The credit and debt capital markets have experienced quite a bit of change over the last year as lenders and borrowers continue to navigate a new landscape due to the Fed’s interest rate policy, bank failures and continued, looming economic uncertainty. The financing markets have endured what has seemed to be continuous and sudden market shifts beginning back in March 2022 when the Fed embarked upon a string of ten consecutive interest rate increases. This resulted in a baseline Secured Overnight Financing Rate (SOFR) or the broad measure of the cost of borrowing cash overnight collateralized by Treasury securities of approximately 5.0% today compared to below 1% in June 2022; a 400% increase within the span of a year. SOFR, which replaced LIBOR in January 2022, represents the baseline-borrowing rate by which banks and other lenders typically price a loan or credit facility to a borrower. The overall velocity of the rate increases over the past 12 months have significantly changed the landscape for both borrowers and lenders today.
The credit and debt capital markets have experienced quite a bit of change over the last year
More recently, in March 2023, the 16th largest bank in the U.S., Silicon Valley Bank (“SVB”) was shut down by the California Department of Financial Protection and Innovation after significant loss in value due to its long-term investments and withdrawals from depositors. This sudden jolt to the banking system, particularly regional banks, was further exacerbated as Signature Bank was shut down, First Republic was supported by the private sector and Credit Suisse was rescued via a merger with UBS. The collapse of SVB coupled with the Fed’s rate hikes largely caused the credit markets to significantly pause resulting in a 60% decline in loan volume in March. The markets, while still dynamic, have since stabilized heading into the back half of 2023.
John Solimine, Head of Debt Capital Markets for Verit, shared that these market developments have resulted in both borrowers and lenders being forced to recalibrate expectations and adjust to a “new norm.” John further expects that the backdrop of these market shifts will result in several key themes that will largely dictate how borrowers should approach the market as well as underlying lending activity for the balance of 2023 and into 2024.
These key credit trends include:
1) Prepare for conservative underwriting conditions. The market sentiment has decidedly shifted towards a “risk-off” approach given interest rate volatility, continued recession fears and macroeconomic headwinds. This has resulted in lower overall leverage levels, increased pricing spreads and more structured credit facilities in the form of tighter covenants, greater focus on collateral coverage and higher contractual amortization or repayment requirements.
2) Expect more stringent lender diligence and underwriting processes. Companies should anticipate a heightened focus on credit risk and should therefore be prepared prior to “going to market.” This entails having comprehensive financial projections, diligence materials and a well-thought out growth story that best positions the credit to a lender. This involves thorough work on the front end including detailed financial modeling, sensitivity analysis and covenant scenario analysis in order to anticipate lender market feedback while best positioning the Company for a successful underwriting process.
3) Proactively assess current banking relationships. Given the overall market environment, it is important to check on the health of your banking partner, develop relationships with a broader set of capital sources and provide insights into your Company. In the early days of credit underwriting, this used to be called the “4 C’s” of Credit: Character, Collateral, Cash Flow and Capital, which have once again emerged as an even more important underwriting framework. For new ESOP transactions, it is prudent to approach a curated group of capital providers that have been thoroughly prescreened for industry, size and transaction structure. Many banks and non-bank lenders are behaving differently depending on the geographic market, industry and credit profile. This has been further reflected with lenders committing to reduced hold sizes and an increased focus from banks on ancillary, non-credit business to boost internal return hurdles. As such, borrowers will benefit from developing relationships early on with a bench of potential capital partners. We have seen more instances of late when this results in the Company staying with their current bank but also bringing in another participant lender or two to help support a new transaction.
4) Reserve flexibility in your overall transaction structure to anticipate lender and market feedback. Given that leverage thresholds remain dynamic and below levels seen in 2022 by potentially 0.5x EBITDA, preserving some structural flexibility or optionality is critical in today’s market for a successful transaction closing. This can come in the form of flexibility to increase levels of junior capital or seller financing, pivoting from a 100% ESOP to a partial ESOP, evaluating a dividend recap or raising minority equity in lieu of an outright sale or other strategic alternative.
Notwithstanding the headwinds and series of micro and macroeconomic surprises, the lending markets remain open for business with an overhang of available capital from commercial banks and non-bank lenders for strong credits and appropriately structured transactions. In particular, ESOP transactions have further exhibited greater resiliency than the traditional M&A markets. This has resulted in an increase in partial ESOP transactions as well as failed M&A processes pivoting to an ESOP given the overall structuring flexibility as an exit alternative. In these instances, Verit continues to successfully navigate the credit markets with clients raising capital for new ESOP transactions as well as existing ESOPs pursuing recapitalizations or other capital raise transactions.
