3Q 2022 Update: Middle Market Credit Spreads, Required Returns
Sustained Sell-Off in More Liquid Markets Since 2021 Continues to Impact Direct Lending Markets in 3Q 2022
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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 tightened 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 3Q22, these trends continued to negatively impact prices, although syndicated secondary credit spreads were similar to 2Q22 levels.
In 3Q22, direct lenders and private equity sponsors noted that the aforementioned negatives continued to impact their markets. As a result, 1st liens, 2nd lien, and unitranche discounted credit spreads increased by an additional 50 bps since 2Q22 (unchanged to +50 bps movement in 2Q22). When coupled with materially higher reference rates, all-in yields increased materially from 12/2021 levels by ~325 to 400 bps.
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. Investors’ demand for direct lenders’ floating-rate securities remains robust.
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. Many lenders report that, given the concerns noted 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 Q4 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 volatility spillover from the more liquid markets into the direct lending markets.
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