In our Q3 report we explore:

• Federal Reserve’s Rate Cuts: Recent reductions and projections through 2025
• Private Equity and M&A Trends: Revival signs and increasing new money issuances
• Private Credit and BSL Market Trends: Key developments and the competitive landscape
• European Financing Trends: Notable shifts and emerging patterns

On October 31, 2024, we hosted a webinar following the release of our quarterly editorial. Watch the “Credit Conditions: Key Debt Market Trends” webinar recording to learn more.

For more, access our Credit Conditions resource page.

Key Debt Market Trends

“Higher for Longer” Ends Not With a Whimper but a Bang

• The recent rate cut of 0.50% – the first rate cut since the Federal Reserve began raising rates in March 2022 – together with projections of another 50% rate cut before year-end marks the end of an era. It also represents a seismic shift from June 2024 when many expected that the Federal Reserve would only cut rates by 0.25% once this year in December. In contrast, the Federal Reserve now projects that the top target range for rates will fall an additional 1.50% (i.e., to a top rate of 3.50%) between now and the end of 2025, which is significantly faster than previously anticipated.
• The September 2024 rate cut shows that the Federal Reserve is shifting the focus of its dual mandate from fighting inflation to stabilizing the labor market as a result of cooling inflation and falling consumer prices. However, concerns remain that a recession may be right around the corner. So it remains too early to know if the Federal Reserve will be able to deliver a soft landing for the economy, even if that outcome looks more likely today.

A Private Equity/M&A Revival?

• Is the long anticipated M&A revival finally here? With an estimated $4.5 trillion of dry powder (or $9 trillion of buying power with leverage), private equity sponsors have the capital to deploy. Declining rates and a corresponding decrease in interest expense should ease some of the challenging math that deal financing faced during the “higher for longer” era. There is also already some evidence that the M&A market has already improved in 2024 with year-on-year increases in M&A and LBO deal value for Q1 of 2024 at 33% and 63%, respectively.
• Limited partner pressure may also spur M&A activity soon. With private equity exits at a five-year low, some limited partners have become focused on distributions on paid-in capital (in lieu of the more traditional internal rate of return benchmark) and have limited commitments to new funds until distributions (typically generated by the sale of portfolio companies) increase.
• On the other hand, it’s still too soon to tell if these trends will be enough to overcome the headwinds, chief of which is a persistent valuation gap between buyers and sellers that has hindered dealmaking since interest rates began to rise. Though there’s anecdotal evidence that some sellers are becoming more realistic about valuation as revenue growth expectations moderate, it does not appear to have become a broad trend yet. An overhang of portfolio companies purchased at high valuations in 2020 and 2021 may also slow M&A recovery as sponsors wait for valuations to return to historic levels to avoid selling at a loss. Additionally, sponsors who have seen negative trends in their own portfolio companies may be more skeptical when reviewing new opportunities, which could slow the pace of acquisitions in the near term.
  

Record-Setting Refinancings, Repricings, and Amend and Extend Transactions

• Refinancings, repricings, and amend and extend (A&E) transactions have set records in the broadly syndicated loan (BSL) market this year, each with the highest year to date through August on record. The volume this year through August has been so high that refinancings and A&E transactions are higher than all full year amounts on record (other than 2013 and 2017 with respect to refinancings). BSL repricing volume has similarly been so high this year that as of early September roughly 35% of the asset class had been repriced.

New Money Issuances Are Increasing

• While refinancings, repricings, and A&E transactions have dominated the market in 2024, the third quarter has seen the tide shift with a sizeable increase in new money issuances (i.e., loans not related to the refinancing or amendment of existing debt). After hitting lows of 25% in 2023, 18% in Q1 2024, and 13% in Q2 2024 (the lowest level since the great financial crisis), the first half of September saw new money issuances account for approximately 70% of total activity. M&A financing, typically a large driver of new money issuances, also saw similar increases with speculative-grade borrowers raising more loans for M&A transactions than refinancings in July for only the second time in the last 18 months.
• Dividend recapitalizations also contributed to the increase in new money issuances after largely disappearing last year. 2024 is on track to set records with $69.3 billion through September 24, placing it ahead of 2021 (the next best year on record, which was at $66.4 billion over the comparable period and ended at an all-time annual high of $76 billion). Notably, Belron, backed by Clayton, Dubilier & Rice; Hellman & Friedman; BlackRock; and GIC, announced the largest ever global dividend recap by transaction size at the end of September, which involved €8.1 billion of new debt, including a $4.69 billion and €2.05 billion cross-border Term Loan B financing, to fund a €4.357 billion shareholder dividend. With limited exit opportunities and a need to return cash to their investors, the appeal of dividend recapitalizations to private equity sponsors isn’t surprising. However, this year’s dividend recapitalizations have a different profile. Based on data collected through August 2024, the size of dividend recaps are at a six-year high (the median was $316.5 million) and priced at the lowest levels since at least 2010 (the average was 3.77%) though average pro forma leverage was markedly lower than the average from 2018 to 2022 at 4.7x as compared to 5.5x, respectively, reflecting a broader trend in public credit markets toward less risky and higher quality borrowers.

