The economic turmoil in the capital markets did not bode well for private equity dealmaking in the third quarter. US companies raised just $10.6 billion of leveraged loans to fund buyouts over the past three months, the lowest such reading in almost seven years. The drop-off in activity is even more stark when compared to a year ago — LBO-related volume totaled $46.1 billion in 3Q21, the busiest quarter since the Global Financial Crisis.
In the year to Sept. 30, US borrowers raised $70.6 billion of leveraged loans to fund buyouts, 44% behind last year’s pace. Again, 2021 was a banner year for leveraged loans, featuring an all-time high for institutional volume ($615 billion) and a 14-year high for loan volume backing buyouts ($146 billion). Looking over a longer history of the first three quarters, the current year is ahead of both 2020 and 2019, and ahead of the 10-year average of $71.4 billion.
For some perspective, the 44% year-over-year decline in LBO loan volume is milder than the 63% decline in total sponsored loan volume (including refinancings, recaps, etc.) or 49% decline in corporate M&A activity. According to PitchBook data, US PE funds had $819 billion of dry powder at the end of 2021, and this year’s drastic retreat in the public equities market presented opportunities for private equity funds.
In fact, take-privates have accounted for 23% of all LBO loans tracked by LCD so far this year, the highest share since 2011, up from roughly 15% between 2016 and 2021 (based on deal count). At the same time, the pace of secondary buyouts has slowed, although it still takes up the largest share of activity, at 46% by count. This was the lowest reading in nine years, down from 55% in 2021 and the 53% post-GFC average, as private equity firms are holding onto their portfolio companies amid challenging market conditions.
However, financing buyouts in the leveraged loan market became very challenging this year — and expensive — as market conditions deteriorated on the back of a worsening economic outlook, rising interest rates, inflation concerns and the war in Ukraine. First-lien term loans account for the bulk of debt used to fund buyouts, at 80%, on average, for all buyouts tracked by LCD in the last five years. The average spread on LBO-related term loans rose to Sofr+514 in the third quarter, the highest level since 1Q16, up 66 bps from 1Q22 (Sofr+448) and 83 bps from a year ago (Libor+431).
The sharp increase in the cost of debt is even more pronounced when looking at the new-issue yield-to-maturity (YTM). YTM takes into account the base rate (Sofr in 2022 or Libor pre-2022), the base rate floor, if applicable, the original-issue discount (OID) and the spread. Three-month term Sofr closed the third quarter at around 3.6%, versus roughly 2% at the end of June and around 0.7% at the end of March. At the same time, investor appetite for risk faded in the third quarter, forcing arrangers to offer LBO loans, which tend to be lower-rated, at uncharacteristically high discounts. The small sample of LBOs syndicated in the third quarter had an average price of 92.3 cents on the dollar and ranged from 90.5 to 94. In January, the average OID stood at 99.2, and the range varied from 98 to 99.8.
As a result, the YTM spiked to 9.86% last quarter, a post-GFC high, up from 7.41% in 2Q21 and 5.42% in 1Q22. In fact, LBO new-issue yields more than doubled over the last 18 months, from 4.70% in 1Q21, a post-GCF low.
The prospect of higher rates (and soaring debt-refinancing costs) combined with slowing growth and expectations of lower earnings has put lower-rated borrowers in the spotlight. LBOs, by definition, carry high debt loads and sit within the lower end of the credit quality distribution. However, they have increasingly migrated into the B-minus bucket in recent years. Starting with 2019, more than half of leveraged loan volume raised to fund buyouts came from borrowers rated B-minus by at least one ratings agency. In the year to date, this share rose to a record 68%, from around a 55% average in the preceding three years.
In fact, the three largest LBO term loans this year belong to borrowers rated B-minus on at least one side — athenahealth, McAfee, and CitrixSystems. These three jumbo loans from the Computers & Electronics sector (LCD’s proxy for technology) account for roughly $16 billion of paper, or almost a quarter of the overall LBO loan volume so far in 2022. In fact, the tech industry accounted for a record 40% share of the total LBO issuance in the year through Sept. 30, up from 25% in 2021.
This comes as companies rated B-minus became, for the first time, the largest share of the $1.4 trillion loan asset class while investors are becoming increasingly concerned with credit quality risks, per LCD’s latest Leveraged Finance Survey.
The risk-off sentiment is evident in secondary loan pricing as investors demand a bigger premium to hold lower-rated paper over better-quality loans. Although loan prices declined across the board in September, as tracked by the Morningstar LSTA US Leveraged Loan Index, borrowers rated B-minus by S&P Global Ratings took a sharper dive. The average bid of these borrowers fell to 90.31 by Sept. 30, the lowest reading since June 2020, while B-flat and B-plus cohorts stayed above their 2022 lows. In addition, the gap between the average bid of B-minus and B-flat cohorts widened to 309 bps on Sept. 30, up from around 30 bps at the end of April and just nine basis points a year ago.
As investor demand for lower-rated debt cooled, arrangers in the third quarter had to sweeten the terms on many buyouts to clear the market — 45% of LBOs improved pricing terms in favor of lenders during syndication, the highest share since 4Q18. This compares to the first quarter, when nearly 40% of buyouts cut spreads and/or OIDs on the back of strong investor demand. In some cases, LBO financings were pulled from the market altogether. For example, Brightspeed, rated B-/B3, late last quarter withdrew a proposed debt financing package pitched in connection with Apollo Global Management’s acquisition of the incumbent local exchange carrier (ILEC) assets of Lumen Technologies. The Brightspeed transaction included a $1.865 billion offering of seven-year senior secured notes, and a $2 billion, seven-year term loan B.
Amid such challenging conditions in the broadly syndicated loan market, direct lenders — which can offer higher certainty of closing as those deals entail a much smaller lending group — continued to gain market share. As reported by LCD News, spreads on private loans have not widened to the same extent as spreads in syndicated loans, making the private credit market relatively more attractive to sponsors than syndicated loans. As a result, multiple large buyouts, that likely would have been done in the syndicated loan market otherwise, were financed by direct lenders.
The share of smaller transactions done in the syndicated loan space has been declining in recent years, even before this year’s market dislocation or pandemic-related disruptions in 2020. For example, in 2019 only 5% of buyout-related loans funded a transaction with enterprise value of less than $500 million, down from 15% in the 2017-2018 period or 33% ten years ago. So far this year only 2% of syndicated loans tracked by LCD fall into this size category and roughly a quarter of deals fall between $500 million to $999 million, down from almost 40% five years ago.
Buyout purchase price multiples rose to a record high for the year to Sept. 30, at 11.9x, up from 11.2x in 2021 and from 10.4x five years ago. However, more than half the deals in the sample came in the first quarter, when market conditions looked decidedly more favorable, and roughly 30% were January loan financings. As a result, a large chunk of this year’s sample includes buyouts structured before the start of the war in Ukraine or before other geopolitical and macroeconomic headwinds over the last six months or so took root. The purchase price multiple for just the last six months is 11.2x, on par with 2021 and slightly below both 2020 and 2019.
At the same time, LBOs financed in the syndicated loan market in the last six months had an average debt/EBITDA ratio of 6.1x, the highest reading since 2007, up from 5.8x in 2021 (based on pro forma adjusted EBITDA). For the year overall, the average leverage ratio is slightly lower, at 5.9x. In addition, the share of buyouts with a leverage ratio of 7x or retreated slightly this year, to 18%, from 21% in 2021, but remains above every year between 2008 and 2020. For the last six months, just 13% of buyouts were levered at 7x or higher, on par with 2020, based on LCD’s data.