Credit Conditions | Q3 2024

Key Debt Market Trends

“Higher for Longer” Ends Not With a Whimper but a Bang

• The recent rate cut of 0.50% – the first rate cut since the Federal Reserve began raising rates in March 2022 – together with projections of another 50% rate cut before year-end marks the end of an era. It also represents a seismic shift from June 2024 when many expected that the Federal Reserve would only cut rates by 0.25% once this year in December. In contrast, the Federal Reserve now projects that the top target range for rates will fall an additional 1.50% (i.e., to a top rate of 3.50%) between now and the end of 2025, which is significantly faster than previously anticipated.
• The September 2024 rate cut shows that the Federal Reserve is shifting the focus of its dual mandate from fighting inflation to stabilizing the labor market as a result of cooling inflation and falling consumer prices. However, concerns remain that a recession may be right around the corner. So it remains too early to know if the Federal Reserve will be able to deliver a soft landing for the economy, even if that outcome looks more likely today.

A Private Equity/M&A Revival?

• Is the long anticipated M&A revival finally here? With an estimated $4.5 trillion of dry powder (or $9 trillion of buying power with leverage), private equity sponsors have the capital to deploy. Declining rates and a corresponding decrease in interest expense should ease some of the challenging math that deal financing faced during the “higher for longer” era. There is also already some evidence that the M&A market has already improved in 2024 with year-on-year increases in M&A and LBO deal value for Q1 of 2024 at 33% and 63%, respectively.
• Limited partner pressure may also spur M&A activity soon. With private equity exits at a five-year low, some limited partners have become focused on distributions on paid-in capital (in lieu of the more traditional internal rate of return benchmark) and have limited commitments to new funds until distributions (typically generated by the sale of portfolio companies) increase.
• On the other hand, it’s still too soon to tell if these trends will be enough to overcome the headwinds, chief of which is a persistent valuation gap between buyers and sellers that has hindered dealmaking since interest rates began to rise. Though there’s anecdotal evidence that some sellers are becoming more realistic about valuation as revenue growth expectations moderate, it does not appear to have become a broad trend yet. An overhang of portfolio companies purchased at high valuations in 2020 and 2021 may also slow M&A recovery as sponsors wait for valuations to return to historic levels to avoid selling at a loss. Additionally, sponsors who have seen negative trends in their own portfolio companies may be more skeptical when reviewing new opportunities, which could slow the pace of acquisitions in the near term.
  

Record-Setting Refinancings, Repricings, and Amend and Extend Transactions

• Refinancings, repricings, and amend and extend (A&E) transactions have set records in the broadly syndicated loan (BSL) market this year, each with the highest year to date through August on record. The volume this year through August has been so high that refinancings and A&E transactions are higher than all full year amounts on record (other than 2013 and 2017 with respect to refinancings). BSL repricing volume has similarly been so high this year that as of early September roughly 35% of the asset class had been repriced.

New Money Issuances Are Increasing

• While refinancings, repricings, and A&E transactions have dominated the market in 2024, the third quarter has seen the tide shift with a sizeable increase in new money issuances (i.e., loans not related to the refinancing or amendment of existing debt). After hitting lows of 25% in 2023, 18% in Q1 2024, and 13% in Q2 2024 (the lowest level since the great financial crisis), the first half of September saw new money issuances account for approximately 70% of total activity. M&A financing, typically a large driver of new money issuances, also saw similar increases with speculative-grade borrowers raising more loans for M&A transactions than refinancings in July for only the second time in the last 18 months.
• Dividend recapitalizations also contributed to the increase in new money issuances after largely disappearing last year. 2024 is on track to set records with $69.3 billion through September 24, placing it ahead of 2021 (the next best year on record, which was at $66.4 billion over the comparable period and ended at an all-time annual high of $76 billion). Notably, Belron, backed by Clayton, Dubilier & Rice; Hellman & Friedman; BlackRock; and GIC, announced the largest ever global dividend recap by transaction size at the end of September, which involved €8.1 billion of new debt, including a $4.69 billion and €2.05 billion cross-border Term Loan B financing, to fund a €4.357 billion shareholder dividend. With limited exit opportunities and a need to return cash to their investors, the appeal of dividend recapitalizations to private equity sponsors isn’t surprising. However, this year’s dividend recapitalizations have a different profile. Based on data collected through August 2024, the size of dividend recaps are at a six-year high (the median was $316.5 million) and priced at the lowest levels since at least 2010 (the average was 3.77%) though average pro forma leverage was markedly lower than the average from 2018 to 2022 at 4.7x as compared to 5.5x, respectively, reflecting a broader trend in public credit markets toward less risky and higher quality borrowers.

Private Credit and BSL Markets Continue To Compete

• The battle for market share between the BSL and private credit markets continued in Q3 of 2024 with private credit increasing its takeouts of the BSL market between Q2 and Q3 (after a spike in favor of the BSL market in Q1). Private credit has competed in part by reducing pricing spreads and increasing leverage, with spreads declining by 50 to 100 basis points or more compared to 2023 and leverage increasing by 0.75x or more compared to last year. Private credit has also differentiated itself from the BSL market with an increase in payment-in-kind (PIK) optionality at closing for high quality borrowers and an increase in the use of warrants or other equity kickers, particularly in the lower middle market on junior capital loans where borrowers are in a high-growth phase. However, if the macroeconomic picture stabilizes and volatility in the BSL market continues to decline, some borrowers may return to the BSL market in lieu of paying a premium for private credit’s lower execution risk. In the long run, expectations remain that the two markets will coexist and borrowers will continue considering both markets, so the competition and convergence between the two will also likely continue.

