Lenders pivot to pro-rata facilities amid downturn in secondary markets

Data InsightDebtDynamics 28 October

Lenders pivot to pro-rata facilities amid downturn in secondary markets

Institutional loan issuance has plummeted to a third of the levels seen last year. During the first nine months of 2022, institutional volume was USD 233.2bn, down 68% from USD 726.9bn in 9M21, and 39% below the USD 384bn seen in 9M20 when COVID-19 first roiled markets. In the secondary market, where lenders offload that debt to investors, bids have tumbled more than seven points this year to 90.97, amid worries over the Federal Reserve’s aggressive rate hikes to combat inflation and a looming recession. Only 1% of loans currently trade in the par-plus segment of the market. No wonder lenders have shied away from underwriting debt that could, in the current market, remain on their books until investors are willing to take on the risk, often at a significant discount.

The pro-rata loan market, where syndicate bankers typically share risk evenly, has filled the void. Volume there was down just 24% year-on-year to USD 830.5bn in 9M22. Institutional loans made up just 15% of total leveraged loan issuance in 3Q22 – its lowest level in years – down from 67% in 9M21 and 28% for 9M22.

Another sign of the shift in risk tolerance can be seen in the rising volume of asset-based lending. ABL issuance reached USD 83.1bn during 9M22, up 40% year on year. Revolvers, amortizing term loans, and asset-based loans generally avoid some of the cash flow and trading risks of institutional tranches, making them more attractive in the current market climate.

Slashing prices: Institutional lenders offer striking discounts to reduce exposure

Lenders have been forced to offer steep discounts on new loans to entice investors who could otherwise find comparable yield in the secondary market. With bids depressed, the average original issue discount (OID) on new institutional loans soared to 721 basis points (bps) in September from only 50bps in January. BBB Industries offered the steepest discount of the quarter at 1,000bps on its USD 1.225bn TLB to support its secondary buyout (SBO) by Clearlake Capital.

Discounts have been more dramatic this year compared to 2020, when the highest monthly average discount topped out at 355bps. This year’s extreme pricing is due to uncertainty over inflation and the heightened risk of default in a rising rate environment, both of which have persisted for months. By contrast, the coronavirus-induced secondary market collapse of 2020 was short-lived, thanks to historic support from the Fed. By September 2020, bids had recovered to 92.25 from March lows of around 81, with discounts averaging just 96bps.

With the Fed actively reigning in monetary policy, lenders have been left to fend for themselves. The only way underwriters of committed financings closed before the market soared can reduce exposure to companies now facing more risk, is to offer substantial discounts, even if it means taking a loss on the deal, as was the case in the Cornerstone Building Brands financing. Lead banks Deutsche Bank and UBS netted a loss of USD 200m on the buyout financing after being forced to sell high-risk PIK debt back to the company sponsor, Clayton Dubilier & Rice, at a major discount. The TLB component priced at a discount of 90.5 in July after receiving pushback from lenders wary of the building-products sector ahead of an expected economic downturn.

Forfeiting returns: Lower pro-rata borrowing costs shrink lender payouts 

The safer nature of pro-rata facilities compared to institutional tranches – enhanced risk distribution, tighter documentation and oversight, and shorter maturities, to name a few – paired with their larger average issuance size, allow borrowers to achieve a lower cost of capital on average. Year-to-date, margins on first lien institutional term loans have averaged 417bps, increasing gradually each quarter to a high of 473bps in 3Q22. By contrast, pro-rata pricing has stood at 226bps year-to-date. In fact, 58% of pro-rata loans issued this year are priced at 200bps or lower, compared to less than 1% of institutional tranches.

The combination of a record high share of pro-rata loan issuance and lower average pricing on such debt should result in a lower return for lenders in the space. But compared to losses from hung syndications, many will be happy to keep the capital flowing to clients and avoid potential defaults. 

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