Private Credit and BSL Markets Continue To Compete

• The battle for market share between the BSL and private credit markets continued in Q3 of 2024 with private credit increasing its takeouts of the BSL market between Q2 and Q3 (after a spike in favor of the BSL market in Q1). Private credit has competed in part by reducing pricing spreads and increasing leverage, with spreads declining by 50 to 100 basis points or more compared to 2023 and leverage increasing by 0.75x or more compared to last year. Private credit has also differentiated itself from the BSL market with an increase in payment-in-kind (PIK) optionality at closing for high quality borrowers and an increase in the use of warrants or other equity kickers, particularly in the lower middle market on junior capital loans where borrowers are in a high-growth phase. However, if the macroeconomic picture stabilizes and volatility in the BSL market continues to decline, some borrowers may return to the BSL market in lieu of paying a premium for private credit’s lower execution risk. In the long run, expectations remain that the two markets will coexist and borrowers will continue considering both markets, so the competition and convergence between the two will also likely continue.

Private Credit’s Shifting Landscape

• Private credit continued growing in scale and scope this quarter. The largest private credit lenders saw record-breaking fundraising with Ares Management raising $34 billion, HPS Investment Partners raising $21 billion, and Goldman Sachs raising $20 billion for new private credit funds. The largest private credit lenders also began lending to investment-grade companies this quarter, pushing further into roles traditionally only available to banks. Consolidation also provided another avenue to scale with Blue Owl Capital agreeing to acquire Atalaya Capital Management to expand its asset-based lending capabilities and Clearlake Capital reaching a deal to acquire MV Credit to help it expand into the European market.
• New private credit and bank joint ventures also continued this quarter. Recent notable partnerships include Citibank partnering with Apollo and Mizuho partnering with Golub Capital. The common logic cited is that banks have relationships, but regulatory tightening has limited their ability to lend while private credit is seeking new sources to deploy its capital. So a joint venture provides private credit access to new clients without the need to hire staff to source new deals while banks can keep their existing relationships and continue providing ancillary services, such as working capital and cash management services. Similar logic has also lead some large banks that underwrite loans in the BSL market to look at buying private credit lenders outright since ownership provides the additional benefit of being able to provide a dual-track underwriting and private credit solution internally and avoid losing business to a competitor.
• This quarter also saw several global asset managers begin targeting retail investors for investments in private credit with BlackRock partnering with Partners Group, Apollo partnering with State Street, and KKR partnering with Capital Group. This shift appears to be in part driven by investor demand for access to private opportunities given the increasing shift away from bank lending and public listings. The asset class is expected to grow significantly with predictions that financial advisers will manage $3.6 trillion of alternative assets for their individual clients by 2028, up 50% from 2023’s $2.3 trillion.

Diminishing Distress but Lingering Concerns

• With reports of increasing interest coverage ratios for the first time since Q1 of 2022, expectations that Federal Reserve rate cutting will only improve those metrics, and bankruptcy and payment defaults declining to 0.78% (approximately 1% lower than their peak in July 2023), one could think that distress concerns were behind us. However, analysts have raised alarm bells that Pandora’s box may have been opened during the “higher for longer” era because of the increasing number of “liability management exercises” (LMEs), largely seen as a result of weak covenant protections for lenders and the increasing cost of bankruptcy. Beyond some lenders’ animus for the creditor-on-creditor violence wrought by LMEs, concerns include that LMEs do not provide sufficient time or flexibility to resolve underlying issues – a view held by a majority of industry experts in a recent survey. While private credit is not immune from LMEs, the stronger covenant structures in the core middle market where many private credit lenders operate often limits their viability. However, reports of silent defaults in private credit (i.e., defaults addressed via amendments and thus potentially unreported) and concerns over inconsistent valuations of private credit portfolio loans indicate that the private credit distress picture may not be as rosy as the public market data suggests. In any event, it remains to be seen how these trends will play out now that the “higher for longer” era is over.

