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 independent sponsors, specifically.
Key Takeaways:
- Lenders want to raise pricing, reduce leverage and increase equity participation. Average equitization amount for IS was in the 35% – 50% range, with 10% of both banks and DLs insisting on more than 55% equitization.
- 53% of banks surveyed will issue cash flow loans to IS. 69% will issue ABLs.
- 54% of DLs surveyed will issue jr. or mez debt to IS. 77% will issue first lien debt.
30,000-Foot View:
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.
It should come as no surprise that IS can expect stricter leverage and equitization requirements than PE firms and corporate borrowers. Most banks are asking SOFR + 3.50% – 4.50% for cash flow loans, while SOFR + 2.00% – 4.00% seems to be the range for ABLs. 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.
A plurality of DLs are in the SOFR + 7.50% – 9.00% range for first lien debt, with 18% selecting both SOFR + 6.50% – 7.50% and Greater Than SOFR + 9.00%. IS can expect SOFR + 9.00% or more for jr. or mez debt.
Banks and DLs converge on the equity required for IS deals, which for roughly half of respondents falls into the 35% – 50% camp. That’s a bit higher than what PE firms and corporate borrowers can expect, which likely reflects lender trepidation about IS’ ability to capitalize a business facing financial pressure, hence lenders want to see IS pledge more skin into the game from the start. This correlates with our aforementioned bifurcated market finding—that lenders are prioritizing conservative deals over costlier debt.
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.
DLs also continue to drive the total leverage preference for IS deals, between 3.0x – 4.0x, where more banks are willing to accept a bit more (0.5x – 1.0x turn more) total leverage, should DLs be willing to invest junior capital, which most of them don’t seem to be in a hurry to inject.
Considering the equitization and total leverage related responses together, a conclusion can be drawn that since lenders want 35% – 50% equity from IS, and they do not want total debt, in general, to be more than 5.0x EBITDA, this means that lenders in general 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.
Conclusion
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 sponsors 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, independent sponsors 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 IS 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.
