The war in Ukraine, the stock market plunge, the spike in inflation, the early March failure of Silicon Valley Bank: each of these events landed like a punch on the chin of the private credit market.
And yet, “that market has just continued to stay resilient, despite the pullback in M&A,” said Sherman Guillema, managing director, capital advisory group at investment bank Lincoln International.
Indeed, Brad Stewart, managing director in the debt advisory group of investment bank Capstone Partners, said his firm had two private-credit deals in the market when the news of Silicon Valley Bank hit. None of the lenders evaluating those deals put pencils down, he said, and both deals remain on course to close.
For strength in the private credit markets you can thank the same institutional investors that have flocked to private equity funds over the last three decades.
“Private credit returns have demonstrated historical consistency throughout all types of market environments,” wrote money manager Hamilton Lane in a recent market overview recommending that its clients invest in private credit. “Previous periods of rising interest rates have meant better yield for these securities, especially since most are floating rate…”
In fact, when it comes to financing PE deals, the private credit market has “overshadowed” the broadly syndicated market in recent quarters, according to a recent presentation by investment bank Lincoln International. “…it is now feasible for large deals to consider private credit as an option, with several recent deals surpassing $1 billion.”
That said, private-credit lenders are not as free-wheeling as in the don’t-look-up days of 2021 and early 2022. They have the prospect of a recession to consider, after all, and the fact that portfolio companies have higher interest rates to pay on their floating-rate loans. That’s meant the adoption of a “defensive posture,” said Stewart.
Below are several trends to be aware of as you approach lenders for deal financing, according to recent presentations from Capstone Partners and Lincoln International:
- Lenders limit their exposure: Single-lender solutions are hard to come by in this market, according to Capstone Partners. Instead, sponsors must find several lenders willing to form a club. And except for very large deals, those lenders typically want to hold smaller portions of each loan on their books. The upshot: sponsors have to spend more time rounding up lenders for their deals.
- Lenders get pickier: Putting those loan clubs together has also grown more difficult as lenders get more selective. Cyclical companies likely to get walloped in a recession are especially out of favor. Be prepared to get quick “nos” from more lenders than before.
- Spreads jump: Even strong-performing companies have to pay SOFR plus 625 to 675 basis points, or more than 10 percent, for down-the-fairway unitranche loans, according to Capstone Partners. Weaker performers may have to pay another 75 to 125 basis points or more.
- Lenders concentrate on coverage ratios: Deal sponsors like talking about leverage multiple ratios. But these days lenders aren’t talking that language. They are far more focused on the fixed charge coverage ratios (more than 1.25x is ideal) and loan-to-valuations (less than 50 percent). In general, you should expect their diligence process to be both “deeper” and “longer,” according to Capstone Partners.
- Terms grow lender-friendly: Some 85 percent of private-credit loans last year had at least one covenant, according to Lincoln International. That was up from 60 percent in 2021. Of those with covenants, 41 percent had at least two covenants last year, up from 26 percent the year before.
- Gap financing becomes popular: Unitranche loans have become so expensive that other forms of financing have become more attractive, especially if sponsors have a gap to fill in the capital structure of a deal. Mezzanine lenders charging a 12 percent fixed rate may not have been palatable when SOFR was close to zero. But with unitranche loans charging double-digit interest rates, mezzanine financing looks attractive as a hedge against even higher interest rates. Other forms of gap financing available to borrowers include hybrid notes, redeemable preferred equity with warrants and convertible preferred equity with warrants.
- Lenders may not support add-ons: It wasn’t that long ago that platform company lenders grew giddy at the prospect of helping to finance add-on deals. But those days are behind us. Today you’re much more likely to have to use equity or go out to find a new set of lenders or structured equity providers to support add-on deals. That way you don’t have to upset the original financing package. If the additional financing sits at the holding company level, you typically don’t need the consent from your senior lenders.
- We’re not out of the woods: While the private credit markets have shown resilience, don’t expect them to hold up in the face of every threat. EBITDA margins have been contracting in recent quarters, according to Lincoln International. Covenant default rates in the private credit market have been steadily rising since the fourth quarter of 2021. Should the U.S. economy tank, lenders may be forced to the sidelines to ensure that their portfolio companies remain solvent.