Credit Conditions | June 2024

Key Debt Market Trends

Interest Rates

• “Start your engines” has shifted to “hold your horses” as rates continue to remain “higher for longer.” Expectations have now shifted from March’s three rate cuts starting in June 2024 to only one rate cut in 2024 between September and December. Expectations for 2025 and beyond were also 0.25% higher than March projections (which were 0.25% higher than December projections). However, Federal Reserve Chairman Jerome Powell noted in his press conference that 15 of the 19 members were in favor of one or two rate cuts, so a second rate cut is still “plausible.” For the time being, though, “higher for longer” remains a game of “wait and see.”

Private Equity and M&A

• High interest rates have continued to dampen M&A activity. First-quarter middle-market dealmaking was flat to slightly up on a year-over-year basis according to PitchBook. However, market sentiment appears to be improving, with bankers seeing a first-quarter increase in pitch activity and sale process launches and lower-middle-market private credit lenders reporting increased M&A activity. Leverage in the broadly syndicated loan (BSL) market has also improved with M&A-driven loan deals seeing total leverage of 4.9x for the three months ended May 31, up from Q4 2023’s 4.1x.
• Private equity exits have been a mixed bag, with the number of exits increasing each quarter since Q1 2023, but with an aggregate value down 22% comparing the first quarters of 2023 and 2024 in part due to a continuing gap between buyer and seller valuations. With 40% of private equity portfolio companies being held for more than four years, some private equity funds have turned to dividend recapitalizations in order to return cash to investors. January to mid-April saw the highest volume of dividend recapitalizations in the broadly syndicated market since recordkeeping began in 2006, and January to mid-June similarly tied historical records over the same period.

Private Credit vs. BSL

• The BSL market surged in the first quarter of 2024, with both domestic loan activity and cross-border loan activity near levels last seen in the first quarter of 2021. The vast majority of these loans have involved opportunistic refinancing or repricing as borrowers seek to reduce the cost of expensive debt issued in the past two years or extend maturities to address upcoming maturity wall issues. Amend and extend transactions similarly increased, with average volume from September 2023 to April 2024 at 70% higher than the average over the preceding two-year period.
• Private credit has continued to dominate financing for leveraged buyout (LBO) transactions as compared to the BSL market but has also seen an increase in refinancings and repricings similar to the BSL market. The first half of 2024 saw double the amount of refinancings as compared to the same period last year. In comparison, private credit LBOs and other types of M&A financings have also risen by 19% and 51%, respectively, over the same period.
• Increasing activity in the BSL market has led to increased competition with the private credit market. The first four months of 2024 saw more private credit loans refinanced in the BSL market, flipping the 2023 trend. The increased competition has led to growing convergence between the two markets. Private credit has become more competitive on pricing by actively leveraging incumbency  and repricing existing deals to fend off refinancings by the BSL market, with average private credit pricing declining by 50 to 150 basis points and the gap between BSL and private credit markets narrowing by 100 basis points between 2023 and 2024. The BSL market has also begun competing on structural flexibility, with some deals including delayed draw term loans and paid-in-kind (PIK) interest, which historically were selling points for private credit financings. Private credit, however, continues to compete on other terms, including the traditional selling points of lower execution risk and higher certainty of loan terms (as compared to the BSL market), no ratings requirements, fewer lenders to negotiate with in the future, and availability of recurring revenue loans, as well as newer terms. Some of the more recent terms include increased leverage and fewer capped EBITDA add-backs, additional PIK interest via synthetic PIK (i.e., interest paid via a delayed draw term loan facility), availability of covenant-lite loans (which historically were a selling point of the BSL market), and preemptive amendments ahead of covenant defaults.
• Private credit has continued to expand beyond its traditional bread and butter of middle-market private equity borrowers. Some private credit funds have begun seeking smaller nonsponsored deals for higher returns and more lender-favorable documentation. Larger private credit funds have begun expanding into various forms of alternative asset-backed debt from the traditional asset-based revolving loans and asset-backed term loans to newer asset classes such as aircraft financing, infrastructure loans, commercial real estate financing, equipment leasing, trade finance, royalty financing, student loans and consumer installment loans.

Blurring Lines

• Private credit and bank financing are further converging as banks have begun partnering with existing private credit lenders or launching their own private credit initiatives. Part of the appeal for private credit has been access to nonsponsored borrower relationships and new asset-backed debt as an asset class, which previously were dominated by bank lenders. Banks have been seeking out private credit, in part, to source third-party funding since Basel III and other stricter bank regulations to which private credit lenders are subject are making it harder for banks to lend off their balance sheets. The partnerships also benefit both banks and private credit as dual-track deals showing a syndicated option, a private credit option and a hybrid option have gained traction with sponsors looking for optionality in the early stages of a financing transaction and are expected to become more important going forward.

Adjacent Structures

• Limited financing activity relative to dry powder, combined with the inherent difficulty in further financing certain over-levered structures, has led borrowers and lenders to explore a variety of financing types, from fund finance and NAV facilities to factoring facilities and even deeply structured instruments that share features of both debt and equity products. This increased complexity will need careful consideration from both a credit and a legal perspective, but the creative nature of this thinking lends heavily to private credit, which can show both terms and structuring flexibility to drive solutions.

Crossing Borders

• The growing trend of US institutions transacting in the European market, either from their US homes or from European offices, has continued across both private equity and private credit. This growing opportunity for lenders to follow their sponsor relationships has also led to an increased conflation across terms not seen quite so starkly since the advent of the Yankee Loan. In particular, Spain, Italy and other European markets that were considered more challenging for transactions – because of a banking monopoly, insolvency or applicable collateral regimes – are now ripe for investment, driving an increased tightening on terms and economics in what is already an increasingly hot market. As institutions become even more comfortable with navigating the regulatory landscapes, activity from US funds in Europe will likely continue to grow.

Diminishing Distress?

• Default rates appear to be moderating. Default rates in the BSL market on a trailing 12-month basis ending May 2024 fell to 4.29%, down by 0.22% since April 2024. The payment default rate over the same period similarly fell to 1.08%, down by 0.22% since April 2024, marking a 15-month low from the peak in July 2023 at 1.75%. However, concerns remain about the underlying health of borrowers’ balance sheets, as interest coverage ratios remain depressed. In addition, the increasing use of PIK interest may be depressing default rates, particularly in the private credit market. In any event, long-term relief will likely only come once underlying base rates begin to fall.

Key Debt Market Data on CreditSights

• Private Credit Pricing & Leverage Data (June 18, 2024)
• BSL Leverage Trends (June 10, 2024)
• BSL Documentation Trends (June 3, 2024)
• BSL Covenant Trends 1Q2024 (April 22, 2024)