McDermott Will & Schulte, a global law firm

Higher interest rates presented a challenging environment for dealmakers and the debt markets in 2023. But what does 2024 have in store? In this edition of Credit Conditions, we look back at last year’s key market trends and explore their potential impact on debt markets in the coming year.

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Key Debt Market Trends

Interest Rates

• 2024 is shaping up to be the year that the debt markets learn what “higher for longer” means in practice. The Federal Reserve indicated at its March meeting that record high rates would remain unchanged for now but that it still expects three rate cuts in 2024. The futures market currently expects the first rate cut to occur in June of this year though  a recent poll of economists suggests it may be later with a majority expecting the first rate cut in September. “Higher for longer” concerns still remain though with the latest Federal Reserve projections signaling that rates for 2025 and beyond are expected to be 0.25% higher than December projections.

Private Equity and M&A

• Higher rates in 2023 proved challenging for dealmaking, with deal volume declining from 2022. Loan supply was also limited last year as lower debt multiples for mergers and acquisitions (M&A) and higher equity contributions (averaging above 50%) became common. However, 2024 looks more promising. Market participants are seeing M&A valuations beginning to decline, reflecting the new normal of higher financing costs as well as increasing pressure on private equity funds to return capital to their limited partners. Industry leaders are predicting an increase in dealmaking as the lending environment improves with lower interest rates and increasing leverage. They also expect a strong bounce back for “sponsor-to-sponsor” deals.

Private Credit vs. BSL

• The private credit industry continued to dominate market share for leveraged buyout (LBO) and M&A financing over the broadly syndicated loan (BSL) market in 2023. Last year, BSL LBO financings were at their lowest level since 2017*, but 2023 also saw some of the largest private credit deals* to date. The private credit industry also appears to be maturing, as private credit funds are beginning to move away from a generalist approach toward specializing in specific industries in an effort to differentiate themselves from the competition, including with private credit entering the asset-backed loan market*.
• As interest rates decline and spreads tighten in the BSL market, it’s likely that the cyclical trend toward private credit will begin to reverse somewhat and the BSL market will see increased deal flow*. Throughout 2023 and thus far in 2024, we have seen some borrowers refinance* private credit loans in the BSL market, though much of the recent BSL volume has been driven by amend and extend transactions, repricings (which were more muted in February following the January Federal Reserve meeting) and refinancings rather than M&A. The BSL market has also begun to see a resurgence in dividend recapitalizations, in part because of the lack of M&A activity in 2023 as sponsors seek to return capital to their investors.
• The line between banks, the BSL market and private credit is also beginning to blur, as several banks have begun partnering with private credit or setting up their own private credit investment funds. However, some investors and regulators have raised concerns about systemic risks created by the private credit industry because of linkages with the insurance and banking industries. The jury is still out on the accuracy of these concerns and regulatory changes are unclear, so the impact on the private credit markets remains to be seen.

Junior Capital

• Last year saw an increasing popularity in junior capital structures*. Paid-in-kind (PIK) interest became a common feature of several private credit deals* not only in the case of distress but also for some new issuances, in part to offset higher borrowing costs and reduce cash outflows. Holdco PIK loans (i.e., loans with no cash payments at a shell holding company above an existing loan party structure) also became more prevalent in 2023* as a mechanism to increase leverage. Additionally, preferred equity became more prevalent last year, with several deals looking to preferred equity to fill leverage gaps*.

Distress and the Maturity Wall

• Concerns remain that the Federal Reserve’s “higher for longer” policy may continue to cause declining interest coverage ratios and increase distress among borrowers. Current distress levels are near the 10-year average but are trending upward, leading KBRA to predict that in 2024, private credit will see a 2.75% default rate (up from 2.1% in 2023) and the BSL market will see a 4% default rate (up from 3.5% in 2023). Concerns also remain about the impending maturity wall as debts become due in 2024 and 2025, though many recent refinancing transactions have helped to alleviate some of those uncertainties.

Key Debt Market Data on CreditSights

• Private Credit Pricing & Leverage Data (March 18, 2024)*
• Private Credit Covenant Trends (February 13, 2024)*
• BSL Leverage Trends (March 1, 2024)*
• BSL Documentation Trends (March 18, 2024)*

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