Early Recovery Recap: Volumes Rebound. Safety Presides.
In late Q1 2020, concerns about the economic impact of COVID-19 and worldwide efforts to counteract it negatively affected global capital markets and caused a material investor selloff and decline in asset prices. Public and private credit spreads materially expanded. Equity and debt capital providers moved to a 100% portfolio management stance, and new deal activity came to a halt. Financial budgets were slashed, and managing liquidity became the primary focus.
In Q2, market tone improved as COVID-related restrictions eased, economies reopened, government stimulus staved off a broader market liquidity crunch, companies managed costs and secured sufficient near-term liquidity from capital providers to combat materially lower revenues.
The Expansion Accelerates: Risk Aversion Moderates. Credit Yields Tighten.
In early Q3, when Q2 financial data was released, it became evident that many “COVID-impacted” companies outperformed worst-case expectations and were going to survive. Downgrades and defaults rose but were lower than expectations. As a result, secondary equity and credit markets rebounded, primary equity and levered finance markets reopened, and the price of risk declined from the Q1 dislocation.
The difference in market multiples and credit spreads for low and medium COVID-impacted industries narrowed and was closer to pre-COVID levels. More storied, highly COVID-impacted, or marginal issuers are still at a spread premium or have tighter leverage and documentation terms to reduce relative risk if they can secure financing at all.
Also, as many underlying fund portfolio companies found their footing, capital market providers moved from a portfolio management-focused stance to once again deploy new capital. Private equity and debt dry powder remained at record levels, and fund managers were eager to put it to work. However, uncertainty remained around a potential second wave of the virus, the U.S. political environment, and company-specific fundamental performance adjustments related to pandemic-impacted periods. Therefore, direct lenders reported increasing competition for high-quality credits with low COVID exposure. However, issuance remains below pre-pandemic levels, and market participants continued to underwrite more conservatively than they did at pre-COVID levels.
Even with the improved competitive market dynamics, VRC observed, and market participants reported a ~75 to 100 bps average tightening in primary market credit spreads from Q2 2020 average levels.
The tighter yields coupled with the material drop in LIBOR resulted in average all-in yields on new deals approximating or falling below pre-COVID deal levels.
Many lenders continued to require tighter documentation, reduce leverage levels by ~0.5x to 1.0x on average from pre-coronavirus levels, increase covenant protection, and add LIBOR floors of 1% or greater, among other requirements. Like Q1 and Q2 2020, lenders continued to pursue industries and deal structures with reduced risk exposure in Q3.
The End is Near: Robust Q4 Activity and a Positive 2021 Outlook
The positive momentum continued into the 4th quarter with more robust reported Q3 company performance and moderation of reported company ratings downgrades and defaults.
U.S. Elections ended with Democrat Joe Biden as president-elect, a Democratic majority continuing in the House of Representatives, and a Republican majority remaining in the Senate. With this split government structure, market fears of major policy and tax changes seem to have been alleviated, and the pre-election season’s rush to get deals done before the new Administration takes over has also eased.
Consequently, capital markets rallied further, and valuations now exceed pre-COVID levels in most industries.
VRC’s private fund clients report robust new deal pipelines, with expectations of much higher new deal volumes in Q4. Although, market participants report, and VRC observes, a renewed imbalance of too much fund money supply chasing too little deal volume (on equity and credit fronts). Accordingly, competition has intensified, putting renewed pressure on deal terms, i.e., lower credit spreads, and higher purchase multiples. All reports have remained strong (better than pre-COVID documentation) with reasonable leverage, more strict EBITDA definitions, tighter debt incurrence tests, and more stringent collateral buckets.
Notably, before Q4, only the safest non-COVID impacted and non-cyclical industries were seeing any M&A and credit deal activity. However, in speaking with VRC clients and examining recent new deal flow and secondary pricing, mid-impacted industries—such as medical practices, manufacturing, and business services impacted by the shutdowns in early Q2—have since (mostly) rebounded and are starting to see more investor interest. Secondary yields have come in materially, and regular way credit issuance for refinancings and buyouts for these industries have come back to the market.
One VRC client noted that “back in Q2, the new deal activity demand or “fairway” probably covered about 50% of industries vs. 90%+ pre-COVID. Now I would say that about 75% to 80% of industries are seeing demand.”
