Pitchbook: Demand surges, leading to record activity.
Financial Times: Bankers wary despite jump in corporate fundraising.
LCD: A record $727 billion in debt was issued in the syndicated debt markets through Jun’24.
Yet, a senior banker at one of the largest banks told me that 1H’24 has been the slowest in the last 30 years as per their internal analysis.
So, what is really going on in the capital markets and how can it impact you?
The real deal(s)
The LCD report is correct, the debt markets saw a massive uptick in volume, with two caveats:
- Almost 50% of loan volume was related to repricing, 30% related to refinancing and extensions and less than 20% related to new transactions. In fact, the new transaction related volume is less than half of what we saw in 2H ’21.
- LCD reports syndicated deals – typically $100MM+ deals with publicly available information. This data is not that relevant for most middle to lower middle market bilateral deals, which are almost always private.
We talk to lenders everyday for deals launched on CAPX. Here’s the real market update that matters to you.
Direct lenders have raised capital a while back but they have not been able to deploy it.
Supply of capital
Syndicated loan markets are clearly affected by the retail investor and institutional demand for securities earning higher rates than treasuries.
For the classic middle market, the dynamic is a bit different.
- Direct lenders have raised capital a while back but they have not been able to deploy it over the last 18 months (soon, 24 months) due to the lack of new M&A deals. So, direct lenders are seriously motivated to put money to work.
- Some direct lenders have faced challenges raising new funds, resulting in lower check sizes for new deals or even scaled back commitments right before closing a deal.
- Banks also have capital to deploy, but they have to strike a balance between higher capital costs due to higher interest paid on deposits and credit teams reluctant to do any deal that is not pristine.
Risk Appetite
Cautious is the right word to describe the credit environment.
Lenders do want to do deals – they have to deploy a mountain of capital – but they also have deals in their portfolios that have deteriorated over the last 18 months. This is true for banks and direct lenders.
- Lenders are focusing on high quality deals, i.e. companies with solid PE backing or solid financial track record. Quality deals can readily obtain aggressive structure and cheapest deal economics seen over the last few years.
- Deals with a story or uncertain equity commitment require broad market outreach to find a lender, unless they have sufficient assets to pursue an asset backed structure.
- Troubled deals in portfolio can color lender reactions to even quality deals – broad outreach is the only way to ensure successful execution.
- Combination of portfolio and fund raising issues have reduced check sizes for many banks and non-bank lenders. Even some small deals may need more than one lender to get to the finish line, which means multiple sets of bankers, underwriters, credit committees, lawyers and processes.Lenders are quite measured when it comes to deal structures.
Lenders are quite measured when it comes to deal structures.
Deal Structures
Despite the pressure to put capital to work, lenders are quite measured when it comes to deal structures. They compete for good deals with low pricing and accommodative documentation vs. high LTV, leverage or advance rates.
Leveraged / Cash Flow Deals
- For a performing credit with double digit EBITDA and solid PE backing, direct lenders can provide debt financing up to 70% of EV.
- For independent sponsors, 60% of EV is the most likely preference with some lenders insisting on 50% equity in every independent sponsor deal.
- For middle market corporates, if the transaction doesn’t involve new cash equity, lenders would want to stay below 60% of implied equity value.
- In terms of leverage, banks would want to stay well under 3.0x senior leverage and no more than 3.5x – 4.0x total leverage.
- While direct lenders are more flexible for a deal they really want to do, i.e. large sponsor, double digit EBITDA company, stable cash flows, etc., their leverage limits would be typically a turn higher than banks.
- Overall, the farther away a deal is from the ideal large company deal backed by a PE firm, the higher the required equity contribution and lower the leverage.
SaaS / ARR / Software Deals
- Tech slowdown has refocused credit teams at various lenders on their portfolios. The result is a more conservative outlook, smaller checks and enhanced focus on growth and mission critical nature of the borrower.
- In addition to PE backing, ideal stats for credit worthy SaaS companies are: (a) double digit YoY ARR growth, (b) 85%+ gross margins, (c) 90%+ gross ARR retention, and (d) 100%+ net ARR retention.
