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Syndicated markets reached their low points from 6/2022 to 10/2022. Since then, prices and credit spreads improved. Syndicated credit spreads were flattish-to-tighter quarter-over-quarter.

VRC’s proprietary research shows that 1st lien, 2nd lien, and unitranche loan coupon spreads decreased by ~25bps at the midpoint of VRC’s ranges since 4Q 2023 in the middle market. Average OIDs remained at ~98. These changes and the flattish 3-month Term SOFR Spot Rate resulted in lower yields since 4Q 2023.

The improved market tone continued through 3/2024 as market participants remained increasingly comfortable with the economic outlook, expected interest rate path, and companies’ ability to weather headwinds. These factors and increased competition amongst lenders, given limited deal flow and additional fundraising, resulted in issuer-friendly changes. However, deal volumes remain limited as market participants remain cautious about sectors perceived as lower quality. The breadth of company quality market participants were willing to bring to market expanded in 1Q 2024, although market participants continue to favor top-tier, or high-quality companies.

There has been a systemic shift in LBO financings in the upper middle market. Direct lenders are still competing and winning large LBO deals, but now there is much higher competition from banks for these deals and banks are refinancing direct lending unitranches. As a result, the pricing is much lower than last year’s standards in the upper 500s to mid-600s spreads. For instance, Wood Mackenzie was refinanced from a direct lending deal at S+6.75% to S+3.50% in the syndicated market.

Direct lenders remain focused on interest coverage metrics as borrowing costs remain high. As a result, leverage levels and purchase price multiples are under pressure for some industries, especially those more exposed to inflation, macroeconomic concerns, and high CapEx requirements. However, direct lenders are considering both spot reference rates (3-month Term SOFR is ~5.3%, per the CME Group) and lower forward expectations (3-month Term SOFR forward curve declines to 4.5% in 12/2024, per Pensford). However, forward expectations shifted materially higher since 12/2023 (the 3-month Term SOFR forward curve was forecasted to decline to ~3.6% in 12/2024, per Pensford) as market participants expect fewer rate cuts in 2024 and market participants continue modeling in higher-for-longer interest rate assumptions as an added layer of caution.

Given the lower forward expectations, direct lenders are willing to accept lower CapEx-adjusted interest coverage levels based on current spot reference rates (recently underwritten deals have a median and mean of ~1.8x) than the traditional 2.0-2.5x lower bound of required levels.

Overall, valuation analyses need to consider case-by-case situations focusing on fundamental performance, outlook, affordability of debt, and available liquidity. Therefore, some credits will continue to fare better than others.

Outlook for 2024

Looking forward to the remainder of 2024, bearing no major shocks, market participants generally expect improving deal flow and a more accessible fundraising environment as market participants become increasingly comfortable with the economic environment, the reference rate outlook, and portfolio performance expectations. Market participants hope that the recent pick-up in deal flow and successful executions will encourage a wider swath of borrowers into the market, versus the 2023 market conditions that heavily favored top-tier companies.

For existing portfolio investments, many market participants expected performance to generally hold up with some potential relief from high cash interest expense as reference rates are largely believed to be at peak levels. While idiosyncratic issues will likely continue, overall default rate expectations remain modest, albeit higher than current levels.