Widely held concerns about inflation, rising interest rates, and a possible recession combined to slow debt financing and deal activity in the first half of 2023. Borrowers deferred new debt deals, delayed planned refinancings, and paused major corporate transactions while waiting for interest rates to top out. Private equity sponsors, in particular, held back on debt-financed leveraged buyouts while watching to see whether interest rates (or business valuations) would fall. Direct lending remained hot, continuing to fill in market gaps. But it was by no means a borrower’s market, whether in terms of pricing, terms, or leverage multiples.
The story changed somewhat in the second half of the year. Inflation slowed and deal activity picked up. Significant M&A transactions included GTCR’s purchase of a 55% stake in Worldpay at an $18.5 billion valuation; Chevron’s $53 billion all-stock acquisition of Hess; Nasdaq’s $10.5 billion acquisition of Adenza; and J.M. Smucker Company’s $5.6 billion cash and stock acquisition of Hostess. Major deal financings included a $28.4 billion term loan for Broadcom’s purchase of VMware; a $10 billion bridge loan and $4 billion term loan for RTX Corporation’s accelerated share repurchase program; and an $8 billion bridge loan for Tapestry Inc.’s acquisition of Capri Holdings.
When the dust settled, 2023 investment grade bond issuance stood at $1.14 trillion, high-yield bond issuance at $169 billion, and leveraged loan issuance at $737 billion. With the exception of the high-yield bond figure, which was up $65 billion from the 13-year low of 2022, those figures were basically flat year-to-year (and were paltry compared to the boom year of 2021, when high-yield bond issuance exceeded $450 billion, and leveraged loan issuance exceeded $800 billion).
Sustained higher interest rates have also increased pressure on already challenged businesses that incurred (too much) debt in the days of “lower for longer.” Some moderately challenged companies were still able to access the high-yield bond market or to use “regular-way” loans from direct lenders to refinance their upcoming maturities, though such transactions tended to have tight covenants and high pricing. Others that could not access regular-way debt at a workable price (or at all) turned to “liability management” transactions, a booming practice that involves complex structuring of new financing options within the limitations imposed by a company’s existing debt documents. And as always in tough markets, some companies ended up in chapter 11, driving an uptick in corporate bankruptcy activity.
With a recent surge in market optimism, it remains to be seen whether 2024 will return to a “risk on” mindset. In any case, though, evolving markets mean evolving financing trends. Here are some that we find most notable.
Direct Lenders Eye Investment-Grade; Banks Flex Balance Sheets and Target Private Lending
Our recent memos (including here and here) have chronicled the rise of direct lenders in financing markets. In the first three quarters of 2023, 86% of LBOs were financed through private credit, as opposed to 62% in 2020. And direct lenders continued to grow their capital, whether from straight fundraising, consolidations with other asset managers, or investments in (or alliances with) insurers looking for sophisticated partners to manage their investments.
Historically, direct lenders catered to smaller, riskier companies that could be compelled to accept higher borrowing costs, while investment-grade credit and large-cap leveraged acquisitions were the exclusive purview of the traditional bank and bond financing markets. Today, direct lenders increasingly seek to deploy capital in transactions with companies of all types and sizes, including public borrowers, and have even begun to take aim at investment-grade issuers (though IG financing, so far, remains almost entirely the purview of the traditional markets).
At the same time, banks have taken note of private credit’s ascendance – and its returns, which, on average, exceeded those offered by equity buyout funds since the beginning of 2022 – and have begun expanding into the space. Some announced partnerships with existing alternative asset managers, such as Wells Fargo’s strategic relationship with Centerbridge Partners and Société Générale’s global partnership with Brookfield. Others, including JPMorgan, are reported to have set aside significant amounts of their own capital for direct lending efforts. In this sense, what’s old is new again, and banks, which moved out of the business of “storing” leveraged loans decades ago and into the business of “moving” them, have started to get back into the storage game.
Direct lending offerings also continue to evolve, with increases in “mezzanine” finance options, as well as the availability of some features not often seen in traditional markets, such as PIK interest and “portable” loans that can ride through a change of ownership in the underlying business.
For corporate borrowers, our advice when considering direct lenders and traditional bank/market options continues to be why choose?, as we believe borrowers should cultivate relationships with both. The right solution will depend on markets, and also on what a borrower needs at the time.
Low-Rate Debt in a High-Rate World: An Uptick in Debt Default Activism
In last year’s memo, we discussed creative strategies that acquirers could use to keep low-rate debt of target companies in place following an acquisition. But just as a rising interest rate environment makes existing low-rate debt more valuable to borrowers, it also makes such debt more burdensome to lenders. 2023 resultantly saw a meaningful increase in “debt default activism” (discussed in our memos here, here, and here), as debtholders deployed legal arguments and maneuvers to seek to force borrowers to refinance existing low-rate debt on new market-rate terms.
Historically, debtholders were reticent to assert technical or dubious breaches of loan documents. But in today’s markets, debtholders have proven eager to scrutinize debt documents for purported breaches. To guard against such challenges, we encourage borrowers to think of their long- term, low-coupon debt as a valuable asset that must be tended carefully. In assessing corporate transactions, borrowers should build a record with defense in mind and carefully review both obviously applicable provisions and those that might seem like minor “boilerplate,” since debt default activists will later scour such provisions for potential slipups.
