Opinion Mid-market

Randy Schwimmer

More than anytime over the past four decades, the impact of rampant inflation on capital markets and private credit, and the Fed’s response with rate hikes and quantitative tightening, deserves special attention.

Structures and pricing became more friendly to issuers as arrangers competed for lead deals. Term erosions were rationalised because elevated purchase price multiples offered greater cash equity cushions below the debt. Covid threatened this momentum, but the Fed’s liquidity rescue quickly restored it. That, combined with supply chain challenges, created headline consumer price index levels not seen in 40 years.

Investors have translated this to greater recession and default risk, with retail cash departing both bond and loan mutual funds on a massive scale. Thanks to quantitative tightening, liquidity is also retreating from the banking system. Bank reserves are projected to be drawn down from $3 trillion to $2 trillion, restricting corporate and wholesale lending.

Direct lenders have built up record levels of dry powder, but they have also have been investing at breakneck pace. The dislocation in broadly syndicated loans has pushed issuers to private markets for credit solutions. But in a world shifting from abundance to scarcity, experienced credit managers are becoming more judicious about deploying their remaining capacity.

As Sofr soars from near zero a year ago to 4%, lenders are seeing shrinking interest coverage ratios on highly leveraged deals. But that dynamic has lowered leverage and enhanced all-in yields for primary senior debt issuance. Meanwhile, terms generally have tightened in favour of credit investors, a marked shift from most of the past decade. Nevertheless, fund managers are cautious about new allocations, thanks to public market volatility and concerns around a slowing economy. Ironically, the better prospects for floating rate assets lead some to wait for even better returns down the road. But that ignores the opportunity cost. New public credit issuance is offline, leaving a secondary market that’s been pretty well picked over.

Private credit deal flow has certainly slowed, as recession worries make past purchase price multiples look overvalued. But private equity sponsors are still flush with LP cash. Middle market buyout financings continue to move through the pipeline at a steady clip. Add-on acquisitions further improve deal supply. Yes, new opportunities are being scrutinised carefully. Cyclical sectors, or businesses with high capex, are less likely to make the cut. That’s all to the benefit of the investor.

Beyond better pricing and terms, direct lenders have pared back their hold levels by half, and underwriting commitments are off sharply. Without more visibility on inflation, rates and the economy, general partners are reluctant to get stuck without a clearing price for the loans. Sponsors are adapting by clubbing more transactions among a smaller group of trusted relationship players, rather than relying on one lead for the entire piece.

Relationships matter

Higher all-in borrower costs are also pressuring PE firms to push the envelope on most favoured nation clauses. These credit agreement covenants protect lenders from issuers obtaining new debt on more favourable (for example, higher spread) terms without treating existing lenders to the same terms, subject to certain baskets.

Another tactic is to expand delayed draw term loans to fund acquisitions. As rates escalate, locking in today’s spreads will no doubt be cheaper than waiting for what tomorrow brings.