Is the Sky Falling?
2022 has been a tumultuous year for the debt capital markets as rampant inflation, recessionary fears, lingering supply chain issues, and the war in Ukraine have driven an aggressive quantitative tightening program by the Fed. These issues have had a severe impact on the high yield and broadly syndicated debt markets, which have largely seized up, as evidenced by broadly syndicated loan volume sliding 47% from Q2 2022 to Q3 2022. This market dislocation has had a major impact on Wall Street, with the largest banks having ~$42 billion in buyout debt stuck on their books (1), driving significant mark-to-market losses.
While the broadly syndicated debt markets have backed up, direct lenders have stepped up to fill the void for middle-market borrowers. In Q3 2022, direct lending volume increased 17% over Q2 2022, with the ratio of direct lending to syndicated middle market loan volume having increased to 4.3 times, an all-time high. Despite the headlines, overall loan volume (broadly syndicated and direct) has kept pace with historical averages, but the more lopsided supply of debt capital has led to tighter structures and higher spreads. So, while borrowers bemoan the more restrictive environment, the reality is that loan volume to support LBOs is there.
However, current market conditions have led to a somewhat “risk-off” approach as lenders are driving higher pricing and slightly lower leverage across the entire credit market. While stream rates have increased by 50-150bps, the real change in interest costs has been the precipitous rise in the secured overnight financing rate (“SOFR”), which has increased from .05% in January 2022 to 3.8% in December 2022 (2). With the minor spread increase, one might hypothesize that leverage must certainly come down, however, when you look at leverage, you will note that senior and total leverage have remained in-line with historic leverage levels.
With pricing up, leverage down slightly, and the continued dislocation of the broadly syndicated/high-yield debt markets, the natural question is, how long can direct lenders support middle-market LBO activity? At what point do direct lenders run out of dry powder to support LBO activity?
According to Pitchbook, middle-market direct lenders have more than ample dry powder to support the market. What is interesting and different from past liquidity crunches is that direct lenders are no longer overly reliant on public BDCs to support liquidity. Although public BDCs are part of a direct lender’s funding mechanism, funding sources have shifted and are comprised of capital provided directly by L.P. (endowments, pension funds, etc.), which provides a more stable capital base which allows lenders to behave more predictably.
Looking Ahead to 2023
Our prediction for 2023 is predicated on the assumption that the macroeconomy will continue to bump along as it has for the past nine months. We anticipate the debt markets will continue to behave in much the same way as they have for the past four months. Direct lenders will continue to step up and fill the void left by the lack of capital in the high-yield and broadly syndicated debt markets, with pricing expected to hover around SOFR + 7.00% for down-the-middle unitranche credits.
Leverage will be available to support LBOs, however, as we saw during the second half of 2022, the credit bar will remain high, and lenders will continue to require 50% equity (cash equity + management rollover) when executing new LBOs. Historically, borrowers were able to fund buyouts with 60-65% debt, however, we believe that the 50%/50% capitalization is here to stay, and borrowers will need to adjust to this new reality.
This borrowing environment will obviously be welcomed by the lending community, while borrowers will yearn for the issuer-friendly structures of 2021. In the past, when money was cheaper and more flexible, PE-backed strategics could easily upsize their credit facilities to fund acquisitions. During Q4 2022, PE-backed strategics were more discerning when evaluating add-on acquisitions, which was largely driven by the more lender-friendly debt packages that showed up in late 2022. Borrowers did not want to open their pre-2022 loan docs as pricing and general terms were more favorable then. This type of behavior results in a slightly less competitive environment for M&A deals, which in turn will impact EV multiples.
As we head into 2023, dividend recapitalizations and opportunistic refinancings will be few and far between, which will lead to fewer transactions for lenders to put money to work. We anticipate the muted deal flow will eventually lead lenders to compete for the limited number of deals that are in the market. You must remember, loan originators are paid to put money to work, and by June of 2023, we anticipate lenders will finally blink and investment committees will begin to loosen structure and pricing to win financing mandates. By the summer, unitranche credits will issue in the SOFR+ 6.00% range and higher quality credits will receive pricing in the 500s again.
The sky isn’t falling, and the debt markets are still open, but this environment will take some getting used to over the next six months. But just like the gray skies that overtake the Midwest from November through April, by May (or sometimes even June), the sun will come out again and everything will be back to normal.
(1) Bloomberg; as of November 2022
(2) Federal Reserve Bank of New York