Leveraged Loans: A Market in Transformation

Headline news about issuance trends tells only a part of the story of what is happening in the leveraged loan market. Rising interest rates, geopolitical uncertainty, and recessionary concerns have led to the lowest level of institutional loan issuance since the second quarter of 2020, down 46% quarter-over-quarter in Q3 2022, per Fitch.¹

Underneath the surface, however, we see highly active pockets of activity. Three areas, in particular, are worth considering: large and complex broadly syndicated deals, secondary markets, and private credit.

These pockets may even hold the keys to where the market will head once conditions stabilize.

Large and complex broadly syndicated deals

Existing deals in the broadly syndicated market show an elevated level of activity. As borrowers look for new money, they are adding tranches more quickly and of greater size. This trend results in more than increases in deal size. It also adds more complexity.

For example, in our experience as an agent, this expansion can result in a significant increase in payments to new lenders as the total debt and syndicate grows. But the complexity expands to every stakeholder in the market. Different terms, credit ratings, and seniority now exist under the umbrella of the original deal.

This increase in add-on facilities makes sense on the borrower side. They are a known quantity with lenders, existing relationships are already in place, and underwriters and credit committees have already reviewed them.

Longer-term, however, add-ons raise a crucial question: are borrowers simply planning ahead, or are they already having issues with cash flows or payments? The answer will set the trajectory for the distressed debt market in the quarters ahead.

Secondary markets

Secondary markets are also extremely vibrant. For example, CLOs showed resilience in the first three quarters of 2022, at $104 billion.¹ There is a lot of inventory on the market, with record amounts outstanding in both the U.S. and Europe. Many banks now feel pressure to get loans off their balance sheets, while many institutional investors want to reduce risk ahead of their concerns about a potential downturn.

Similarly, some lenders have restrictions in credit grades. And turbulence in a borrower may prompt some to diversify their holdings and therefore sell down their stake in the loans. Moreover, CLOs and bilateral facilities have concentration limits and asset diversification requirements that guide the asset makeup of the portfolio, which, in turn, can lead them to dispose loans facing a potential decline in credit quality. Breaching rating or concentration limitations also restricts CLOs’ new purchases because managers must maintain or improve collateral tests that are currently failing.

The resulting supply glut is pushing secondary market offerings to trade at noticeable discounts, making them more attractive to some investors who see opportunities to buy at a discount. There are also opportunistic investors looking for targets in poor shape where they can gain influence over the borrower’s future. Finally, there is still a lot of money in the market looking for investible assets. While some investment managers have told us they have paused fundraising, they still are keen to deploy capital.

If the secondary market is taking much of the oxygen away from the primary market, what happens in the next few quarters? When the factors disrupting the global economy stabilize, will it be sufficient to make primary-market activity more robust and attractive? The answers may not arise quickly—it partly depends on whether the primary market can also stabilize at pricing that makes sense to investors versus the secondary market.

Private credit

We see a continued pickup in private transactions, both in mid-market deals and large ticket deals (including club deals with multiple private credit providers). Private lenders are generally more insulated from current price fluctuations and the macroeconomic factors constraining banks and investment managers. In some cases, however, they are still looking to back out of some of their positions before the end of 2022. Doing so will be challenging, given the secondary market conditions described above.

However, they also have more room to develop unique covenant structures or deal characteristics to manage their balance sheets and yields. Bespoke arrangements allow them to offer more speed, flexibility, and optionality to borrowers. At the same time, agents, sub-agents, custodians, and trustees need to have the platform and people capacity to adjust. Given these conditions, ability to execute is at a premium more than ever.

The scenario to watch is whether private lenders will put more pressure on banks in primary deals as the market normalizes. As a result, banks may reexamine the types and number of deals they want to do in a given year. Banks may also look for options to deploy capital more efficiently elsewhere. As a result, the potential for more bespoke arrangements could start to look more like a norm than an exception.

Conclusion

The turbulence in leveraged loans will not last forever. The combination of dry powder to deploy and stabilization of inflation and interest rates, for example, could result in more M&A leveraged loan activity in the second half of 2023. But the adjustments made in some parts of the market may well indicate an emerging future. While it is easy to say that we are no longer in the era of easy money, it is much harder to acculturate to the unknown. It takes a while for deal flows to find a new level. It also takes time for people participating in the market to adjust their behaviors and assumptions, especially given how long previous market conditions stood.

Because of this environment, we are closely watching the signals given by the market in the next few quarters. They could plausibly move the needle in favor of the scenarios we have mentioned here, but it remains unclear to what extent. What is certain is that the leveraged loan market will not simply return to “normal.”