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Pricing Trends

VRC’s proprietary research indicates that the range of observed coupon spreads widened for 1st lien, 2nd lien, and unitranche loans since last quarter due to increasing competitive pressures. Accordingly, we decreased the low end of our “fairway” credit spread ranges by 25 bps across the board from 4Q 2023 while maintaining the high end, resulting in a 12.5 bps decline at the midpoint of our ranges:

• 1st lien loans: 4.25% – 5.25%
• 2nd Lien loans: 8.25% – 9.25%
• Unitranche loans: 5.50% – 6.50%

These changes, coupled with similar Spot EURIBOR and SONIA, the base reference rates considered by VRC’s yield matrix, resulted in lower all-in yields since 4Q 2023.

While competition in the European market increased quarter-over-quarter, market participants note that the tightening of credit spreads was more subdued than in the U.S. Direct Lending market, which saw a decline of ~25 bps quarter-over-quarter. This is a continuation of the trend over the last year as U.S. Direct Lending credit spreads are ~88 bps lower year-over-year versus ~50 bps in the European market.

Direct lenders report more competition and pressure on credit spreads for deals that traditionally would have gone to the bank market as banks re-enter the market. Credit spreads in the syndicated market tightened materially, with European average primary B-rated TLB credit spreads at ~425 bps in YTD 2024 versus ~480 bps in the first half of 2023 and European average secondary B-rated loan spread-to-maturity tightening to ~460 bps in 1Q24 from ~485 bps in 4Q23. As a result, some of the large unitranche deals previously won by direct lenders have been refinanced with syndicated debt. Given this pressure, some direct lenders are proactively repricing coupons in exchange for additional call protection to stay in deals in the upper middle market.

Deal Volume Trends

Starting in the second half of 2023, improvement and clarity around the inflation and reference rate outlook bolstered pipelines for direct lenders. However, M&A volume remains muted despite market participants working on an increasing number of potential deals, and market participants are waiting to see if these deals result in successful executions. Existing portfolio companies continue to be a material source of further investment opportunities for direct lenders as companies continue to execute buy-and-build strategies and other accretive investments.

Deals completed in 2023 were generally viewed as “high-quality” and typically demonstrated some combination of strong growth expectations via organic and/or acquisitive means, high margin and stable cash flow profile, and modest leverage levels. These factors gave the acquirers and lenders confidence in the company’s ability to weather the higher cost of debt and any unexpected deterioration in the economic environment. As a result, these deals continued to command purchase price multiples closer to pre-Ukraine invasion levels and typically forecasted improving interest coverage ratios on the back of growth and the lower forecasted reference rate based on the forward EURIBOR and SONIA curves. This trend continued into 2024, although market participants note some easing in the required quality of companies being brought to market. As a result, underwritten leverage levels remain aggressive, and direct lenders are willing to underwrite interest coverage ratios, adjusted for capital expenditures, that are less than the historical lower bounds of 2.0x – 2.5x based on current spot rates. Where possible, direct lenders include interest rate hedges (typically 50% of debt hedged).

Deals considered “lower-quality” are largely not being brought to market as sponsors do not want to risk a failed sale process, work to improve the underlying businesses, or fix any capital structure issues. Sponsors and direct lenders report that any issues with portfolio companies are proactively managed, and portfolios are holding up relatively well, with performance and liquidity generally better than worse-case scenarios in early 2023. Most problem areas in portfolios have been known throughout the year with few big surprises. Common capital structure solutions include PIK toggle adjustments, sponsor equity contributions, enhanced liquidity monitoring, and amendments to covenant levels. The overall goal of these adjustments is to better position the company to weather the higher cost of debt from higher reference rates by reducing leverage levels and/or cash interest burden. Direct lenders typically receive extra economics (PIK premiums, amendment fees, and/or principal repayments) as part of the amendments.

2024 Outlook

Looking forward to the rest of 2024, bearing no major shocks, market participants generally expect improving deal flow and a more accessible fundraising environment as market participants become increasingly comfortable with the economic environment, reference rate outlook, and portfolio performance expectations. Market participants hope the recent pick-up in deal flow and successful executions will encourage a wider swath of borrowers into the market.

