A 3Q 2021 Update on Middle Market Credit Spreads and Required Returns

Quarter Three a 3-Peat, Marked With a Continuation of Q2's High Competition and Term Aggression

By: Adrian Lowery

Estimated reading time: 2 minutes

In Q3 2021, both direct lenders and private equity sponsors note similar trends as Q2 2021, including aggressive loan pricing, purchase price multiples, and deal terms. Market participants continue to react to high competition, positive vaccination rates, optimism about the economy and company prospects, and demand for floating rate securities given increased concerns about potentially higher inflation rates. As a result, investors reported a greater willingness to underwrite more storied, high COVID impacted, or marginal issuers.

Credit spreads for first-lien, second-lien, and unitranche loans in the traditional and lower-middle markets and the small market remain ~100 to 125 bps above pre-COVID levels. This is attributable to an increased risk aversion, and LIBOR floor benefit from the decline in spot LIBOR below the average LIBOR floor of ~1%. However, considering the competitive market dynamics, market participants report a ~125 bps tightening in credit spreads since Q2 2020 and generally stable credit spreads in 2Q and 3Q 2021 as market participants note that pricing has hit somewhat of a floor relative to return requirements in these markets.

Q3 2021 Middle Market Credit Spread Comparison

Credit spreads for first-lien, second-lien, and unitranche loans widened ~50 to 100 bps from pre-COVID levels in the upper-middle market. The lesser magnitude versus the above markets is due to increased competition between the upper-middle and broadly syndicated markets, which results in the migration of large market terms into the upper-middle market (e.g., tighter first-lien discounted spreads, average LIBOR floors of ~0.75%, and inter-credit spread between first-and-second-liens below 400 bps.) VRC reflected these factors in the Q2 2021 matrix, and credit spreads were generally stable in 3Q 2021.

Upper Middle Market Credit Spreads as of September 2021

The unitranche structure continues to take share from more traditional first-and-second-lien or first-lien-and-mezzanine structures. Therefore, matrix levels more heavily consider unitranche levels. Market participants note that the blended pricing on the first-and-second-lien capital structures is likely lower than the comparable unitranche structure all else equal and the inter-credit spread is likely lower than the traditional 400 bps. This notion is demonstrated by the average broadly syndicated market inter-credit spread of ~300 bps. However, supporting data points for the traditional middle market are limited. Market participants note that borrowers are willing to pay a premium for the unitranche structure given the certainty of close, sole lender, lack of rating (relative to the syndicated market), availability of follow-on capital, and fewer counterparties.

We expect valuations to reflect stable market yields for existing portfolio securities and incorporate fundamental and technical data as it becomes available. 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.

VRC’s Outlook for Q4 and Early 2022 Expectations

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

  • Tax policy changes to capital gains and carried interest gains are anticipated in 2022.
  • The Delta variant threatens to shut down industries that suffered early on in the pandemic, including restaurants and travel. However, this is somewhat mitigated by increasing vaccination rates.
  • Inflation is leading to rising costs for raw materials, fuel, and wages, putting downward pressure on margins. Still, many companies have been increasing prices to offset higher costs with uncertain success.
  • Reduced government stimulus measures, scaled back asset purchases by the Federal Reserve, and the potential need for the Fed to raise interest rates in 2022.


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