NEW YORK, May 3 (LPC) - Middle market institutional term loan yields fell in the second quarter of 2019, reversing six consecutive quarters of upward momentum, as investor demand continues to exceed a limited supply of deals.
Average yields fell to 7.57% in the second quarter, from 8.06% in the first three months of the year, but are still higher than 6.66% in the second quarter of 2018, according to LPC data.
The US middle market is seeing unprecedented demand as cash continues to flood into the sector from alternative lenders and private debt funds, who are competing with more established banks and institutional investors for limited dealflow, which is putting pressure on pricing.
“Pricing is crunching down,” a middle market lender said. “There are deals, but not at the level we all want.”
Excess demand is putting downward pressure on spreads and new issue prices, which together with Libor – the benchmark rate for floating-rate loans – make up the three components of leveraged loan yields.
Falling Libor rates are also contributing to the drop in yields. Rising Libor rates previously helped to boost returns and offset the effect of tighter spreads, but the benchmark rate has been falling after peaking in December.
Average middle market spreads have tightened to 463bp from 483bp in the first quarter, while the average issue price is now 99.03 versus 98.64 in the first quarter, LPC data show.
“At the syndicated end of the middle market, where a lot of people are looking, the premium over large corporate deals has clearly diminished, which is one reason we don’t think investing in those deals makes sense,” said Tom Newberry, global head of direct lending at CVC Credit Partners.
Investors expect a premium for middle market lending as the loans are less liquid and smaller companies are more vulnerable in an economic downturn due to higher customer concentration and less diversified revenue streams.
Middle market loans offer a premium over broadly syndicated loans as a result, but this has shrunk to 70bp from 102bp a year ago, which is raising concern that investors are not being sufficiently rewarded for the additional risk. Rather investors can find additional yield in the smaller and more illiquid segments of the market.
“Typically if you lend into illiquid situations you can still get 200-300bp of premium. That is a bit compressed relative to a year ago, but the spreads are still decent.” Newberry said.
US institutional volume is picking up again after December’s volatility put a hole in the M&A machine and loan pipeline for early 2019. Dealflow is still limited, which is forcing investors to take what they can get and helping companies to achieve competitive pricing.
In April, home maintenance and repair services provider Wrench Group raised a US$420m buyout loan, backing the company’s sale to Leonard Green & Partners. The funding included a US$45m revolving credit facility, a US$225m first-lien term loan, a US$75m first-lien delayed draw term loan and a US$75m eight-year second-lien facility.
Jefferies was lead left on the first-lien portion of the transaction and was joined by Macquarie and Antares Capital, while Crescent Capital was lead arranger on the second-lien term loan.
The first-lien term loan was well oversubscribed, according to a middle market investor. The spread cleared at 425bp, at the tight end of guidance of 425bp-450bp over Libor.
Also in April, SERVPRO, a franchisor of property damage restoration services, was in market with a US$485m credit facility backing Blackstone’s acquisition of a majority stake in the business. The company raised a US$45m five-year revolver, a US$315m seven-year first-lien term loan and a US$125m eight-year privately placed second-lien term loan.
During syndication, SERVPRO cut pricing on the first-lien tranche. The spread decreased to 350bp with a 0% floor, tight of guidance in the 375bp-400bp range. The discount also tightened to 99.75 from the 99.5 offered at launch. Pricing will step down by 25bp if the company issues an initial public offering.
Jefferies, Credit Suisse and Deutsche Bank arranged the deal.
Pricing pressure is to be expected in the current environment, where deals remain thin on the ground despite improving market technicals, market participants said.
Although pricing is moving lower, loan spreads and all-in yields are still higher than a year ago, and look robust compared to red-hot conditions in 2017 and 2018, when repricing drove robust dealflow.
Although cash continues to flow into the US middle market from direct lenders and private credit funds, 24 weeks of outflows from retail loan funds totaling US$26.2bn is tempering demand, as relative value investors see better opportunities elsewhere while further US interest rate rises remain on hold.
If the situation reverses and US rates start to rise again, middle market pricing could come under renewed pressure as investors that buy loans for bigger companies chase yield in smaller middle market deals.
This could be exacerbated by the return of opportunistic refinancing and repricing loans, after the recent reappearance of aggressive dividend recapitalisation loans, which allow private equity firms to extract money by releveraging portfolio companies with new debt. (Reporting by Leela Parker Deo. Editing by Tessa Walsh and Lynn Adler)