Debt Capital Markets Update

By Managing Director WIll Bloom and Senior Associate Dan Kaczmarek

When we last commented on the state of the capital markets, U.S. debt capital markets remained robust and did not appear to be overly concerned with equity market volatility.  Well, debt providers and potential issuers seem to be feeling the effects of market uncertainty now!  In addition to a volatile stock market, increasing caution in the debt capital markets reflects Chinese economic growth concerns, continued stress on oil prices, and general market turbulence in Europe.  Furthermore, the Federal Reserve is taking a more cautious stance with its interest rate policy and delayed a once anticipated rate hike at its March 2016 policy meeting.

Although indicators in the high yield and liquid loan markets suggest debt investors are noticeably pulling back on the throttle, it remains our belief that now is still a relatively attractive time to access debt capital in the middle market, particularly for those issuers operating outside unfavorable markets (e.g., oil and gas). Fundamentally sound borrowers issuing less than $300 million of credit can still successfully maximize proceeds to fund and execute on strategic initiatives.  While lenders may voice concern over the recent volatility and the state of the markets, we have seen them move quickly and aggressively to win roles in recent financing opportunities.  The following data points support our conclusion of a strong and favorable credit market, seemingly open for business for at least the time being.

INTEREST RATES REMAIN NEAR HISTORICAL LOWS, BUT TRENDING UPWARD

Interest rates, as measured by 10-year Treasuries and 3-month LIBOR, remain at historic lows when compared to their 20-year averages of 411 bps and 278 bps, respectively.  10-year Treasuries are currently trading at 179 bps and 3-month LIBOR is trading at 63 bps (as of March 31, 2016).


Source: S&P Capital IQ

As we look to the future, there is a high likelihood of a rising interest rate environment.  The Federal Reserve raised rates for the first time in nine years in December 2015 but held its key federal funds rate at 0.4% at its March policy meeting, citing softer global economic growth and financial market volatility.  While inflation is showing signs of rising, some Fed policy makers worry that increasing rates too soon will smother a recovery.  Fed officials lowered their projections for the number of rate hikes across 2016 from four at its December 2015 meeting to two in March 2016, implying a year-end target fed funds rate of 0.875%.

MIDDLE MARKET LOAN VOLUME OFF TO A TEPID START IN 2016

Middle market loan volume finished 2015 on an uptick, likely due to the typical seasonal push that occurs at calendar year end.  However, year-to-date volume has cooled significantly as increased volatility in the equity capital markets is curtailing some lenders’ appetite.  Contrary to the trend, attractive issuers with strong fundamentals are still able to achieve maximum leverage for LBO and recapitalization transactions.  Large middle market is defined as deal size ranging from $100 million to $500 million, while traditional middle market is defined as deal size below $100 million.


Source: Thomson Reuters LPC

MIDDLE MARKET LEVERAGE LEVELS PEAKING DURING 2015, BUT WILL TREND CONTINUE?

Leverage, as measured by debt to EBITDA levels, continued its upward trend in 2015. The senior debt component increased to approximately 3.0x debt to EBITDA, illustrating robust credit appetite and willingness to leverage balance sheets for recapitalizations, refinancings, or acquisitions.  Recent deal activity and discussions with participants in the capital markets reveal a slight tightening of leverage level tolerances due to increased capital markets volatility as well as continued pressure from commercial bank regulators on risk taking.  Nevertheless, as previously stated, bank and nonbank lending institutions are willing to lend deep into the capital structure for attractive and proven issuers.  Data is based on private M&A transactions in the $10 to $250 million value range. (Source: GF Data)

CREDIT SPREADS EXPANDING CAUSING SOME ISSUERS TO PAUSE

After tightening during the majority of 2015, senior debt loan spreads expanded during the fourth quarter as concerns within the debt capital markets began to appear. (Of note, the pricing charts represent an average of commercial bank leveraged loans and nonbank leveraged loans.)  Commercial bank pricing remains attractive, ranging from 100 – 250 bps for strong borrowers with either significant collateral or a lower leverage profile (<2.5x) and 300-400 bps for higher leveraged transactions (>2.75x) with limited collateral.  Meanwhile, the nonbank market for issues less than $250 million are currently pricing in the 500 – 800 bps range, up approximately 50 -100 bps over the average for 2015.

Subordinated or mezzanine debt generally tightened during 2015 as debt investors lowered required returns in order to place capital in a competitive environment.  On average, cash coupons priced between 11% and 12% fixed and 1.5% to 2.5% for paid-in-kind (PIK) components, resulting in all-in cost of 13-14%.

 
        
Source: GF Data