Leveraged Loans and Private Debt: Key Insights for Business Owners

Private Versus Broadly Syndicated Loan Markets

Watkins: There are many options available under the leveraged loan umbrella. Can you give us a bird’s-eye view of private versus broadly syndicated loan (BSL) markets? 

Díaz: For some time, the broadly syndicated loan market was the only major option available in the leveraged lending market. Typically, the borrower seeks such a loan from a large bank, which then markets the loan to a group of other lenders and investors, who each contribute to amass the total loan amount needed.

In recent years, large asset managers, including private equity groups, began to realize they could create something similar in a private market, which allows them to be a little more creative and nimbler in certain situations. This private debt market has grown dramatically in recent years (see Figure 2). We are starting to see larger-cap deals that have historically been isolated to the broadly syndicated markets now looking to private credit markets. In fact, the presence of institutions with a direct lending arm has grown dramatically in the last five years.

Figure 2: Private Debt Assets Under Management 

In M&A-related financings, there are various financing structures which can be used. Typically, private equity sponsors try to use as much senior or first lien debt as a company can reasonably support, primarily driven by the lower cost of this financing solution. This senior debt can be supported by the cash flows of the business, the assets, or both.

As more debt is placed on the business beyond the capacity of senior lenders, a different set of lenders and investors can focus on more junior tranches of debt. Those might include second lien and subordinated debt, depending on the size of the business, valuation expectations, and deal dynamics. The deeper into the capital stack, the more expensive the tranche of debt. Beyond pricing, other variables include financing fees, rate structures (e.g., variable, fixed or PIK), amortization amounts, and elements of structure such as covenants and collateral.

In recent years, the popularity of the “unitranche” financing option has grown dramatically among leveraged borrowers. At a high level, the unitranche option blends both senior and junior debt to form a single loan offered at a blended interest rate. The borrower usually works with one or two relationship lenders and the deal does not require a rating from an agency. Benefits of the unitranche option include speed and greater certainty of closing, simplicity in documentation, minimal capital markets risk, and flexibility for additional capital in the future.

Key Lender Considerations

Watkins: We often talk to clients about the factors that contribute to the value of their companies, such as market leadership position, management team, customer and supplier diversification, growth, and financial trends (see For What It’s Worth: Key Valuation Drivers). Many of these factors are considered by lenders when underwriting loans. In general, what are some of the key lender considerations?  

Díaz: In addition to all that you mentioned, sustainability of cash flows is a primary focus as that’s a clear indicator of the ability to pay back the loan. Underwriters also look at EBITDA ramp, or projected EBITDA growth, and how “clean” EBITDA is. At Antares, we look very closely at the percentage of EBITDA add-backs. We like to cap that at a certain number to ensure the likelihood of market receptivity.

Credit rating is another key consideration and is essentially mandatory in any BSL deal. A B3/B- rating would be the minimum for access to most middle-market leveraged loan investors. Some lenders may require a B2 rating if, for example, there is an expectation of future challenges based on sector or cycle risk.

Sectors matter too, and if you're hitting end markets that are cyclical, then chances are you're going to be priced at a premium. Showing systematic consideration of relevant ESG issues is another, more recent consideration.

Valuation can be an important variable as well. While total leverage multiples are important, high purchase price multiples can offset some of the risk from a loan-to-value standpoint. Generally, we feel comfortable at 50% LTV or lower, given the significant amount of equity cushion below our position. This is a drastic difference from the original LBOs from decades ago, which were done at 80% plus LTV levels. In addition, in a rising rate environment, Interest Coverage (EBITDA / Interest Expense) becomes an important gauge for our underwriting.

Recommendations for Working With Lenders

Watkins: What are your recommendations for borrowers on how to best work with their lenders?

Díaz: Overall, I’d say lean into your relationships and be in constant communication. Early conversations between lead arrangers and potential investors are critical—even if it's on a no-name basis—to get comfortable with what’s possible and provide early education to lenders who may be less familiar with the business or industry. If we are in consistent communication with the borrower and we know the business well, we can pre-market the opportunity very well. In any deal, whether it’s a first lien or second lien, you need to build in a pre-marketing period. I would also plan a few weeks for a junior capital component, because you want to make sure you can represent to the first lien folks that the junior capital piece is spoken for.

If the company has a debt rating, the agencies are also key constituents in a lending relationship. One of the key benefits of a strong agency relationship is the assurance to the investor universe that the company has financial reporting and controls in place. Such a relationship can also open the door to a variety of other investors, which helps optimize debt capacity for future transactions, whether M&A or the future exit (sale or IPO) of the company.

Once the business is in a particular lender’s portfolio, communicating early and often about concerns and opportunities typically leads to faster turn-around-time on future credit requests. The relationship can also expand. The lender can, for instance, have a team looking at credit to see where there are opportunities to provide more financing and bring other ideas forward to benefit the borrower and help it pursue its growth goals over time.