Generally, we expect valuation analyses to reflect improved company performance, tighter market yields, and more favorable credit terms, all of which will improve many portfolio securities valuations. We still expect fully impacted industries such as retail, leisure, travel, and any in-person businesses to remain under pressure. Although, secondary prices for these industries have rebounded materially after announced restructurings and COVID-19 vaccine approval. New regular-way deal activity remains scant in these industries, with some rescue financings occurring for the most distressed companies.
Despite more robust markets and momentum, several risks continue to exist that could derail the rebound:
- Globally, COVID cases are escalating. When publishing this report, worldwide cases on December 11th have reached 69.9 million, 45.1 million recoveries, and 1.59 million deaths. Several European countries have once again implemented stay-at-home mandates, and some U.S. cities have re-implemented mandatory business closures.
- Fundamentals are generally better than original worst-case expectations but remain under pressure and below pre-COVID levels.
- Many companies secured sufficient liquidity for the near-term, but the impact on long-term liquidity from a second virus wave and further reopening delays remains unknown.
- The if, what, and when governments might provide further stimulus programs.
- A full understanding of if and how consumer behavior has changed as a result of the pandemic.
- Workforce impacts once government measures that are in place to offset high unemployment end.
- How a new White House Administration will impact the markets and economic policy will begin to unfold after January 20th, 2021.
If we consider a worst-case scenario, VRC will keep portfolio company fundamental performance seen during Q1 and Q2 2020 in mind. Many companies survived the pandemic’s initial shock with financial support from the PPP and CARES Act even though their underlying businesses suffered. Suppose COVID cases continue to climb now and into early 2021, and a new stimulus package does not come to fruition. In that case, recent business slowdowns may foreshadow how they will fare over the next couple of quarters and how their valuations may be impacted.
Of course, we will have to wait and see what will happen and how capital markets react before reassessing private capital valuations’ impact. But, these risks seem to be much lower in Q4 vs. Q3.
Diving Into the Data: VRC's Key Observations
VRC matrix yield levels represent average, middle-market regular-way credit profiles for private equity-backed borrowers with average EBITDA between ~$7 million and $50 million. The small-cap market represents borrowers with EBITDA of ~$1 million to $7 million. Matrix levels are based on VRC’s proprietary database consisting of data gathered from new client deals, client surveys, and aligned with publically-sourced primary and secondary credit market yield data.
In graphing the data, some observations of note:
- Credit spreads tightened in Q3 2020 by an average of ~75 to 100 bps since 2Q 2020, and by another 25 bps or more as we gather intel on Q4 2020 new deal intel.
- Credit spreads are now just above or close to pre-pandemic levels as the Q4 activity and pipelines swell to pre-COVID levels, and competition has resumed as too much money is chasing too few new deals.
- Spot LIBOR has declined to below 25 bps, which is well below average LIBOR floors of ~1%.
- Average all-in yields are at or below pre-COVID levels as the lower LIBOR has more than offset modestly higher new deal spreads.
Spread premiums or term adjustments should be considered to the ranges below for storied, COVID-19 impacted, or marginal issuers.
As we review the data for the fed funds rate and treasury curves and compare it alongside spot LIBOR rates, we note:
- The three-month LIBOR three-year forward swap rate indicates that investors believe the three-month spot LIBOR will remain around current levels in the next three years. LIBOR floors, generally in the 75 bps to 100 bps range, have become quite valuable. Also, all floating rate loans have effectively become fixed-rate instruments.
- Lenders ultimately consider all-in yields to meet minimum hurdle rates.
- Pre-COVID loan coupons that were issued when LIBOR was north of 2% and spreads were at historically tight levels are below investment cost yields and likely below target all-in yields, despite most having 1% LIBOR floors.
- Dividend payout levels and yields to investors have come under pressure given the lower coupons due to lower LIBOR.
Through the third quarter of 2020, the larger institutional debt market generally experienced net investor outflows as retail investors drove prime fund outflows given declining reference rates due to the Fed’s tightening and increased concerns about the economy post-COVID. Year-to-date broadly syndicated collateralized loan obligation issuance ($67.4 billion) was robust but not enough to offset retail outflows.
