CAPX recently conducted a survey of U.S. lending professionals—at both banks and direct lenders (DLs)—on their expectations for deal activity, credit and pricing in 1H23. Our previous article provided insights into how lenders are approaching deal activity and borrower credit-worthiness. In this article, we cover structuring and pricing debt instruments for PE firms, specifically.
- Almost half of respondents want PE firms to inject 40% or more equity in new LBOs, with banks landing in the 35%-50% range, making them a bit more lenient than DLs.
- The most aggressive rates for ABLs we saw a year ago are still available, but only from a small number of banks. Most want to increase pricing by about 50 bps. Jr. and mez lenders are similarly hoping to increase pricing by around 100 bps for PE deals.
- For DLs issuing first lien debt, a 50-100 bps price increase is likely, whereby the new comfort level is S+6.5% – 7.0% for PE deals.
Overall, lenders want to increase pricing, but are hamstrung by competition and excess dry powder in the market. Larger middle market deals are getting done with minimal price increases, despite the rise in SOFR over the last year.
The area where lenders are making adjustments is with debt structure. Given the current macro picture, lenders will acquiesce on price for a more conservative structure, assuming the underlying business looks resilient in the face of a market downturn.
So, we’re looking at a bifurcated debt market: strong credits with a conservative debt structure can expect favorable pricing, while riskier credits / debt structures can expect price increases in-line with what many might expect given the looming recessionary pressure.
**Please note: the below responses are what lenders indicated they plan on doing, vs. what they might actually be doing in today’s market. Our aim is to follow up with future reporting on how lender expectations measure up vs. actual issuances.
PE firms can expect around a 0.25%-0.50% premium over what banks would charge corporate borrowers. Most want to increase pricing by about 50 bps compared to where they were a year ago. Those seeking mez deals from SBICs should expect to be in the low-mid teens range for jr. capital deals.
On a positive note, the most aggressive rates for ABLs we saw a year ago are still available, but only from a small number of banks. This is welcome news given the dislocation in the cash flow market, as cyclical and capital-intensive businesses must rely on assets to raise capital, which means ABLs should outperform other debt structures this year.
Almost all banks want to charge more to take risk–mostly by 25-50 bps. A quarter of banks surveyed want to charge up to a percent more. In contrast, almost half of DLs surveyed want to increase margins by 50-100 bps. This sentiment is reflected in the pricing feedback for first lien and jr. debt as well.
A little over one third of respondents want PE firms to inject 40%-50% of EV in the form of equity, with over 60% in the 35%-50% range. This illustrates a clear conservative stance on the part of lenders, compared to the top of the cycle where 30%-35% equitization was considered adequate. This correlates with our aforementioned bifurcated market finding—that lenders are prioritizing conservative deals over costlier debt.
Interestingly, this increase is somewhat driven by DLs, as many want equitization in the range of 40%-50%, with banks being more likely to accept 35%-50%. In general, both groups have grown more conservative, but it seems that DLs want more skin in the game from PE firms compared to Banks.
2.5x-3.0x is the most preferred sr. leverage range for respondents. However, for PE deals, some are willing to go half a turn higher. And nearly one-third of respondents indicated that over 3.50x sr. leverage is appropriate.
3.5x-4.0x is the most popular total leverage level for cash flow deals. However, banks are a bit more generous with PE firms compared to DLs, as more banks are ready to accept a turn more of total leverage at 4.0x-5.0x, compared to DLs.
Considering the equitization and total leverage responses together, a conclusion can be drawn that lenders want 35%-50% equity from sponsors / buyers in deals, and they do not want total debt, in general, to be more than 5.0x EBITDA. This means that lenders believe that 10.0x EBITDA is the top of the range for the purchase price for acquisitions. If buyers want to pay more, they should be ready to finance through a higher equity contribution.
The credit markets are indeed tightening, but not as harshly as many have feared. According to Proskauer’s Private Credit Default Index, private credit senior secured and unitranche loan defaults reached 2.06% in 4Q22, for a second-straight quarter of default increases. High-profile bankruptcies like Serta Simmons Bedding and Heritage Power caused the default rate of the Morningstar LSTA US Leveraged Loan Index to rise from 0.72% (by dollar amount) in December, to 0.83% in January.
These are leading indicators of a market under stress. Add to this the fact that larger borrowers are negotiating portions of loan amounts to PIK (F45 Training and Rent the Runaway are prominent examples), and that PE firms are adding equity at the end of a quarter to avoid breaching covenants, and we can begin to see the fraying of an otherwise frothy market.
Given the shift in lender sentiment, PE firms would be wise to reach out to as many lenders as possible, as there is no telling which are open to approving deals and negotiating on pricing. The best strategy, therefore, is to cast a wide net when approaching the debt markets, and to do so quickly and efficiently—given that lender preferences will evolve once a clearer economic picture materializes.
If you’d like to learn more about how CAPX helps PE firms access banks and direct lenders across the country in as efficient a manner as possible (averaging 4 days to first term sheet from deal launch), click the link below to schedule a brief phone consultation.