Private Credit’s Shifting Landscape

• Private credit continued growing in scale and scope this quarter. The largest private credit lenders saw record-breaking fundraising with Ares Management raising $34 billion, HPS Investment Partners raising $21 billion, and Goldman Sachs raising $20 billion for new private credit funds. The largest private credit lenders also began lending to investment-grade companies this quarter, pushing further into roles traditionally only available to banks. Consolidation also provided another avenue to scale with Blue Owl Capital agreeing to acquire Atalaya Capital Management to expand its asset-based lending capabilities and Clearlake Capital reaching a deal to acquire MV Credit to help it expand into the European market.
• New private credit and bank joint ventures also continued this quarter. Recent notable partnerships include Citibank partnering with Apollo and Mizuho partnering with Golub Capital. The common logic cited is that banks have relationships, but regulatory tightening has limited their ability to lend while private credit is seeking new sources to deploy its capital. So a joint venture provides private credit access to new clients without the need to hire staff to source new deals while banks can keep their existing relationships and continue providing ancillary services, such as working capital and cash management services. Similar logic has also lead some large banks that underwrite loans in the BSL market to look at buying private credit lenders outright since ownership provides the additional benefit of being able to provide a dual-track underwriting and private credit solution internally and avoid losing business to a competitor.
• This quarter also saw several global asset managers begin targeting retail investors for investments in private credit with BlackRock partnering with Partners Group, Apollo partnering with State Street, and KKR partnering with Capital Group. This shift appears to be in part driven by investor demand for access to private opportunities given the increasing shift away from bank lending and public listings. The asset class is expected to grow significantly with predictions that financial advisers will manage $3.6 trillion of alternative assets for their individual clients by 2028, up 50% from 2023’s $2.3 trillion.

Diminishing Distress but Lingering Concerns

• With reports of increasing interest coverage ratios for the first time since Q1 of 2022, expectations that Federal Reserve rate cutting will only improve those metrics, and bankruptcy and payment defaults declining to 0.78% (approximately 1% lower than their peak in July 2023), one could think that distress concerns were behind us. However, analysts have raised alarm bells that Pandora’s box may have been opened during the “higher for longer” era because of the increasing number of “liability management exercises” (LMEs), largely seen as a result of weak covenant protections for lenders and the increasing cost of bankruptcy. Beyond some lenders’ animus for the creditor-on-creditor violence wrought by LMEs, concerns include that LMEs do not provide sufficient time or flexibility to resolve underlying issues – a view held by a majority of industry experts in a recent survey. While private credit is not immune from LMEs, the stronger covenant structures in the core middle market where many private credit lenders operate often limits their viability. However, reports of silent defaults in private credit (i.e., defaults addressed via amendments and thus potentially unreported) and concerns over inconsistent valuations of private credit portfolio loans indicate that the private credit distress picture may not be as rosy as the public market data suggests. In any event, it remains to be seen how these trends will play out now that the “higher for longer” era is over.

European Trends

• The BSL market in Europe continued to advance its recovery in the first half of 2024, reaching more than twice its volume compared to the same period in 2023, according to Bloomberg. This was supported by an increased risk appetite from investors, solid collateralized loan obligation (CLO) issuances/repricings, and the relatively new tapping of retail investors, which did not feature in Europe before 2023 unlike the US market.
• Surprisingly, this BSL volume has been used mainly for refinancings and repricings, with spreads coming down materially even against a backdrop of relatively slower growth in Europe compared to the United States. This has translated to repricings often in the range of a 25 to 50 bps reduction and repricings at a 50 to 100 bps reduction from last year (similar to the US).
• M&A and dividend-recap-related financing picked up in Q2 of 2024 in Europe. However, normally the single biggest driver of new supply in the leveraged debt markets, M&A activity remains at a surprisingly muted level. Refinancing needs are expected to continue to drive the European leveraged finance market, with significant maturities each year and a peak in 2028, although the short-term maturities have mostly been addressed over the past year.
• The European private credit market has also thrived, with notable fundraising successes in 2024 compared to 2023, particularly for the better-known established names. Additionally, the private credit market seems to be spreading out in terms of the geographies and industries that will be financed, with an increased popularity of deals in Benelux and the Nordics.
• The downward pressure on spreads results largely from favorable technical factors. For example, the strong CLO issuance levels in Europe (some predict 2021’s record in terms of issuance volume will be surpassed, although CLOs are not as significant a portion of the European institutional market as they are in the US) benefitting demand for BSLs and the positive fundraising results benefitting demand from credit funds has meant solid demand to make leveraged loans. However, not many opportunities are presented by the market, particularly M&A-related ones. This has resulted in spread compression in European BSLs, increased pricing, and, to a degree legal terms, competition between the underwriters of BSLs and private credit funds. The historical 150 to 200 bps differential to BSL pricing for senior secured private credit is now seen as low as 100 bps.
• Separately, regulatory capital relief strategies for regulated banks and other pressures to increase participation in the private credit space and make use of their extensive contacts for non-sponsor origination have resulted in more banks joint venturing with credit funds and/or starting direct lending operations funded either by balance sheets or separately raised funds managed by the bank. This year, we have also seen a marked increase in clubbed credit lenders making large cap (more than €1 billion) loans.
• How this will play out when M&A markets inevitably improve, perhaps after a period of volatility as the markets digest the recent French, German, and United Kingdom elections and a wary eye is kept on the US election, is not entirely clear, but the private credit market has ways to compete with the BSL market while covering areas and certain debt products not covered by the BSL market. Thus, we expect the European private credit market to continue to thrive but alongside a more functional and competitive European BSL market over the next period.

Key Debt Market Data

• Private Credit Pricing & Leverage Data (October 3, 2024)
• BSL Leverage Trends (October 7, 2024)
• BSL Documentation Trends (October 9, 2024)
• BSL Covenant Trends Q2 2024 (July 30, 2024)