2019 could be quite a year – after a strong bull run, stock markets are bringing 2018 to a jittery end, and credit markets have followed suit. Alternative lenders are facing a landscape that is the result of looser covenants, generous EBITDA add-backs and borrower-friendly terms. And those deals may come home to roost for credit managers that didn’t take care in their underwriting. Private Debt Investor chatted with Fran Byers, director of market analysis at Refinitiv, formerly Thomson Reuters’ Financial and Risk business.
PDI: What was the loan market like this year?
Fran Beyers: The first half of the year was really strong, driven by robust M&A loan supply and significant inflows of capital into the asset class, which kept market conditions favourable for issuers.
However, in the second half of 2018, we saw meaningful patches of volatility, which has slowed down deal-making activity. There have been a lot of concessions to get deals done. We’ve seen many deals flex up, we’ve seen deals get pulled and a lot of arrangers are telling issuers to hold off until January if possible.
In the direct lending market, for the smaller deals, you continue to see a competitive environment where there’s a lot of capital and not enough dealflow to go around. Lenders are seeing this volatility up market, they want to push back and widen pricing, but it has been a challenge because there’s so much cash and it’s a relationship market.
Where are we headed into 2019?
Lenders do not have great visibility heading into 2019. Lenders in the middle market are looking at their pipelines and they are not overly thrilled about dealflow heading into 2019. Furthermore, with low interest rates abroad, lenders are still anticipating solid inflows into US direct lending.
Is there any upside for mid-market lenders?
The positive is that when volatility strikes the broadly syndicated market, it does make the direct lending execution much more appealing to issuers. So, well-positioned direct lenders who have material hold sizes could see some nice financing opportunities in 2019, especially from some larger issuers.
Transactions done this credit cycle have been rife with EBITDA add-backs. How are they performing?
EBITDA add-backs are not a new technology; it’s just in this cycle they’ve become so egregious, largely in part due to banks trying to circumvent leveraged lending guidance. They’re flowing throughout [the loan] documents, and sponsors are getting way more credit for add-backs in this cycle than they have in the past.
When they are real cost-saving synergies – like a jet is going away, we’re closing down a plant – there’s real tangible dollars you can assign to them, there’s a higher chance the add-backs can actually happen. In this cycle we’ve seen a lot more soft add-backs, which are much harder to project and less likely to materialize.
If you talk to lenders in either the broadly syndicated loan market or the direct lending market, they will tell you some of the add-backs materialized but not a lot of them. And that’s a problem because you’re lending off debt/EBITDA, and you’re looking at EBITDA/interest and it looks more favourable than the reality. If you drill down into actual free cashflow, it’s much weaker than what these sponsors said it was going to be, and free cashflow is what pays down debt.
So, the EBITDA add-backs are keeping lenders up at night?
Well, lenders are saying their biggest stress isn’t just the add-backs, it’s the add-backs with other stuff. You’ve got rising rates, rising costs and a very tight labor market. Lenders are looking at their issuers’ numbers and they’re seeing margin compression.
It’s not like everything’s going off a cliff. But going into 2019, lenders are closely watching their portfolio performance and trying to get in front of [any potential stress]. They’re seeing the triggers and they’re seeing the pressures. That’s not a conversation we were having going into 2018.