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In late February and continuing into March of 2020, the global capital markets declined precipitously given concerns about the economic impact of the novel coronavirus (COVID-19) and worldwide counteraction efforts. These efforts included urging citizens to “social distance,” stay home, and the widespread closure or cancellation of stores, events, and activities.
As a result, default rate forecasts increased meaningfully, expectations for a global recession are high, and many industries, especially those with consumer exposure, are facing materially lower or no revenues for as long as “shelter in place” measures are in effect. On the world stage, governments and central banks also took steps to support the financial system, businesses, and employees.
To ensure survival, many companies are drawing on additional liquidity sources, reducing costs, delaying payments, working with creditors and equity holders, stress testing projections, and reviewing government programs. However, given the unknown duration of “safer at home” measures to slow the spread of the virus, material impacts to revenue, and the state of the economy and consumers upon exiting this environment, the outlook for many companies (even in light of financial survival tactics) remains highly uncertain.
As a result, secondary markets sold off meaningfully, reflecting increased investor risk aversion. While secondary indexes are good barometers of investor sentiment and market trends, unlike the primary markets, they are exposed to over-levered credits, changes in documentation requirements, and technical selling pressure. Therefore, levels reflected in secondary indexes may not be fully reflective of company fundamentals and pricing for a new-issue deal with market clearing terms reflecting the new normal.
Also, we note that syndicated credits, reflected in secondary indexes, were generally underwritten with more borrower-friendly terms than the direct lending middle-market, such as no LIBOR floors, no covenants, higher leverage, and looser controls around additional leverage or assets leaving the company.
Overall, determining the price of risk is challenging. Markets are largely in “price discovery mode” as primary markets remained largely shuttered through March 2020. Debt and equity investors have turned their primary focus to assessing impacts on their existing portfolio companies to ensure adequate liquidity. While many investors report high levels of dry powder and an open for business stance, little issuance is being completed as underwriting anything other than the safest credits has proven to be extremely challenging.
Based on VRC’s conversations with market participants, direct lenders and private equity investors in the middle-market were not immune from the negative trends observable in the Broadly Syndicated and Institutional Middle Markets. However, indications are that the increase in required credit spreads was not as pronounced as in the more liquid secondary markets. Generally, market participants indicate higher credit spreads as outlined here for high-quality issuers, while storied, or more marginal issuers may have to pay a premium or adjust other terms to reduce relative risk.
However, we note that credit spreads are only one piece of the underwriting equation. Many lenders are adjusting term sheets to require, among other items, tighter documentation, lower leverage, increased covenant protection, 1.0 percent or greater LIBOR floors, and pricing grids. Overall, lenders are looking to reduce risk and increase the compensation for the risk that is underwritten, given the high uncertainty around company and economic outlooks.
For existing portfolio securities, we expect valuations to reflect the new state of the market and incorporate fundamental and technical data as it becomes available on a case-by-case basis.