Private Eye: Cracks in credit market turn to fault lines

About a year ago I wrote in this column that cracks were starting to appear in the credit markets used to finance leveraged buyouts. Those early cracks, after a reasonably steady start to 2015, have since widened into fractures.

Behind those fractures lies a growing wedge of fears. Among the biggest is that a slowing world economy will leave many companies struggling to meet targets for growth and profit margins.

“Lenders are really concerned about where the business cycle is heading, and quite frankly concerned also about highly leveraged deals,” said Christine Tiseo, a managing director at Chicago investment bank Lincoln International, during a “State of The Middle Market” webcast hosted by her firm January 19.

Indeed, a January survey of 71 loan officers at banks, credit opportunity funds, finance companies and other mid-market lenders by Lincoln International finds them far more conservative in their predictions for leverage multiples and pricing than they were at this time last year.  More than half (54 percent) believe total leverage multiples on sponsored deals will fall. The implication: Either sponsors will have to put more equity into their deals or sellers will have to come down on price.

By contrast, last year’s survey found just under a third (32 percent) predicting leverage multiples would fall in 2015, while 24 percent predicted that multiples would move higher. In one sense, they were both right. For large corporate buyouts (deals above $50 million in EBITDA) leverage multiples fell from 5.6x EBITDA in the first quarter to 5.2x in the fourth, according to figures from S&P Capital IQ Leveraged Commentary & Data cited during the webcast. Over the same period leverage multiples in the middle market rose from 5.0x to 5.6x.

Meantime, lenders predict debt will become more expensive this year. More than two-thirds (68 percent) of respondents predict senior spreads will rise in 2016, 63 percent say unitranche spreads will rise, and 58 percent say spreads will rise on mezzanine and second-lien debt. Last year at this time only about a third of respondents were making similar predictions.

In short, lenders predict a continuation of trends that have been building up steam. As noted, leverage multiples on large corporate buyouts fell in 2015. But they took a particularly hard hit in the fourth quarter, dropping a full turn to 5.2x from 6.2x in the third quarter, according to S&P Capital IQ LCD. At the same time all-in yields on BB/BB-rated debt on large corporate deals shot up 186 basis points over the two-year period starting in January 2014, from 3.33 percent to 5.19 percent.

Overall new-issue loan volume was choppy during the year. It popped to $140.2 billion the second quarter, then fell in each of the next two quarters, sinking to just $73.5 billion in the fourth quarter, according to S&P Capital IQ LCD. In past years, Tiseo said, she would have chalked up such drops to a lack of supply of companies on the market. This time evidence points to a lack of demand for loans. This includes $9 billion in pulled deals in the fourth quarter, a wave of deals whose loan terms had to be sweetened (“flexed,” in industry parlance) to clear the market, and a return of more lender-friendly terms, such as a 50 bps Libor floors, down from 100 bps.

If there is good news it is that the debt markets for middle-market deals have held up better. As leverage multiples for large deals plunged in the fourth quarter, they eased down just 0.3x in the middle market, from 5.9x to 5.6x, according to S&P Capital IQ LCD. New-issue yields on first-lien loans in the middle market ticked up just 15 bps from the second quarter of 2015 to the fourth quarter, to 6.44 percent. By comparison yields on comparable large corporate loans jumped 86 bps, to 5.84 percent over that time.

During the webcast, Lincoln International Managing Director Robert Horak attributed the relative calm in the middle market in part to the lack of need for the broad syndication of loans. In the middle market, you’re more likely to see a handful of buy-and-hold lenders club up to finance acquisitions after doing an extensive analysis of risks. The competition for deals among these lenders has until now sustained healthy leverage multiples and reasonable loan prices.

That said, Horak and colleagues believe borrowers can’t expect lenders in the middle market to ignore broader market forces. Business development companies (BDCs), a growing source of mid-market financing since the financial crisis, saw a sharp decline in equity capital raised in the fourth quarter. A number of them trade below net asset value, making it practically impossible for them to raise money through secondary offerings. Another big supplier of mid-market loans, CLOs, saw total issuance drop from $7.6 billion in 2014 to $5.5 billion in 2015.

As their war chests dry up, lenders like these will by necessity become more selective. And if they see a slowdown in cash flows on their portfolio companies? They will become even moreso.

“As compared to 2015, do you think your portfolio companies’ 2016 performance will be better, worse, or flat?” asked the Lincoln International survey.

Just a smattering (9 percent) of mid-market lenders lenders said “better,” 62 percent said “flat” and 30 percent said “worse.”

Action Item: Get a complete list of BDCs from the SEC at

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