European Trends

• The BSL market in Europe continued to advance its recovery in the first half of 2024, reaching more than twice its volume compared to the same period in 2023, according to Bloomberg. This was supported by an increased risk appetite from investors, solid collateralized loan obligation (CLO) issuances/repricings, and the relatively new tapping of retail investors, which did not feature in Europe before 2023 unlike the US market.
• Surprisingly, this BSL volume has been used mainly for refinancings and repricings, with spreads coming down materially even against a backdrop of relatively slower growth in Europe compared to the United States. This has translated to repricings often in the range of a 25 to 50 bps reduction and repricings at a 50 to 100 bps reduction from last year (similar to the US).
• M&A and dividend-recap-related financing picked up in Q2 of 2024 in Europe. However, normally the single biggest driver of new supply in the leveraged debt markets, M&A activity remains at a surprisingly muted level. Refinancing needs are expected to continue to drive the European leveraged finance market, with significant maturities each year and a peak in 2028, although the short-term maturities have mostly been addressed over the past year.
• The European private credit market has also thrived, with notable fundraising successes in 2024 compared to 2023, particularly for the better-known established names. Additionally, the private credit market seems to be spreading out in terms of the geographies and industries that will be financed, with an increased popularity of deals in Benelux and the Nordics.
• The downward pressure on spreads results largely from favorable technical factors. For example, the strong CLO issuance levels in Europe (some predict 2021’s record in terms of issuance volume will be surpassed, although CLOs are not as significant a portion of the European institutional market as they are in the US) benefitting demand for BSLs and the positive fundraising results benefitting demand from credit funds has meant solid demand to make leveraged loans. However, not many opportunities are presented by the market, particularly M&A-related ones. This has resulted in spread compression in European BSLs, increased pricing, and, to a degree legal terms, competition between the underwriters of BSLs and private credit funds. The historical 150 to 200 bps differential to BSL pricing for senior secured private credit is now seen as low as 100 bps.
• Separately, regulatory capital relief strategies for regulated banks and other pressures to increase participation in the private credit space and make use of their extensive contacts for non-sponsor origination have resulted in more banks joint venturing with credit funds and/or starting direct lending operations funded either by balance sheets or separately raised funds managed by the bank. This year, we have also seen a marked increase in clubbed credit lenders making large cap (more than €1 billion) loans.
• How this will play out when M&A markets inevitably improve, perhaps after a period of volatility as the markets digest the recent French, German, and United Kingdom elections and a wary eye is kept on the US election, is not entirely clear, but the private credit market has ways to compete with the BSL market while covering areas and certain debt products not covered by the BSL market. Thus, we expect the European private credit market to continue to thrive but alongside a more functional and competitive European BSL market over the next period.

Key Debt Market Data

• Private Credit Pricing & Leverage Data (October 3, 2024)
• BSL Leverage Trends (October 7, 2024)
• BSL Documentation Trends (October 9, 2024)
• BSL Covenant Trends Q2 2024 (July 30, 2024)

In this report, you’ll discover:

• Private Equity and M&A Activity Trends
• Private Credit and BSL Market Trends
• Cross-Border Financing Trends

For more, access our Credit Conditions resource page.

Key Debt Market Trends

Interest Rates

• “Start your engines” has shifted to “hold your horses” as rates continue to remain “higher for longer.” Expectations have now shifted from March’s three rate cuts starting in June 2024 to only one rate cut in 2024 between September and December. Expectations for 2025 and beyond were also 0.25% higher than March projections (which were 0.25% higher than December projections). However, Federal Reserve Chairman Jerome Powell noted in his press conference that 15 of the 19 members were in favor of one or two rate cuts, so a second rate cut is still “plausible.” For the time being, though, “higher for longer” remains a game of “wait and see.”

Private Equity and M&A

• High interest rates have continued to dampen M&A activity. First-quarter middle-market dealmaking was flat to slightly up on a year-over-year basis according to PitchBook. However, market sentiment appears to be improving, with bankers seeing a first-quarter increase in pitch activity and sale process launches and lower-middle-market private credit lenders reporting increased M&A activity. Leverage in the broadly syndicated loan (BSL) market has also improved with M&A-driven loan deals seeing total leverage of 4.9x for the three months ended May 31, up from Q4 2023’s 4.1x.
• Private equity exits have been a mixed bag, with the number of exits increasing each quarter since Q1 2023, but with an aggregate value down 22% comparing the first quarters of 2023 and 2024 in part due to a continuing gap between buyer and seller valuations. With 40% of private equity portfolio companies being held for more than four years, some private equity funds have turned to dividend recapitalizations in order to return cash to investors. January to mid-April saw the highest volume of dividend recapitalizations in the broadly syndicated market since recordkeeping began in 2006, and January to mid-June similarly tied historical records over the same period.