- A small but growing group of banks lend to enterprise SaaS firms through ARR underwriting methodology. Many of them will entertain only PE backed companies with funded debt under 1.0x ARR and most require a toggle to a leverage covenant within 2-3 years of closing.
- Direct lenders can lend up to 1.5x ARR, with exceptions to go up to 2.0x for a fast growing company with an entrenched market position and a meaningful investment from a PE firm.
- While the software lending is available to companies that do not fit the ideal profile, the number of available lenders drops quickly for companies without sponsor backing, lower growth rates and lower SaaS stats.
Asset Backed Deals
- Banks might be open to lending against unconventional collateral and reducing reporting burden, but advance rates are still remaining within the historic range.
- Direct lenders focused on ABL structures may offer higher advance rates, but for most companies, the difference between banks and direct lenders might not be too large.
- Direct lenders end up winning ABL deals when very few banks want to do the deal. If a bank likes an ABL deal, they can always outcompete a direct lender.
A few will go after story credits, for a price.
Pricing
Lenders need to deploy capital, if they can find the right deals. In this slow market, good deals are hard to come by. When they do, aggressive lender competition ensues, benefiting borrowers.
But, all deals are not the same. The all or nothing theme prevails in today’s market where all lenders want to do good deals while a few will go after story credits, for a price.
Just to be clear, we know from recent experience that there is a lender out there for pretty much any credit. However, the increase in economics from the ‘ideal’ credit to ‘less than ideal’ can be quite steep.
- Sponsor backed double digit EBITDA companies easily see SOFR + 5.50% pricing from direct lenders for leveraged deals. Increase the EBITDA and PE firm AUM, and you will see deals priced under SOFR + 5.00, pretty much in competition with the syndicated loan market.
- Less than pristine credits in the lower middle market should expect pricing above SOFR + 6.00%. As the borrower EBITDA moves towards $10MM or less, pricing is going to increase towards SOFR + 7.00%, and higher.
- If banks like a cash flow deal, their pricing floor would be around SOFR + 2.00%. Most wouldn’t price cash flow deals higher than SOFR + 4.50% – the deal would be too risky at that point for credit committee approval.
- Enterprise SaaS or ARR deals have similar pricing structure as leveraged deals. However, the pricing would climb a bit faster for story credits. As borrowers approach venture lenders for smaller deals, expect total interest to be in the mid-teens range, accompanied by exit fees and meaningful prepayment or call premiums.
- If you want cheap money, ABL is the structure to pursue. We have heard SOFR + 1.50% from banks as the new low, which is not that far above the all time lows. Most banks would still prefer to be in SOFR + 1.75% – 2.25% range. If you have to pay much more for a bank ABL, non-bank ABL lenders should be considered, who might be able to provide higher advance on collateral at SOFR + 4.50% and higher.
SOFR Floors and Call Premiums
SOFR will go back down toward 0.25% someday when the FED lowers rates. But, lenders don’t want SOFR to go much below 2.00%, which is the typical SOFR floor request. We have seen SOFR floors of 3.00% for story deals.
While this is an important yield enhancer for lenders, practically speaking, SOFR floors would have limited impact on debt service costs for borrowers, even if rates start declining in short order, as most loans are refinanced or repriced within 3 years.
Borrowers thinking about refinancing within a couple of years should think about the call premiums or pre-payment penalties. Most lower middle-market deals open with prepayment prohibition during the first year, followed by 2% call premium in year 2 and 1% in year 3. We have also seen 2% call premium in the first year and 1% in year 2 for better credits.
Conclusion
Lenders are eager to lend capital, but they are also seeing a lot of deals that their credit teams wouldn’t approve. Most lenders we know are really focusing on deals they can close, as there is no real consensus on how the rest of 2024 will turn out for the deal markets.
For under $50MM middle-market deals and larger story credits, expect a much longer deal process as lenders will take their time to provide feedback. And then again, you might have to approach many lenders to find a competitive and reliable solution.
If you have that ideal deal that all lenders want, congratulations, you get to close fast and cheap!
