2Q 2022 Update: Middle Market Credit Spreads, Required Returns

Increased Volatility in More Liquid Markets Began to Impact Direct Lending Markets in 2Q 2022

By: Adrian Lowery

Estimated reading time: 2 minutes

Since 2021, syndicated markets have 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. These trends accelerated in 2Q 2022, and syndicated market activity indicated wider primary and secondary credit spreads.

VRC Matrix Q222 Credit Market Price And Spread Changes

In June 2022, direct lenders and private equity sponsors noted that the negatives mentioned above began to impact their markets. As a result, 1st liens and unitranche credit spreads increased by ~25 to 50 bps, while 2nd lien credit spreads were deemed unchanged, reflecting tighter 1st-to-2nd lien inter-credit spreads over the last several quarters. When coupled with materially higher reference rates, all-in yields increased materially from March 2022 levels by ~125 to 175 bps.

VRC Matrix Q222 Credit Spreads Traditional Middle Market

The change in direct lending credit spreads are 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. Overall, investors’ demand for floating rate securities remains robust, and direct lenders continue to raise additional capital commitments.

Direct lenders indicate increasing 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 documentation, leverage, and covenant protection more in line with pre-COVID levels. However, given the concerns as 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 or if credit spreads tighten in response to higher reference rates and all-in yields.

We expect valuations to reflect wider market credit spreads and all-in yields for existing portfolio securities. Valuation analyses need to consider case-by-case situations focusing on fundamental performance, outlook, and liquidity. Therefore, some credits will continue to fare better than others.

Outlook for Third Quarter 2022

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.
  • Further spillover of volatility in the more liquid markets into the direct lending markets.

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