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Syndicated markets reached their low points from 6/2022 to 10/2022. Since then, prices and credit spreads improved but remain averse to levels in 1/2022. Syndicated credit spreads were tighter quarter-over-quarter.

In the middle market, based on VRC’s proprietary research, 1st lien, 2nd lien, and Unitranche loan coupon spreads decreased by ~38bps at the midpoint of VRC’s ranges since 3Q2023. Notably, the range of observed coupon spreads for these loans narrowed since last quarter due to increasing competitive pressures. Average OIDs remained at ~98. These changes, coupled with a lower 3-month Term SOFR Spot Rate, resulted in lower yields since 3Q2023.

Market tone improved through December 2023 as market participants became increasingly comfortable with the economic outlook, expected interest rate path, and a company’s ability to weather headwinds. These factors, along with 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. Market participants continued to favor top-tier, or high-quality companies.

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%, according to CME Group) and lower forward expectations (3-month Term SOFR forward curve declines to 3.6% in 12/2024, per Pensford). However, since forward expectations shifted materially lower since 9/2023 (the 3-month Term SOFR forward curve was forecasted to decline to ~4.6% in 12/2024, per Pensford), market participants are generally 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 ~1.5x and 1.75x, respectively) than the traditional 2.0-2.5x lower bound of required levels. However, underwriting projections generally show an increase to the 2.0-2.5x band as EBITDA grows and reference rates tighten.

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 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.