July 27, 2017 - Defaults remain benign and technicals – despite flipping around quarter end – remain rather supportive of issuers. Is it any wonder, then, that loan terms continue to soften? We review such trends below.
On the fundamentals side, Fitch reported that July’s trailing 12-month high yield default rate sits at 1.9%, down from 2.2% on June 30th. This is the seventh straight month the rate has declined, and it’s now at the lowest level since March 2014. This is not entirely surprising as the pig (2016 energy defaults) has been working its way through the python (HY outstandings). Supporting this thesis is the fact that the E&P HY default rate and the Energy HY default rate were above 30% and 15%, respectively, between May 2016 and January 2017; both now sit below 5%. (To be fair, Fitch forecasts the default rate to end near 3% this year as defaults from the retail sector and iHeartCommunications reinflate default volumes.)
In addition to benign default rates, technicals – after flipping in favor of investors – again seem biased toward issuers. The predictable result? The WSJ reported on repricings, while LevFinInsights notes that terms and conditions are re-easing.
While repricings reduce the return part of the risk-return equation, loosening credit terms increase the risk part. Indeed, weakening terms have concerned investors for several years. But as large corporate credit agreements got looser, many investors said that they still could find traditional protections in the middle market.
Can they still? Several credit data providers aren’t sure. Covenant Review looked at the terms on deals from “big boy” sponsors – such as Apollo, Blackstone, Carlyle, CVC, KKR and TPG – against mid-sized PE firms. Bigger sponsors, of course, did bigger deals (average EBITDA of $255 million) than smaller sponsors (average EBITDA of $147 million). And the bigger guys got easier terms on their larger deals. Covenant Review saw that bigger sponsors sported an average EBITDA adjustment of 35% on their transactions vs. 25% for the middle market sponsors. And, unsurprisingly, the big boys also commanded more leverage. The adjusted debt/EBITDA on their deals was 5.7x vs. 5.38x for smaller sponsors. Likewise leverage through the free & clear was 6.64x for big boys, 6.1x for their smaller brethren.
But smaller sponsored deals might be catching up. Xtract Research drilled into credit agreements to see how terms had changed for different types of borrowers over the past 12 months. They divided the world into sponsored deals of $300 million or more, non-sponsored deals of $300 million or more, and middle market sponsored deals of less than $300 million. An aha moment? Sponsors are increasingly importing large corporate deal terms into middle market transactions. (Caveat: The sample of middle sponsored deals was limited, comprising 11 deals in 2Q17.) Areas where Xtract’s sample of middle market sponsored deals showed looser terms in 2Q17 included percentage of deals with uncapped EBITDA add-backs for cost savings and synergies (60%) and a share of deals with uncapped cash netting (over 70%). In addition, their middle market sample demonstrated a decline in transactions governed by maintenance financial covenant transactions and a rise in transactions governed by springing financial covenants. Credit terms, it seems, do roll downhill.