2Q 2023 Update: Middle Market Credit Spreads, Required Returns

Markets remain stable but with a cautiously optimistic outlook in 2Q 2023

By: Adrian Lowery

Estimated reading time: 1 minute

Syndicated markets reached their low points from June 2022 to October 2022. Since then, prices and credit spreads improved but remain adverse to levels in January 2022. Market participants have a cautiously optimistic outlook for the remainder of 2023 despite continued concerns about the impact of inflation, higher borrowing costs from increased reference rates, and a potential recession. Improving sentiment led to further tightening in syndicated credit spread quarter-over-quarter.

Q2 2023 Private Credit Price and Spread Changes

In the middle market, competition increased for “high quality” deals, as the improved sentiment also impacted direct lenders and private equity sponsors, leading to slightly more advantageous terms for borrowers and sellers. However, deal volumes remain limited as market participants remain cautious about sectors perceived as lower quality. Therefore, during the second quarter of 2023, the direct lending market remained stable quarter-over-quarter as discounted credit spreads remained near recent highs.

Q2 2023 Traditional Middle Market Reference Rates

Direct lenders remain focused on interest coverage metrics as borrowing costs continue to increase in line with Spot Reference Rates. 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 (according to the CME Group, 3-month Term SOFR is ~5.3%) and lower forward expectations (according to Pensford, 3-month Term SOFR Forward Curve declines below 4% after November 2024). 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 Q3 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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