targets with more debt. While the ratio of
debt-to-equity has remained stable in many cases, the higher absolute quantity
of debt is likely to put additional pressure on highly leveraged borrowers when
debt becomes more expensive to service, said Chris Lund, a managing director and
portfolio manager at Monroe Capital.

"There could be a double whammy from higher interest expense at the same time
that inflationary pressures are resulting in margin pressures," Lund said.
"While higher interest expense should result in higher returns in credit,
lenders need to be on top of their existing deals and ensure that borrowers are
able to generate adequate cash flow."

Lund added that if the economy weakens further, the pendulum could swing more in
favor of lenders. Debt investors will see more opportunities in areas that are
less active when valuations are elevated, such as deals that don't involve a PE
sponsor.

"In a recessionary environment, PE firms may be more focused on existing
portfolio companies and less focused on making new platform acquisitions," he
said. "In our historical experience, in more volatile markets, we see an
increase in deal flow of attractive non-sponsor-backed transactions, which
typically offer higher returns than sponsor-backed deals as that market is less
competitive and direct lenders can typically get equity upside through warrants
or co-investment opportunities on senior secured positions."

Monroe Capital, a private debt-focused asset manager with about $14 billion in
AUM, currently invests 80% to 90% of its direct-lending portfolio in loans that
back corporate buyouts by PE funds. But Lund said the firm's non-sponsored deals
are likely to increase if the current volatility results in a slowdown in
mergers and general financial market activity.

Some private lenders in recent weeks have negotiated for a larger risk premium
and have curtailed so-called "covenant-lite," or borrower-friendly, deals in the
middle market, according to Marcel Schindler, who leads the private debt
business at StepStone.

"We have recently seen pricing being adjusted, which means the spread that
investors demand to hold private loans over risk-free rate has increased,"
Schindler said. "We also have seen, in a few transactions, people reconsider
valuation and grow more cautious about EBITDA adjustments."

It might be too early to say whether these adjustments to deals are indicative
of a broader change in the market for private debt deals, Schindler added, but
should market turmoil persist, lenders will be able to use their increased
bargaining power to demand better prices and more protective terms.

Featured image by tiero/Getty Images

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TAGS:

 * Private Equity,
 * Buyouts,
 * debt & lenders,
 * Private Debt


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