A 2Q Update on Middle Market Credit Spreads and Required Returns

Second Quarter Continues Trend of High Competition and Aggressive Terms

By: Adrian Lowery

Estimated reading time: 2 minutes

In Q2 2021, both direct lenders and private equity sponsors noted continued high levels of competition, which is driving aggressive loan pricing, purchase price multiples, and deal terms. Market participants are reacting to 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 middle market, the lower middle market, and the small market remain ~100 to 125 bps above pre-COVID levels. This is given increased risk aversion, and the LIBOR floor benefit from the decline in spot LIBOR below the average LIBOR floor of ~1%. However, given the competitive market dynamics, market participants report a ~125 bps tightening in credit spreads since Q2 2020 and generally stable credit spreads in 2Q21. Further, market participants note that pricing has hit somewhat of a floor relative to return requirements in these markets.

Q2 2021 Middle Market Credit Spread Comparison

Credit spreads for first-lien, second-lien, and unitranche loans in the upper middle market widened ~50 to 100 bps from pre-COVID levels. The lesser magnitude versus the markets mentioned above is due to increased competition between the upper-middle and the broadly syndicated markets, resulting in the migration of large market terms into the upper-middle market. Specifically, VRC made the following changes to its upper-middle market matrix in June 2021:

  1. Reduced the first-lien discounted spread by 25 bps;
  2. Lowered the average LIBOR Floor from 1.00% to 0.75%, resulting in a reduced LIBOR Floor benefit; and
  3. Tightened the intercredit spread between first-and-second-liens to 375 bps from 400 bps. The tighter LIBOR floors and intercredit spreads have been relatively standard in the large market for several months, and direct lenders are adopting similar terms to better compete with the broadly syndicated market.

Upper Middle Market Credit Spreads as of June 2021

Credit spreads are only one piece of the underwriting equation. In the first half of 2021, many lenders report documentation, leverage, and covenant protection moving more in line with pre-COVID levels for low and moderate impacted credits due to reduced risk aversion from the trends mentioned above. Market participants note that lenders are increasingly competing on terms and leverage with the positive outlook for the reopening economy and credit spreads at somewhat of a floor.

We expect valuations to reflect tightening 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 pandemic impacts, the benefits of any offsetting measures, outlook, and liquidity. Therefore, some credits will continue to fare better than others, although many outperformed worst-case expectations at this time last year and moved closer to par valuations.

VRC’s Third Quarter Outlook

Moving into 3Q 2021, VRC continues to monitor market tone and expectations as COVID continues to impact markets:

  • How will the Delta variant and rising cases impact the economy?
  • How will inflation impact interest rates, consumer behavior, and company performance?
  • How will proposed tax changes impact capital markets?
  • Have consumer behaviors changed, and what happens when government measures to stimulate the economy end?
  • Given a reopened economy, how will companies handle potentially higher debt burdens undertaken to secure liquidity?

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