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Middle Market Leveraged Finance Report – Fall 2024

Credit Market Conditions

Favorable Tone in Middle Market Credit

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The Debt market is firmly in “borrower-friendly” territory marked by institutional lenders that are competing heavily to win new loan mandates. Lackluster merger and acquisition (M&A) activity, improving corporate performance, and ample “dry powder” have resulted in heightened pressure amongst lenders to stem repayment of outstanding loans (via refinancings) and to deploy their growing capital funds into new opportunities. The net result for middle market (MM) borrowers has been a meaningful reduction in borrowing rates and improved loan terms across the U.S. Credit landscape.

M&A Loan Activity Rising

While the M&A market has been depressed for roughly two-and-a-half years since the Federal Reserve rate hike cycle began, the Leveraged Finance market has adopted a more upbeat tone in recent weeks. Uncertainty is the enemy of M&A but with the U.S. Presidential election now behind us, better visibility on interest rates, lower inflation, and healthy financial results by MM private companies, M&A activity is now gaining momentum. For the first time in nearly two years, refinancing and repricing loan activity is now taking a back seat to leveraged buyout (LBO) and acquisition financings. As highlighted below, a growing chorus of market participants believe that the long-stalled M&A market is now awakening with deal flow picking up in Q4 2024 and expected to continue into next year, according to PitchBook.1 At Capstone, the pace of client non-disclosure agreement (NDA) signings in Q3 2024 was up +24% year-over-year (YOY) and, since the election, our near-term M&A calendar for post-holiday launches has improved—two leading indicators that suggest a rosier 2025 M&A market.

Middle Market Borrowers Remain Strong

Favorable financial results by borrowers have supported these trends. MM private companies have continued to perform well with YOY revenue growth of 5.1% and earnings growth of 7.9% through Q3 2024, the eighth quarter in a row of solid performance, according to Golub Capital.2 While their index reflects consistent margin expansion is being driven by cost discipline and pricing power over the last five quarters, dispersion of operating results is increasing with many companies adapting well to the macro environment while low-performers are falling further behind, according to Golub Capital.

Rates Trending Down

Borrowing rates on senior/unitranche loans continue to decline based on the tandem impact of Secured Overnight Financing Rate (SOFR) reductions and spread compression. Following two rate cuts by the Federal Reserve this year (and a third possible in December), the SOFR has meaningfully dropped from its peak of 5.3% to circa 4.6% today. Currently, the market anticipates further Federal Reserve rate cuts well into 2025 and for the SOFR to ultimately bottom out near 3.8% a year from now, according to Chatham Financial.3

After peaking in Q2 2022, SOFR spreads have compressed for most borrowers by 75-125 basis points (bps) over the last five quarters, although market participants believe spread levels may now be approaching the bottom. Pricing on private credit deals have stabilized, at least for now, at the SOFR+4.5%-4.75% level for sponsored upper MM deals and 50-75bps higher for core MM credits. LCD recently noted that about 80% of private credit deals in the last six months were priced below SOFR+6% while about 80% of loans in H2 2023 were priced above SOFR+6%, according to PitchBook.4 Based on our recent experience, smaller and “story” credits are finding pricing in the SOFR+6.5%-7.5% range today.

Debt Capacity Inching Upwards

As lower-rated deals continue to take a larger slice of the market this year, average leverage ratios have risen from their 2023 dip. This year, upmarket leverage loans (companies with $50 million+ in EBITDA) have had an average debt/EBITDA ratio of 4.7x, up from 4.5x last year but well below the 5.3x levels seen in 2022-23, according to PitchBook. Smaller businesses are typically limited to more conservative levels (by 1x-1.5x) depending on size, sponsorship, sector, and other factors.