On an ongoing basis, borrowers of all profiles with low-rate debt trading at below-par levels should mind their covenant analysis. A “look out for No. 1” attitude prevails in today’s debt markets, and lenders may conclude that sending a default letter is an effective weapon even when their underlying claims are weak.
Acquisition Agreement Financing Provisions: More Important than Ever
As the conditionality in acquisition agreements has generally become tighter and tighter, acquirers with buyer’s remorse have searched for new ways to force a renegotiation or termination of pending acquisition agreements. As highlighted in our 2021 memo, financing cooperation covenants in acquisition agreements can provide buyers with an opportunity to try to leave a target at the altar. In the Twitter litigation, for example, Elon Musk fixed his case on the financing cooperation covenant, arguing that he should be able to exit the transaction because Twitter did not satisfactorily reply to his extensive information requests between signing and closing.
Now more than ever, sellers, buyers and their respective counsel should strive for as much specificity and clarity as possible when negotiating these covenants to ensure that the parties’ expectations and needs are met while limiting the chances for opportunistic assertions or interpretations. This is an intricate team task that will involve outside M&A/financing counsel, as well as internal financing, treasury, accounting, and business strategy teams, and that should be approached early in the process.
Liability Management: Open Season
“Liability management” transactions – in which new or existing debtholders coordinate with a borrower facing distress to provide new liquidity and maturity extensions, discount capture, or other concessions while working within the confines of the company’s existing debt agreements – are no longer limited to sponsor-backed portfolio companies. In 2023, commentators counted 21 liability management transactions, which was more than double the prior peak in 2020, including several by public companies.
Direct lenders, in particular, have “played on offense,” eagerly seeking opportunities to lend at attractive rates to “unrestricted” subsidiaries, or other subsidiaries sitting outside a company’s existing credit group, to help the company raise “priming” financing. Existing debtholders, aware of this threat, have largely concluded that the best defense against getting primed is to compete on offense themselves, and they in turn now make proactive proposals to provide priming financing. Put simply, liability management is a field that rewards debtholder initiative. As a result, emboldened by precedent and taking the markets “as they are,” debt investors of all stripes now initiate liability management.
Liability management transactions also continue to grow in sophistication, complexity, and variety, fueled by fund participation in the space. For instance, new “double dip”1 and “pari plus”2 transactions emerged in 2023 and quickly gained momentum, offering new pathways for borrowers to use their existing debt baskets to give extra credit support to newly incurred debt in return for correspondingly cheaper rates on such debt.
The main takeaway for borrowers facing distress, as discussed in our recent article (here), is that they can and should make the best of the modern competitive dynamics in the debt financing markets – both among existing creditors (including within debt classes), and between existing creditors, on the one hand, and prospective financing sources, on the other. Liability management can buy maturity and liquidity “runway” and/or capture debt “discount” (though borrowers must often choose whether to use their liability management tool kit to focus more on the latter or the former, which requires gut-checking conviction in business projections and directing efforts accordingly). Implementing liability management transactions is a complicated, time-consuming process with little margin for error, but for challenged companies, presents significant opportunity.
Lightning Round: Other Developments to Monitor
Below are several new developments in the financing markets that we are watching in the new year:
Beware the Boilerplate. A running theme of many of the points above is the tough, no-holds-barred nature of modern debt markets. When putting new debt in place, we recommend that borrowers scrub and erase boilerplate provisions that create a gray area around basket usage – such as “no default” conditions on a key basket, which could arguably make use of the basket prohibited due to a minor, disputed, or unrelated default.
More Convertibles. Many companies – particularly in the technology sector – issued convertible notes with low coupons and relatively short maturities in 2020 and 2021. Now, as interest rates remain high, some of those convertible notes are deeply out of the money, trading at considerable discounts, and beginning to see liability management activity. Despite this, low coupons have made convertibles generally more attractive than they were in the lower-for-longer years, even for companies outside the tech sector. By mid-November, issuance was up 34% from last year.
Despite whispers of rate cuts, “higher for longer” remains the order of the day, and markets seem to be embracing this new normal. 2024 is off to a dynamic start, but careful planning and sophisticated advice on debt-related issues will remain paramount, however the environment evolves.
Joshua A. Feltman John R. Sobolewski Charles C. See
Gregory E. Pessin Emily D. Johnson Joel M. Simwinga
Michael S. Benn Benjamin S. Arfa Alana M. Thyng
1 Liability management is rapidly coming to the point where it deserves its own glossary: a “double dip” transaction is a transaction in which a creditor lends money to a company’s non-guarantor subsidiary, guaranteed and secured on a pari passu basis with the company’s existing debt obligations. The subsidiary borrower then onlends the proceeds of the initial loan to the company’s credit group, again guaranteed and secured on a pari passu basis with existing debt obligations. As a result, the new creditor has (1) a direct claim against the credit group through the initial loan (“dip” one), and (2) an indirect claim against the credit group via the intercompany loan (“dip” two). In this way, the double dip offers participating lenders enhanced credit support and dilutes existing creditors’ claims.
2 Another term for the liability management glossary: a “pari plus transaction” is a transaction in which new-money lenders receive both a pari passu claim against the existing credit group and claims against an entity or assets that sit outside the existing credit group. This creates an obligation that is structurally senior to those of existing creditors on a portion of the enterprise. Recent examples include Oaktree Capital Management’s $250 million loan to Rayonier Advanced Materials in July and TeamHealth’s $700 million secured notes financing, led by King Street.