In the middle-market, direct lending funds continue to attract institutional investor money, a trend that started over ten years ago, despite all the COVID impact noise. The same drivers continue to exist today:
- Demand for higher yields as historically low investment-grade corporate and treasury yields, the once favored assets classes, no longer cover liability spreads,
- More stiff banking regulations force banks up the capital structure and towards safer, lower-yielding credits, and
- Pension and insurance regulation favors private debt over private equity.
Many are also betting on increased private equity activity and increased corporate liquidity demand in 2021 to support increased loan volumes at more attractive yields. According to Private Debt Investor, YTD September fundraising at ~$110 billion is already ahead of full-year estimates, with most expecting direct lending fundraising to exceed $140 to $150 billion for 2020.
Moreover, CLO vehicles’ creative use in the middle-market expects to add approximately $15 to $20 billion of investor funds. BDC equity fundraising has primarily been on the sidelines, given persistent price-to-book ratios below 1x. However, some stronger BDCs have been able to selectively raise public bonds and expand revolver lines to support asset growth.
Deal flow activity and new debt issuance came to a halt in the second quarter of 2020 due to the pandemic shutdown. YTD volumes are below last year, and full-year figures expectations will be well below 2019 and 2018 volumes. Still, volume did materially pick up in the third quarter as the economy slowly reopened, and investor optimism and the capital markets rebounded materially.
Responses to VRC’s proprietary client survey reveal more robust new deal pipelines in late Q3 and early Q4 and expectations that deal volumes could approach pre-COVID levels in the current quarter and into first-quarter 2021. A significant force has come from the proven resilience of underlying portfolio equity and credit investment to the novel coronavirus pandemic, along with prospects for a nearer-term vaccine.
Industry & Relative Risk Analysis
Given low LIBOR, all-in yields are now lower than pre-pandemic levels. Private credit spreads declined from Q1, but less so relative to public high-yield bonds and loans. Significantly impacted industries remain at a premium compared to pre-COVID pricing. However, higher risk category yields tightened up materially in November after Pfizer and Moderna’s announcements of 90%+ efficacy with Phase 3 COVID vaccine trials.
Given the material impacts to revenue, the unknown duration of the efforts to contain the virus, and the state of the economy and the consumer upon exit, many companies’ outlook has been highly uncertain. As a result, in March 2020, secondary markets sold off, and credit spreads widened meaningfully. However, beginning in April 2020, secondary market prices rebounded, and yields trended downward. This was due to the success of government liquidity initiatives, reports of global stabilization of COVID cases, a gradual easing of the stay-at-home restrictions, a reopening of many businesses, and a reported rebound in corporate financials. Despite the material improvement in secondary index spreads, spreads remain elevated when compared to pre-COVID levels.
We caution that while secondary indexes are good barometers of sentiment and trends, unlike the primary markets, they are exposed to underperforming credits, changes in documentation requirements, and technical selling pressure, most notably in conditions of extreme volatility when volumes drop off as well. Therefore, levels reflected in secondary indexes may not be fully reflective of pricing for regular way, new-issue deals with updated market-clearing terms. Nevertheless, it is clear that the price of credit risk across all market segments, including private credit markets, continues to decline closer to pre-COVID levels.
For 2019 and early, pre-pandemic 2020, the middle market experienced peak competitive conditions. These peak conditions were characterized by historically high leverage and tight coverage ratios, looser covenants on deals with wide test cushions, a push for higher EBITDA adjustments in underwriting and covenant tests, and more flexible asset protection and call schedules.
However, beginning in March 2020, after the onset of the pandemic’s outbreak in the U.S., the market became much more risk-averse, which led to much tighter deal terms. Generally, based on data collected and conversations with market participants, leverage levels have declined, and interest and asset coverage metrics are higher vs. pre-COVID deal structures.
Trends are expected to stabilize in Q4. However, the competition is definitely heating up, whereby our clients’ report and VRC observes that many minimally or positively impacted COVID-19 industries (e.g., healthcare, SAAS technology, internet businesses, etc.) are beginning to realize close to pre-COVID structures (e.g., 6x and 7x total leverage) given the demand for these deals. Other “mid-impact” industries are starting to see a rebound in activity and a pickup in secondary market demand via higher prices, which are pushing more competitive terms.
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