Underwriters will continue to focus on interest coverage and forward expectations to manage risk. If reference rates remain high, there may be further pressure on credit spreads. If either credit spreads or reference rates decline and the market remains competitive, underwritten leverage levels will likely remain on the aggressive end of historical standards. To supplement capital structures where cash interest costs remain high, Sponsors will increasingly look to PIK toggle or 100% PIK pay securities to secure the appropriate leverage to meet private equity required IRRs and maintain reasonable interest coverage ratios. Direct lenders will likely continue to require high equity cushions providing downside protection, more adequate cash flow coverage levels, and more robust credit agreements that include liquidity or cash flow coverage tests and 50% hedging requirements.

For existing portfolio investments, many market participants expected performance to generally hold up with some potential relief from high cash interest expense as reference rates are largely believed to be at peak levels. While idiosyncratic issues will likely continue, overall default rate expectations remain modest.

Overall, valuation analyses need to consider case-by-case situations focusing on fundamental performance, outlook, affordability of debt, and available liquidity. Therefore, some credits will continue to fare better than others.

Q1 2024 VRC European Market Credit Spread Matrix

• VRC lowered the bottom end of pricing ranges by 25bps and held the high end of our pricing ranges in March 2024 for our Middle Market Matrix, resulting in 12.5bps lower midpoints. OIDs have stayed steady from 4Q 2023 at 97-100. Although new deal volume improved in 2024, the availability of lending capital is outstripping supply thus leading to elevated competition, tighter pricing, and historically aggressive capital structures based on today’s spot rates.

Inflation Rate

• Inflation in the United Kingdom declined month-over-month from 4.0% in January to 3.2% through March 2024. Inflation is down materially from the December 2022 figure of 10.5%.
• In the European Union, inflation declined to 2.6% in March from 3.4% in December 2023 and has significantly declined since December 2022, dropping from a peak of 10.4%.
• Inflation for the Euro Area declined from 2.9% in December 2023 to 2.4% in March 2024.

Reference Rates

• In late 2022, the Bank of England’s Monetary Policy Committee (MPC) and the European Central Bank (ECB) began periodically increasing base lending rates to combat inflation.
• Consequently, UK and European reference borrowing rates, SONIA and EURIBOR, rose from late 2022 through August 2023, effectively mirroring MPC and ECB policy increases, before leveling off in November and December when both MPC and ECB held base rates as inflation continued to trend lower. Like in the U.S., many now believe that inflation is under control.
• 3M EURIBOR increased from 1.17% in September 2022 to 3.91% in December 2023 before declining to 3.89% in March 2024. SONIA 3M Compounded increased from 1.55% in September 2022 to 5.22% in December 2023, driving loan yields to historical highs. SONIA 3M Compounded held steady in 1Q 2024 at 5.22%, flat from 4Q23.
• According to Bloomberg forecasts, EURIBOR rates peaked in October 2023 at 3.97% and are projected to level out in the ~2.50%-2.75% area in the long term. SONIA also likely peaked, increasing to 5.22% through March 2024, and is projected to decline to ~3.5% over the long term. These longer-term rates have declined about 100bps since Q3, after stronger inflation, employment, and macroeconomic news. This leads to the expectation that UK and Euro Union governments will lower base rates sooner and by a greater magnitude.
• In their April meeting, the Bank of England’s MPC left interest rates unchanged at 5.25%. Meanwhile, the ECB also held its main deposit facility rate at 4.0% in March. The current 4.0% rate is the highest level in the history of the ECB.

Secondary STM and YTM

• Spread to Maturity for the ELLI Index decreased ~25bps quarter-over-quarter to 4.77% in 1Q 2024; Spreads are down ~210 bps from peak spreads in 2Q 2022. Meanwhile, the ELLI Index YTM of 8.78% in 1Q 2024 decreased from 9.05% in 4Q 2023. Since 2Q 2022, ELLI Index YTM increased ~212bps, with the rise in reference rates more than offsetting the decline in spreads.
• The European B-rated loan index followed a similar trend to the larger ELLI Index, with spreads decreasing 26bps from 4Q23 to 4.59% in 1Q24. Yield to Maturity for B-rated loans declined quarter-over-quarter to 8.57%.