Private Credit vs. BSL

• The BSL market surged in the first quarter of 2024, with both domestic loan activity and cross-border loan activity near levels last seen in the first quarter of 2021. The vast majority of these loans have involved opportunistic refinancing or repricing as borrowers seek to reduce the cost of expensive debt issued in the past two years or extend maturities to address upcoming maturity wall issues. Amend and extend transactions similarly increased, with average volume from September 2023 to April 2024 at 70% higher than the average over the preceding two-year period.
• Private credit has continued to dominate financing for leveraged buyout (LBO) transactions as compared to the BSL market but has also seen an increase in refinancings and repricings similar to the BSL market. The first half of 2024 saw double the amount of refinancings as compared to the same period last year. In comparison, private credit LBOs and other types of M&A financings have also risen by 19% and 51%, respectively, over the same period.
• Increasing activity in the BSL market has led to increased competition with the private credit market. The first four months of 2024 saw more private credit loans refinanced in the BSL market, flipping the 2023 trend. The increased competition has led to growing convergence between the two markets. Private credit has become more competitive on pricing by actively leveraging incumbency  and repricing existing deals to fend off refinancings by the BSL market, with average private credit pricing declining by 50 to 150 basis points and the gap between BSL and private credit markets narrowing by 100 basis points between 2023 and 2024. The BSL market has also begun competing on structural flexibility, with some deals including delayed draw term loans and paid-in-kind (PIK) interest, which historically were selling points for private credit financings. Private credit, however, continues to compete on other terms, including the traditional selling points of lower execution risk and higher certainty of loan terms (as compared to the BSL market), no ratings requirements, fewer lenders to negotiate with in the future, and availability of recurring revenue loans, as well as newer terms. Some of the more recent terms include increased leverage and fewer capped EBITDA add-backs, additional PIK interest via synthetic PIK (i.e., interest paid via a delayed draw term loan facility), availability of covenant-lite loans (which historically were a selling point of the BSL market), and preemptive amendments ahead of covenant defaults.
• Private credit has continued to expand beyond its traditional bread and butter of middle-market private equity borrowers. Some private credit funds have begun seeking smaller nonsponsored deals for higher returns and more lender-favorable documentation. Larger private credit funds have begun expanding into various forms of alternative asset-backed debt from the traditional asset-based revolving loans and asset-backed term loans to newer asset classes such as aircraft financing, infrastructure loans, commercial real estate financing, equipment leasing, trade finance, royalty financing, student loans and consumer installment loans.

Blurring Lines

• Private credit and bank financing are further converging as banks have begun partnering with existing private credit lenders or launching their own private credit initiatives. Part of the appeal for private credit has been access to nonsponsored borrower relationships and new asset-backed debt as an asset class, which previously were dominated by bank lenders. Banks have been seeking out private credit, in part, to source third-party funding since Basel III and other stricter bank regulations to which private credit lenders are subject are making it harder for banks to lend off their balance sheets. The partnerships also benefit both banks and private credit as dual-track deals showing a syndicated option, a private credit option and a hybrid option have gained traction with sponsors looking for optionality in the early stages of a financing transaction and are expected to become more important going forward.

Adjacent Structures

• Limited financing activity relative to dry powder, combined with the inherent difficulty in further financing certain over-levered structures, has led borrowers and lenders to explore a variety of financing types, from fund finance and NAV facilities to factoring facilities and even deeply structured instruments that share features of both debt and equity products. This increased complexity will need careful consideration from both a credit and a legal perspective, but the creative nature of this thinking lends heavily to private credit, which can show both terms and structuring flexibility to drive solutions.

Crossing Borders

• The growing trend of US institutions transacting in the European market, either from their US homes or from European offices, has continued across both private equity and private credit. This growing opportunity for lenders to follow their sponsor relationships has also led to an increased conflation across terms not seen quite so starkly since the advent of the Yankee Loan. In particular, Spain, Italy and other European markets that were considered more challenging for transactions – because of a banking monopoly, insolvency or applicable collateral regimes – are now ripe for investment, driving an increased tightening on terms and economics in what is already an increasingly hot market. As institutions become even more comfortable with navigating the regulatory landscapes, activity from US funds in Europe will likely continue to grow.

Diminishing Distress?

• Default rates appear to be moderating. Default rates in the BSL market on a trailing 12-month basis ending May 2024 fell to 4.29%, down by 0.22% since April 2024. The payment default rate over the same period similarly fell to 1.08%, down by 0.22% since April 2024, marking a 15-month low from the peak in July 2023 at 1.75%. However, concerns remain about the underlying health of borrowers’ balance sheets, as interest coverage ratios remain depressed. In addition, the increasing use of PIK interest may be depressing default rates, particularly in the private credit market. In any event, long-term relief will likely only come once underlying base rates begin to fall.

Key Debt Market Data on CreditSights

• Private Credit Pricing & Leverage Data (June 18, 2024)
• BSL Leverage Trends (June 10, 2024)
• BSL Documentation Trends (June 3, 2024)
• BSL Covenant Trends 1Q2024 (April 22, 2024)

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.

For more, access our Credit Conditions resource page.

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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