NEW YORK, April 30 (LPC) - A trickle of deals in middle market sponsored lending is showing early signs of increased pricing and more lender-friendly documentation, reversing a years-long trend that had seen private equity borrowers’ benefit.
With the continued shutdown of the US economy, a consequence of the Covid-19 pandemic, direct lenders to small and middle-size companies wary of the heightened risk are demanding better protections—and compensation—for any additional lines of credit that sponsored-owned companies request.
Recent transactions that have come into the direct lending market have been mainly add-ons for existing portfolio companies, rather than new loans for leveraged buyouts. Still, those deals have seen sponsors paying for debt and agreeing to lower leverage levels than those they had become used to obtaining.
Pricing for first-lien loans is estimated to be at 600bp over Libor, up from an average of 450bp-475bp before the onset of the health crisis. Margins on senior stretched secured loans, and unitranches are also going up.
“At the moment, new deal data is skimpy, but I expect spreads to be much wider and leverage well off from where we were in January,” said Randy Schwimmer, head of originations at Churchill Asset Management, a direct lending firm.
To cover liquidity needs, sponsors have drawn down on existing revolving credit facilities and delayed-drawn term loans (DDTL). Direct lenders financed US$2.4bn in DDTL in the first quarter, according to Refinitiv LPC data, beating issuance for the same unfunded commitments in both 2019 and 2018.
But a protracted shutdown of the economy is pushing some private equity sponsors to seek new debt in the form of add-ons with assessments of future cash flows proving a tricky task for lenders.
“No sponsor forecasts a no-revenue scenario. With visibility uncertain, you can’t safely leverage anything. It’s not so much pricing discovery as much as on-going concern discovery,” Schwimmer said.
Amid investor risk-aversion, US leveraged loans went virtually a month without a widely syndicated transaction. With less debt capital available, loan documentation is starting to improve.
Even in the middle market lending space, where covenant-lite has been the exception, maintenance covenants are likely to be tightened. A report from law firm Proskauer last year showed covenant-loose structures were prevalent in middle market loans in 2019 with some expecting that to change.
“No-one can speak on behalf of the market. Everyone is reacting differently, but the covenant cushion has contracted, and sponsors have to accept that. We’re out of time, and they’re not in a position to negotiate hard on brand new debt,” said one fund manager.
Stephen Boyko, a partner at Proskauer, said there had been an increased focus on the parts of the documentation that allowed for greater flexibility for sponsors in the last two decades, including exceptions to negative covenants that permit additional debt and J. Crew Group-like leakage of collateral.
“It’s been a return to 2000. Documents are becoming much more restrictive,” he said.
In 2016, private equity owners TPG Capital and Leonard Green & Partners provoked investor outrage after the intellectual property assets of the troubled retailer J. Crew were moved into a separate subsidiary outside the existing credit agreement as the company undertook a restructuring of its debt.
For direct lenders today, the market is in a new world.
Provisions regarding add-backs to earnings before interest, tax, depreciation and amortization (Ebitda) and restrictive payment clauses that have become the norm in recent years are being curbed as other avenues of debt financing for middle market buyout firms have been closed with the broadly syndicated market shutdown.
“So far, there has been limited relief from lenders. Requests by borrowers to eliminate all financial covenants for the rest of the year have been resisted. Lenders are taking a more incremental, wait-and-see approach,” said Boyko. (Reporting by David Brooke; Editing by Michelle Sierra and Kristen Haunss)