Nevertheless, given today’s still-elevated rate levels, debt capacity is often range-bound by projected interest coverage ratios (not EBITDA per se). For all deals (LBOs, refi, etc.), the average EBITDA/interest ratio has fallen to only 3.1x this year, well below the 4+ levels experienced in 2020-2022. Further, lenders continue to require healthy equity cushions—most new loans today bear loan-to-value (LTV) ratios (debt/enterprise value) below 55% (averaging 52% for LBOs in Q3 2024), according to PitchBook.5

Upper Middle Market Refinancing Trend

Predictably, the reduction in rates spurred a wave of refinancings in H1 2024 across the Credit landscape, especially refinancings in the Broadly Syndicated Loan (BSL) market of private credit term loans issued in 2022-2023 by sponsored upper MM (EBITDA >$50 million) borrowers.

The rapid pace in Q1 of private credit loans being refinanced in the BSL market has slowed if not reversed over the last six months due to competitive pressure. Historically, private credit lenders (non-banks) have been paid 100-150 bps more than banks in exchange for certain structural advantages they can offer: speed, certainty, no ratings, Delayed Drawn Term Loans (DDTL), Payment-in-Kind (PIK) options, etc., according to SRS Acquiom.6 However, this rate premium compressed during H1 2024 as direct lenders lowered spreads (especially in the upper MM) to better compete against banks. At Capstone, we have noticed some larger lenders pivoting towards non-sponsored and/or core MM credits to help preserve pricing spread on new loans.

LCD reported that through Q3 2024, more than 60% of all leveraged loans outstanding at the start of the year have now been repaid, repriced and/or extended, an all-time record, according to PitchBook. While refinancings have now largely played-out, lender attention has pivoted to other uses (dividends and M&A). Unless already considered, borrowers are encouraged to explore a refinance to avoid a crowded environment once M&A fully recovers.

Dividend Recaps Back on the Scene

This year, sponsors have increasingly turned to loan-funded dividends as a means to return capital to their limited partners (LPs) given the difficulties of exiting portfolio investments through traditional sale and initial public offering (IPO) routes. The resurgence of the M&A market cannot come quick enough for them. The median age of private equity (PE) portfolio companies in the U.S. last year was 4.1 years (a 10-year high), while the median hold period for exited companies was 7.1 years (an all-time high), according to PitchBook.

After minimal activity in H2 2022, dividend recaps have soared this year, particularly during Q3 2024. In September alone, more than $19 billion in dividend loans were issued, by far the most for any single month in the U.S., according to PitchBook. While typically reserved for sponsored companies with strong business models and balance sheets, lenders have been willing at times to widen the aperture for lesser credits as well, especially when the dividend is combined with an accretive use of proceeds (M&A or growth initiatives). Most lenders (especially banks) have a natural bias against dividend recaps but many will consider such deals for existing borrowers and/or new clients showing particularly strong financial performance. Should M&A platform acquisitions activity return, lender appetite for dividend recaps will likely decline.

Expansion of Private Credit

As the breakneck growth in the Private Credit market continues, not a week goes by without us developing new relationships with non-bank credit firms. Some recent specialty lender additions to our network include Chicago Atlantic, 5C Investment Partners, Aquiline Capital/Credit, JPalmer Collective, Phoenix Merchant Partners, Canal Road Group, and Altriarch to name a few. Today, our rolodex well exceeds 600 institutional non-bank lenders that we leverage upon in clearing the market for clients.

Not to be left out, commercial banks are increasingly finding creative ways to play in the Private Credit market as highlighted by several announced partnerships between banks and private credit lenders. Recent joint venture (JV) partnerships include Citigroup/Apollo, Webster Bank/Marathon, Wells Fargo/Centerbridge, JPMorgan/Cliffwater-FS-Shenkman, among others that can offer a one-stop solution to prospective borrowers.

