The Great Recession vs. The Next One
On the heels of the most extended credit cycle in recent memory, the last six months have delivered a long overdue dose of economic reality. Middle-market borrowers have enjoyed 10+ years of historically low rates and loose lending conditions (save for the brief, covid-induced, recession-that-wasn’t in mid-2020). However, the lending environment has changed due to the inflationary conditions we experience every day and the Fed’s actions to curtail them.
The Fed has raised the benchmark Fed Funds Rate 6 times and 375 basis points since March, with an additional 50-75 basis point increase expected in Mid-December. In turn, companies have seen borrowing costs skyrocket; SOFR, the index rate for new-issue corporate loans, stood at 3.8% on November 30th after beginning the year at near zero.
This SOFR spike, combined with middle market spreads that have widened ~75-150 bps and original issue discounts (OIDs) that have increased to 1.5-2.5% have driven yields for middle market senior secured loans to ~11-12% versus 5.75-7.25% at the end of Q1.
At the current levels, interest expense for a 4x levered business consumes 45% of EBITDA, which substantially limits debt capacity and has the knock-on effect of softening valuations. What’s more, the 3-month Term SOFR forward curve peaks at 4.9% in April ’23 and remains above 4% through March ’24.
Now that we’ve addressed the bad, here’s the good: while lending conditions have deteriorated, this downcycle will bear little resemblance to 2008/09 due to the secular shift in the composition of middle market lenders.
Fundamental Shift in Middle Market Loan Demand
The lender landscape has changed materially since 2009. In the halcyon days of 2005-2007, commercial banks and institutional investors, i.e., pro rata and institutional syndicated loans, accounted for over 90% of middle market volume. Private credit was in its relative infancy and hardly moved the needle regarding loan volume. Thirteen years later, private credit is now the dominant source of financing for middle market companies with a market size of $1.2 trillion vs. $284 billion in 2008.
Why Does it Matter
Looking back on the GFC, it was characterized by an utter lack of liquidity, including within the middle market. But as previously noted, commercial banks accounted for the lion’s share of volume. As risk-off entities whose primary objective is to not lose money, when the proverbial music stopped in 2008, so did their desire and willingness to provide new credit. In fact, it was banks’ withdrawal from the market that turbocharged private credit’s growth.
Conversely, private lenders have different capabilities and incentives to deploy capital in times of volatility. First, rather than avoiding risk, private lenders price, and structure around it. Second, fund managers are compensated for deploying capital, not waiting out the storm. One need not look any further back than Q3, when, per LCD, “direct lending deals tracked by LCD exceeded syndicated loans and high yield bonds…combined.”
As a result of the new landscape, the private credit market will remain open for business regardless of the depth of the looming recession, and financing will remain available for most borrowers, albeit with very lender-friendly pricing and terms.