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 middle market (MM) corporations, specifically.
- Roughly one-fifth of respondents selected 30%-35% equitization for MM corporations, while another fifth selected 35%-40%, and yet another fifth chose 40%-50%. Thus, a full 60% of lenders surveyed are in the 30%-50% range.
- Corporate borrowers seem to be the favorite of banks when it comes to pricing, as they receive a 0.25%-0.50% discount over what banks would charge PE firms and independent sponsors.
- Nearly half of respondents we surveyed did not want to extend jr. capital to corporate borrowers, likely due to concerns over a potential liquidity crunch, and a lack of identifiable secondary sources of liquidity.
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.
Corporate borrowers seem to be the favorite of banks, as they receive a 0.25%-0.50% discount over what banks would charge PE firms and IS.
While nearly one-third of banks did not want to extend cash flows loans to corporates, and one-third of DLs did not want to extend first lien debt, nearly half do not want to extend jr. capital to corporate borrowers, likely due to concerns over the potential liquidity crunch, and a lack of identifiable secondary sources of liquidity.
Only 26% of bank respondents won’t do ABLs for corporate borrowers. And while most have increased pricing by about 50 bps, the good news is that the most aggressive rates for ABLs which we saw a year ago are still available (though they are getting harder and harder to come by). 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.
Around 60% of respondents want corporate borrowers to inject 30%-50% of EV in the form of equity. Considering that another 24% selected N/A, corporate borrowers should consider 40% equitization or less a generous offer (all else being equal). 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.
In terms of the split by lender type, more DLs are ready to live with 30%-35% equitization compared to the 35%-40% preferred by the largest number of banks that responded.
Interestingly, 2.5x-3.0x is the most preferred sr. leverage range for PE firms and IS. However, roughly one-fifth of lenders want to see either 2.0x-2.5x, or 3.0x-3.5x. So there is a bit of a diversion in how lenders are approaching corporate borrowers in relation to sr. debt requirements.
3.5x-4.0x is the most popular total leverage level for cash flow deals. Both banks and DLs converged on this range as a sweet spot, according to the largest number of respondents in both groups.
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 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, corporate borrowers 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 middle market companies 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.