A Dramatic shift in the credit markets
COVID-19 has completely upended the private capital markets, reversing the excess liquidity conditions that have characterized the market for the past decade.
- Following the public market, the current economic dislocation has caused credit spreads to widen, while reducing leverage tolerance and keeping a large group of lenders on the sidelines assessing the real impact of the damage.
- The focus has been on companies successfully managing liquidity. Companies with liquidity challenges have negotiated temporary reliefs that include interest capitalization, amortization grace periods, and extension of maturities.
- Since the start of coronavirus-related shutdowns, the U.S. has witnessed a dramatic increase in workers seeking unemployment benefits. The coronavirus pandemic is impacting state labor markets to varying degrees, with some seeing as many as 1 in 5 workers file for unemployment benefits.(1)
Change in market tone
Middle market debt issuers are experiencing delayed deal timetables as lenders are increasingly reluctant to commit to pricing and other closing terms in the current environment where in-person due diligence has been temporarily postponed.
- Traditional lenders (i.e., commercial banks) have been providing ongoing support to existing relationship clients with revolver drawdowns and the application process to available stimulus programs
- Non-traditional lenders (e.g., credit funds) claim that they “are open for business” and supporting prior commitments; however, there have been limited transactions that support these claims.
- Based on a few select KPMG deals, leverage has declined by 0.5x to 1.0x and pricing has increased by 100 to 200 bps.
- Traditional control equity sponsors are now actively seeking minority equity positions with reduced levered structures with M&A activity in decline.
- Borrowers are encouraged to approach a broader universe of capital providers for their financing needs given the deal environment uncertainty.
Insured Unemployment Rate (%)(2)
The advance seasonally adjusted insured unemployment rate was 11.0% for the week ending April 11th
Liquidity in focus – revolving credit draws reach $175.4bn since March 5th – by industry(2)
Volume: $175.5 billion
New issue leveraged loan volume - monthly ($bn)(2)
Government support through stimulus programs
- There has been significant recent legislative and administrative actions in the U.S. to provide economic relief for both individuals and businesses.
- The Coronavirus Aid, Relief, and Economic Security Act – or the CARES Act –provides more than $2 trillion in emergency aid to individuals and businesses in various forms including loans, direct payments, and insurance benefits intended to cushion the economic impact of the coronavirus outbreak (COVID-19).(3)
Two key programs that support businesses are:- Paycheck Protection Program (~US$350 billion): Small businesses with up to 500 US employees (with limited exceptions) could be eligible for loans up to $10 million with 2-year maturities and interest rate of 1%. The loans are forgivable if companies maintain payroll and wages - the forgiveness amount is in relation to any reductions in payroll or wages. Eligible companies may apply through an SBA approved financial institution.
- In response to overwhelming demand for the emergency funding by the CARES Act, Congress has authorized an additional $380 billion toward SBA programs, including $310 billion for the Paycheck Protection Program, along with additional healthcare-related funding for hospitals, health care workers, and COVID-19 testing.(4)
- Main Street Lending Program (~$600 billion): Mid-size businesses with not more than 15,000 employees (or 2019 revenues up to $5 billion) could be eligible for 4-year loans between $500 thousand and $200 million. Eligible firms seeking Main Street loans must commit to maintain payroll and follow compensation, stock repurchase, and dividend restrictions that apply to programs under the CARES Act. Eligible banks may originate new Main Street loans or use Main Street loans to increase the size of existing loans to businesses. Launch date of the program have not been finalized.(5)
- Paycheck Protection Program (~US$350 billion): Small businesses with up to 500 US employees (with limited exceptions) could be eligible for loans up to $10 million with 2-year maturities and interest rate of 1%. The loans are forgivable if companies maintain payroll and wages - the forgiveness amount is in relation to any reductions in payroll or wages. Eligible companies may apply through an SBA approved financial institution.
Hot topic – “dusting off the credit agreement”
As companies seek to address the challenges caused by COVID-19, many are trying to successfully manage liquidity, review existing credit agreements for covenant loopholes and prepare for amendment discussions with lenders
- The recommended course of action for borrowers is to
- appropriately draw on available revolver capacity to support ongoing liquidity needs, provided that they will be in a position to support new leverage levels;
- refresh financial models to assess covenant compliance implications over the next few quarters; and
- begin working with the lenders to request covenant waivers and/or other amendments in the credit agreement
- Typical credit agreement negotiation points include: adjusting covenant levels, modifying covenant / definitions, deferring amortization and interest payments and maturities in return for amendment fees, LIBOR floors, adjusting revolver capacity and anti-hoarding provisions, to name a few.
- In the current environment, the lender community has been generally supportive with existing clients, but that could change come June and September when required payments are due.
- Borrowers may want to consider consulting with advisors to assist in financial forecast and scenario analysis, covenant assessment and credit agreement negotiations.
Footnotes
- Wall Street Journal, Coronavirus sends one fifth of workers to unemployment line in some states, April 21, 2020
- U.S. Department of Labor; LCD Quarterly Leveraged Lending Review: 1Q 2020
- U.S. Department of Treasury; The CARES Act works for All Americans.
- U.S. Department of Treasury, Paycheck Protection Program Information Sheet.
- Board of Governors of the Federal Reserve System, Main Street Lending Program.
