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Since 2021, syndicated markets experienced volatility as capital markets assessed the potential impacts of inflation, the increase in spot reference rates as central bankers tighten policy to combat inflation, the Russian invasion of Ukraine, and recession fears. As a result, syndicated market activity indicated wider primary and secondary credit spreads. In 1Q23, prices increased QoQ, given the improved market tone. This resulted in flattish to tighter syndicated secondary credit spreads versus 4Q22 levels.

In 1Q23, direct lenders and private equity sponsors noted that, while the negatives remained, their markets remained stable QoQ. As a result, 1st liens, 2nd lien, and unitranche discounted credit spreads were unchanged since 4Q22. However, the widening of Coupon + OID credit spreads earlier in the year (+50 to 100 bps) and reference rates throughout the entirety of the year (+475 bps) drove higher all-in yields from 12/2021 levels by ~450 to 525 bps, after accounting for the Reference Rate Floor Benefit at the beginning of the year.

The change in direct lending credit spreads is at a lesser magnitude than implied by the syndicated loan, high-yield bond, and public equity markets, considering competition for deals, especially those deemed high quality, remains competitive. Investors’ demand for direct lenders’ floating-rate securities remains robust.

Given rising reference rates during the quarter and the expectation that reference rates would remain higher for longer, some market participants noted in the middle of the quarter that direct lending spreads were starting to tighten versus 4Q22 levels to offset the higher all-in yields. However, during 1Q23, the banking sector experienced material uncertainty and bank failures. This and updated expectations on the Federal Reserve’s progress against inflation and the probability of a near-term recession led reference rates to tighten and forward reference rate curves to indicate a nearer-term tightening cycle than previously expected. As a result, towards the end of 1Q23, market participants noted that trends in direct lending spreads showed unchanged levels instead of tighter.

Direct lenders indicate continued caution when underwriting more storied, inflation-exposed industries or marginal issuers. Therefore, these credits may command a premium relative to more in-favor industries and/or reflect lower leverage levels or purchase price multiples.

Credit spreads are only one piece of the underwriting equation, and many lenders report that, given the concerns mentioned above and higher borrowing costs from increased credit spreads and reference rates, leverage levels and purchase price multiples have come under pressure for some industries, especially those more exposed to inflation, macroeconomic concerns, and high CapEx requirements. While market participants do not note a material shift, they are keeping an eye on CapEx-adjusted interest coverage levels. Given the sudden increase in all-in yields, these are dipping below the traditional 2.0-2.5x lower bound of required levels. VRC will continue to monitor the trend to see if it results in a material shift in leverage levels and purchase price multiples.

We expect valuations to reflect wider market credit spreads and all-in yields for existing portfolio securities since 2021. 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 Q2 2023

VRC continues to monitor market tone and expectations. Risks to the positive market dynamics remain, including, among others:

• Impact of inflation and labor shortages on companies’ fundamental performance.
• Impact of increasing reference rates on companies’ interest burdens and leverage levels.
• Impact of increasing reference rates on market credit spreads as these sometimes tighten with rising reference rates.
• Impact of recession fears on consumer behavior and companies’ fundamental performance.

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