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The Private Credit Market Is Shifting In Lender's Favor - Let's Break Down How
The sponsor finance market wasn’t really a market from 2016-2021. It was more of a hunting grounds for PE firms to murder lenders for sport and get the absolutely most aggressive terms possible. It was a spiral-to-the-bottom shitshow where every deal was more egregious than the previous. Interest rates were 0% or close to it, no company could do any wrong, and nobody was going BK unless you had some idiosyncratic issue or were connected to an industry with secular headwinds. Life was good for sponsors – they were like Thanos, legs crossed surveying their exhausted lenders that were doing whatever they said, thinking “I finally rest, and watch the sun rise on a grateful universe”.
Then Jerome Powell pulled the plug on the money printer and the music stopped. Since then, lenders have been licking their wounds and started to apply some serious pressure back on sponsors. They have been released from their shackles and like their new found freedom. To alter my favorite clip from the other guys, “we’ve communicated and said, ‘you know what? [sponsors] taste good. Let’s go get some more [sponsor].” A must watch clip for those who haven’t seen it.
So in doing my part to aid The Resistance, I wanted to recap some of the recent trends in private credit. Shoutout to Jen Daly (K&S partner), whose Private Credit newsletter was the inspiration for this post!
Tighter credit agreements: This is kind of a “no, duh” but still needs mentioning. For the last couple years, credit agreements were based almost entirely on precedents (aka the most recent deal with the same sponsor). The interesting situation now though is that lenders are pushing back against these precedents and actually having to negotiate again. Whenever a Company trips a covenant, lenders also have a Christmas list of requests on any waiver/amendment. The top of the list request is always going to be asking for the sponsor to put in more equity. A real “nut up or shut up” situation.
MFN: MFN has been covered in previous blogs, see link for refresher. Lenders are holding strong not waiving this MFN, as it protects their existing yields. However, luckily for sponsors, lots of these MFN’s were created during fast money times, thus are weakly defined – this includes sunset provisions (where the MFN falls away after a certain amount of time, these are persona non-grata right now), and carveouts allowing junior/subordinated debt. It’s like the nature documentary battles between the king cobra and the mongoose: the lenders have the venom to kill the sponsor, but the sponsor usually finds a way to wrangle out of it.
PIK: It seems like debt markets have tightened quicker than private market valuations have. So if you’re getting less debt now, time to put in more equity right? Right?! Well, sponsors are doing everything they can to avoid this. And while LTV (“loan to value” = debt / (debt + equity)) has decreased, sponsors are still looking for creative ways to minimize equity checks at close. One of the most common methods is PIK interest. The way PIK works is super wonky, so stay with me noobs. Instead of cash interest going out to lenders quarterly, the interest accrues as principle with PIK. So the balance of the loan increases, which compounds to more interest when the Company flips back to cash pay. Given this buy now, pay later situation, lenders usually charge more interest (so, if a deal would be S+600 cash pay, those same lenders might want S+700 if its PIK.) Note that banks cannot do this, so another W chalked up for private credit.
Preferred Equity: To describe quickly, preferred equity is senior to common equity, but junior to everything else. It is similar to mezz debt, except there is no contractual requirement to be repaid. So it accrues PIK interest rather than cash interest. After the last recession, preferred equity retreated to the mountains, defeated as cheap floating rate senior debt reined supreme across the capital structure kingdom. However, rising interest rates have hindered senior debt’s (or any debt with cash pay) ability to be freely deployed. Many capital structures are broken, overleveraged pieces of shit that are sitting in the ER on life support. So when senior debt raises the white flag, who must rise to the occasion? Preferred equity. They are like the warrior in a movie who is banished from the empire halfway through the movie, only to come back and save the day riding his white knight. Sponsors have been using preferred equity to delever senior debt and “rightsize” capital structures (trying to fix their “good business with a bad balance sheet”). For example, when you use preferred acquisitions for acquisitions, you are acquiring EBITDA that lowers debt related leverage and makes it easier to cover capex / cash interest expense given preferred is non cash pay.
EBITDA Addbacks: It’s pretty funny that EBITDA adjustments, which are rooted in technical accounting, end up being so subjective. The poor accountants have been fully corrupted by bankers and PE investors. Did you know the reason why most QoE’s are labeled “Draft” is to cover the asses of the accountant firms that conduct them? Because if they say “don’t worry guys, this 96 month run-rate addback for stores management is thinking about building is super legit”, they could theoretically get sued by the end buyer down the road if they feel like they were deceived. In a tough financing market, a bunch of the shitty adjustments don’t make it through. But when the money is flowing, lever it the fuck up who cares! So given the current situation, you’re seeing a lot cleaner adjustment profiles. Addback caps are being lowered (i.e. synergies can only be 15% of EBITDA instead of 30-40% a couple years ago) with subcaps being added to the most controversial adjustments (i.e. 15% cap on synergies, but 5% subcap on the ones we really hate). This is both on the Deemed EBITDA side and credit agreement side – this is a niche nuance. Basically, lenders might tell sponsors “OK, this run-rate contract adjustment in the QoE is suspect as fuck, but we will agree to lever off it (i.e. include it in “Deemed EBITDA”). HOWEVA, this is a one time deal. The next time you sign a new contract, you cannot include it in Credit Agreement EBITDA.” Once the Deemed EBITDA portion rolls off, it’s gone.
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