Growing Interest in Junior Capital

Driven by the dramatic rise in SOFR since Q1 2022 and the resulting cost of senior/unitranche facilities, Capstone has experienced increased borrower interest in junior capital (subordinated debt and redeemable preferred capital). While the cost of sub capital has risen from its traditional range of 11%-12% into the 14%-15% context, the increase has been less than that witnessed in senior facilities. As a result, the traditional pricing gap between the two has shrunk making junior capital more attractive to borrowers (on a relative basis), especially given the increased flexibility that these structures provide. Further, the PIK component of junior capital instruments has generally expanded, driven by debt serving concerns.

Loan Defaults Are Running Below Expectations

Market predictions last year of a coming recession and a resulting uptick in loan defaults during 2024 were not realized as the Corporate Credit market proved surprisingly resilient. While lower quality borrowers continued to face headwinds due to elevated interest rates that hurt their ability to service debt, lenders have been quick to provide support through amendments that allow covenant relief, maturity extensions and liberal use of PIK interest. PIK interest essentially allows borrowers to pay its interest with more debt. Moody’s Ratings estimates that PIK has risen to ~6.7% of income amongst private credit funds today, according to SRS Acquiom.7

Lower interest rates, accommodative lenders, and equity support from PE sponsors have positively impacted loan default rates this year. The Proskauer private credit default index for senior and unitranche loans in Q3 was 1.95%, a healthy decline from 2.71% in the prior quarter, according to a Proskauer press release.8 The improvement suggests that sponsors, borrowers, and lenders are proactively finding ways to avoid true defaults by addressing potential credit issues before they become acute. Of note, the default rate for private credit was lower than levels experienced in the Syndicated Loan market largely due to the structural differences of private credit: more rigorous underwriting, constant monitoring, greater access to information/management, a small group of lenders, and financial maintenance covenants.

For loans that do default, recovery rates tend to be higher in the Private Credit market (75%+) versus the Bank/BSL market (40%-60%) owing to tighter covenants, better lender protections, and tighter relationships with borrowers/sponsors, according to PitchBook. Private credit lenders also tend to rely more heavily on out-of-court restructurings in lieu of value-eroding bankruptcy proceedings.

To discuss middle market leveraged finance, provide an update on your business, or learn about Capstone's wide range of advisory services and debt capital knowledge, please contact us.

 


Endnotes

  1. PitchBook, “U.S. Private Credit & Middle Market Quarterly Wrap,” https://files.pitchbook.com/website/files/pdf/Q3_2024_US_Private_Credit_and_Middle_Market_Quarterly_Wrap.pdf, accessed December 3, 2024.
  2. Golub Capital, “Golub Capital Middle Market Report Q3 2024,” >https://golubcapital.com/wp-content/uploads/2024/10/24_Q3_GCMMR.pdf, accessed December 3, 2024.
  3. Chatham Financial, “Limited economic data releases leave economic outlook uncertain,” https://www.chathamfinancial.com/insights/limited-economic-data-releases-leave-economic-outlook-uncertain-11-25-2024, accessed December 3, 2024.
  4. PitchBook, “U.S. Private Credit & Middle Market Weekly Wrap,” https://files.pitchbook.com/website/files/pdf/November_14_2024_US_Private_Credit_and_Middle_Market_Weekly_Wrap.pdf, accessed November 14, 2024.
  5. PitchBook, “Reawakened LBO market shifts the funding landscape,” https://pitchbook.com/news/articles/reawakened-lbo-market-shifts-the-funding-landscape, accessed December 3, 2024.
  6. SRS Acquiom, “Peaceful Coexistence: Evolving Private Credit Market Shows Similarities to BSL Market,” https://www.srsacquiom.com/our-insights/private-credit-market-trends/, accessed December 3, 2024.
  7. SRS Acquiom, “Deflated Default Rate May Not Tell the Whole Story,” https://www.srsacquiom.com/our-insights/capital-markets-loan-default-trends/, accessed December 3, 2024.
  8. Proskauer, “Proskauer Q3 Private Credit Default Index Decreases to 1.95%,” https://www.proskauer.com/report/proskauer-q3-private-credit-default-index-decreases-to-195, accessed December 3, 2024.

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