Debt Download

In the News

• The leveraged loan market showed signs of optimism in July, with an increase in volume, pricing flex favoring borrowers 18 - 0 and average all-in clearing spreads for single-B new issuances dropping to S+494 (down from S+510 in June). Additionally, there has been an increase in repricing activity among other opportunistic transactions as spreads start to decrease slightly. Nonetheless, amend-and-extend activity remains robust, accounting for 23% of all leveraged loan activity tracked by LevFin Insights YTD through July, the highest annual total since LevFin Insights began compiling such stats in 2017. On average, such amended loans had higher pricing, tighter covenants, and additional liability management “protections”.
• Despite the positive signs in the loan market, leveraged loan defaults are on the rise – LCD notes that there has been a rapid increase in the number of payment defaults and bankruptcy filings of borrowers in the Morningstar LSTA US Leveraged Loan Index (with technology companies in the lead for most debtor-in-possession (DIP) financings – debt incurred by companies in bankruptcy – in the first half of 2023). While analyzing leveraged loans backing M&A in the past year, PitchBook found that, although total leverage has declined in 2023, so has the “debt cushion” (the proportion of first lien loans to junior/subordinated debt), which historically has meant less recovery for senior lenders in a default scenario. The NYT recently covered the “creaking” credit markets and warned that further acceleration of bankruptcies and defaults were coming. The FT also noted that the trend of rating downgrades for leveraged loans – stemming in large part from rising interest rates – could trigger CLOs’ built-in risk caps on the amount of low-rated debt they hold, forcing riskier companies to even higher-cost funding. The market also continues to closely monitor the impact of rising rates on interest coverage ratios. With respect to private credit loans, however, the default rate seemed to improve in 2Q23 compared to 1Q23.
• As increased rates make debt less attractive for financing add-on activity, PE firms are increasingly funding such acquisitions with equity in order to avoid bumping up against leverage-based financial maintenance covenants. Another alternative to senior debt that is becoming more attractive to borrowers is the use of junior capital as a funding source, which (like equity financing) can help avoid triggering “MFN” protections on senior debt – a provision in many leveraged loan documents that automatically increases the interest rate on a borrower’s existing loans if the all-in yield of a new loan is higher (typically 50 bps) than the all-in yield of the existing loans. On the other hand, Bloomberg notes that wall street banks are eager to start issuing broadly-syndicated loans to start funding M&A again, so we may be seeing some light at the end of the tunnel. With respect to the PE industry more generally, the end of the age of cheap borrowing and robust markets may mean that private equity is heading back towards needing to invest “in the old-fashioned way” rather than riding the tailwinds of the last decade which made it easier to profit on investments. In addition, as the private equity industry faces a tough fundraising environment, some PE firms are offering incentives to would-be investors, including discounts on management fees, more co-investment opportunities, and, in some cases, even a portion of the management fee that normally is paid to fund managers.
• The impact of the banking turmoil from earlier this year is still being felt – Banc of California agreed to buy PacWest in a deal that does not require any assistance from the federal government (unlike JPMorgan’s recent takeover of First Republic Bank), though PE firms Warburg Pincus and Centerbridge are investing $400 million in the deal. While the collapse of Silicon Valley Bank (SVB) led to a flight to both too-big-to-fail banks and private credit providers, venture-backed companies may make their way back to banks (as opposed to private credit) that focus on venture debt, including banks that have bulked up venture debt business like HSBC and Stifel. In addition, SVB, now under ownership by First Citizens Bank, has been successful in winning back some of its client base after its collapse.
• Despite a somewhat challenging fundraising environment, private debt funds, particularly funds targeting investments in mezzanine and special situations strategies, have been raising more capital globally than in years past, though with a smaller number of funds. Indeed, there has been a trend of PE firms buying asset managers and general consolidation in the industry. Interestingly, recent research from Barclays notes that it may be more accurate to value U.S. private credit volume around $700 billion rather than the $1.4 trillion that has been previously stated, since the latter includes dry powder.
• The Fed increased its benchmark rate another 25 bps in July, bringing it to a 22-year high. The European Central Bank also raised its rates by another 25 bps, its ninth increase in a row and also a 22-year high, and the Bank of England raised its key interest rate by another 25 bps.
• As we covered in the July edition of Debt Download, the SEC declined to officially comment on whether it views term loan Bs as securities in the Kirschner case after asking for multiple extensions – this Covenant Review article provides an excellent breakdown of the case, the legal arguments and the implications for the loan market. For an inside view of the advocacy efforts of JPMorgan, Citibank and the LSTA, and some educated speculation on how the SEC came to its decision, check out this article by Institutional Investor.
• CUSIP announced a new unique entity identifier that was made specifically for loans (both syndicated and private credit) called a CUSIP Entity Identifier (CEI). This will be a unique 10-character code for each issuer of corporate loans.
• Quick roundup of recent new direct lender debt funds (and related updates):
  • Jefferies announced that it is launching a BDC with $1.7 billion to invest in private credit.
  • Antares closed a new senior loan fund, SLF II, with $6 billion to invest.
  • Angelo Gordon closed AG Asset Based Credit Fund at more than $1 billion.
  • Comvest closed its latest fund, Comvest Credit Partners VI, at $2 billion.
  • Neuberger closed its NB Credit Opportunities Fund II at approximately $2.5 billion.
  • Blackstone closed the largest energy transition private credit fund, Blackstone Green Private Credit Fund III (BGreen III), at $7.1 billion.