Leveraged Loan and HY Bond Volumes (€Bn)

• LCD reported that European senior loan volume was ~€28Bn in 2023, a ~14% decline from 2022 figures. Thus far in 2024, senior loan volume has totaled €29.32Bn (compared to €8.28Bn in 1Q23), forecasting €117.28Bn of issuance for 2024.
• Private credit continues to be active despite higher base rates and geopolitical risk.
• Volumes picked up in comparison to 2022 but are still below historical averages. Most of the volume coming to market is add-on financing (44.6% per LCD) compared to new deal financing. Through the first two months of 2024, volume has been robust as banks re-enter the market and try to regain market share.

Broadly Syndicated Credit Statistics (Primary)

• Given higher market interest costs from the ~400bps rise in base rates, average leverage ratios declined over 1x on new deals. Meanwhile, average interest coverage declined to below ~3.0x from over 4x before the run-up in base rates. Relative to their U.S. counterparts, European deals were underwritten more conservatively to better absorb EBITDA declines and the interest rate shock. Based on VRC data, 2023 new deal average interest coverage levels for private lending borrowers are ~1.7x in Europe.

Morningstar European LL Index Default Rate

• Per Morningstar, average leverage loan default rates declined in early 2024 as companies have successfully dealt with increased interest costs via higher base rates. Via cost controls and increased prices, inflation has stabilized in Europe.

European Defaults Should Be Relatively Stable, Following a Surge at the Beginning of the Year

• According to S&P Capital, European speculative-grade corporate defaults will be flat at 3.50% by December 2024, according to their most recent forecast, unchanged from December 2023. They note highly improved market sentiment, with slowing inflation supporting ECB rate cuts later in 2024. We note this is ~125bps lower than the expected default rate for U.S. borrowers as the Euro deals were initially more conservatively levered (lower leverage ratios, higher interest coverage, and larger cash/liquidity cushions).
• Overall, these levels are still relatively low compared to other higher stressed periods (great Recession, COVID, etc.) and are unlikely to lead to material portfolio losses for managers and investors. Generally, most economists expect a “soft landing” as macro growth is expected to continue, and unemployment is expected to remain low.

European PE Deal Activity

• Annual 2023 European Private Equity deal volume of €420.5B is a 26.5% decline over 2022 deal volume, as reported by Pitchbook. Through 1Q 2024, there has been €69.9Bn of deal activity.
• In 2024, the majority of deals are add-on acquisitions to existing PE platform deals, with only a limited volume of the highest quality, “Tier 1” deals getting completed (buyers/sellers aligned on valuation and credit financing are available). Add-on share of total PE deal count has increased to 59.42% YTD 2024, up from 54.16% in 2023.
• The outlook for 2024 is more positive, with large coffers of dry powder, and PE pipelines are already larger through 1Q 2024. Lower expected borrowing costs and improving company valuations will likely tighten the bid-ask spread between buyers and sellers and reinvigorate M&A activity.

European PE Fundraising

• According to Pitchbook, European PE funds raised €119.3 in 2023, just shy of the record $120.9Bn raised in 2021. PE fundraising is expected to remain strong in 2024 with improved company fundamentals and an improved exit environment, with €61.6Bn raised through 1Q 2024, more than half of 2023 full-year totals.

European PE Dry Powder (€M)

• According to data from CapitalIQ Pro, cumulative dry powder in 2023 for European sponsors is €463Bn, the highest recorded level since 2010, which should fuel deal flow for the remainder of 2024 and into 2025 without additional fundraising needs.
• These figures also support the continued high demand for private credit. Assuming an average 50% LTV on PE deals, the PE dry powder figures imply an equal demand of €463Bn for credit to finance PE leveraged buyouts.
• In addition to higher volumes from new PE LBO deals, lenders may see more opportunities to finance creative PE exits via dividend recaps and net asset value lending in 2024.

European Median EV/EBITDA Multiples

• European median PE Buyout EV/EBITDA multiples declined in 2023 to 10.2x, dropping ~2.0x from 2022 but remained within historical bands as mostly Tier 1 deals are coming to market. Through the first quarter of 2024, median EV/EBITDA multiples have increased 1.5x to 11.7x.
• Nevertheless, a slower consumer and corporate spending outlook and the much higher cost of borrowing are clearly negatively impacting growth forecasts and valuation multiples.
• For 2024, higher public market valuations and lower expected borrowing costs should continue the momentum from Q4 2023 with higher deal volumes and higher valuations.