Goodwin Insights

Equity cures – often overlooked as “boilerplate” in credit agreement negotiations – are getting increased attention as businesses contend with more frequent financial maintenance covenant breaches and market volatility. Sponsors and other equity investors (“Investors”) and lenders are learning that robust equity cure rights allow Investors to buy time to protect their investment by addressing underperformance and avoiding renegotiating existing credit agreement terms and pricing in a lender-friendly market. Recent trends and points of negotiation on equity cures include:

• Back-to-Back Cures: Among other conditions applicable to equity cures, credit documents typically limit Investors and borrowers from exercising equity cure rights more than twice in any period of four fiscal quarters. Some credit documents will additionally prohibit Investors and borrowers from exercising equity cure rights in any two consecutive fiscal quarters (meaning that they would have to skip a quarter after exercising the cure right before exercising it again). In today’s environment, companies will often require more than one quarter to turn around performance and, accordingly, Investors have been prioritizing the right to make equity cures in back-to-back quarters. The right to cure in consecutive quarters may be key to providing companies sufficient time to recover (and could prevent Investors from putting in capital in one quarter only to have a default the following quarter that cannot be cured with additional investments). To that end, in some larger cap credits, the cap on cures is flipped such that the borrower is prohibited from having more than two consecutive cure quarters in any four quarter period (i.e., the cap is three cures in a four quarter period).
• Timing for Q4 Cures: Credit documents include deadlines by which Investors must make an equity cure for a particular fiscal quarter, and such deadlines are typically on (or within 10-15 days after) the date on which financial statements are required to be delivered for such fiscal quarter. As such, in transactions where borrowers are required to deliver quarterly financials only for the first three fiscal quarters of a fiscal year and an audit after year-end, such borrowers have significantly more time to make an equity cure in Q4 than they do in Q1, Q2 and Q3. In transactions where borrowers must deliver quarterly unaudited financials for all four fiscal quarters, as well as an audit for the full fiscal year, there is a question as to whether the cure deadline for Q4 should be tied to the delivery of the quarterly unaudited financials or the audited annual financial statements. Investors and borrowers have been pushing to tie the deadline for Investors to make an equity cure to the delivery of the audit instead of such Q4 financials. Successfully bargaining for this flexibility can give Investors an extra 2-3 months to evaluate the company’s performance and whether to make an equity cure. Also, borrowers should be cognizant if they are required under the loan documents to test their financial maintenance covenant at the end of each of the Q4 test period and the annual test period. If so, the borrower should consider how year-end audit adjustments may affect the required equity cure amount if the borrower needs to cure the Q4 financial covenant and then re-test the financial covenant when the audit is due.
• Source of Capital: In order to exercise an equity cure, credit documents typically require only that there is an equity investment in the borrower (or the direct parent company of the borrower, to the extent it is a party to the credit documents). Credit documents do not, however, control the source of such equity investment. As such, Investors are regularly funding or arranging from third parties PIK holdco notes and other debt and hybrid debt and equity investments at a parent company outside of the credit group (which, in turn, uses the proceeds of such debt or other instrument to make a qualifying equity investment in the borrower or its direct parent) to finance, in whole or in part, equity cures in lieu of funding solely with traditional equity. PIK holdco notes funded or arranged by Investors can be more attractive than a traditional equity raise, because, among other things, they are not dilutive to existing equity owners, the cost of capital is lower, they are quicker to implement and may avoid triggering preemptive or other investor rights and they are a good option for Investors that do not have sufficient capital or the appetite to call capital to fund additional investments.
• Lender Reactions: Some lenders are increasingly looking to identify additional defaults to force borrowers and their Investors to the table to negotiate a full amendment now instead of allowing them to delay or avoid those negotiations by exercising cure rights. Frequent targets for other defaults include late financial reporting or material event notices, missing certificates and challenges to the accuracy of EBITDA adjustments. Sponsors can significantly minimize the risk of surprise defaults by training management to rigidly adhere to all credit agreement requirements, whether big or small.

In Case You Missed It – Check out these recent Goodwin publications: Use of EBITDA in Earnouts Increased 22% in Two Years; Redemption Rights, Minus the Redemption; Be Mindful of Phantom Equity; Phantom Equity to the Rescue; Navigating the SEC’s Focus on Private Fund Fees: Understanding the Trends and Mitigating Risk; US Antitrust Agencies Release Revised Draft Merger Guidelines; and How Much Do Fund Managers Have to Contribute to Their Own Funds?

 

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For inquiries regarding Goodwin’s Debt Download or our Debt Finance practice, please contact Dylan S. Brown,  and Robert J. Stein.

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