Amid more rate hikes, PE-backed leveraged loan issuers eye rising costs, outsized risk

At more than 60% of the Morningstar LSTA US Leveraged Loan Index, private equity-backed companies loading up on ultra-cheap debt have powered the decade-long growth of the $1.44 trillion leveraged loan market.

But now, with a regime change from near-zero rates fully underway, these sponsor-backed companies must adjust to higher interest costs on this floating-rate debt, which represents almost all of the riskiest (and therefore priciest) U.S. leveraged loans outstanding.

In this analysis LCD looks at the landscape of sponsored companies and the leveraged loan index. The headlines:

• 90% of loans rated B-minus or lower back sponsored companies.

• Investors command 111 bps more to hold sponsored loans in the secondary market.

• During bankruptcy waves, PE loans default at a lower rate.

Edge of the precipice? One of the starkest data points when drilling down in the index is found in the ratings compilation. LCD data shows that companies backed by private equity sponsors account for a staggering 90% of index loans with loan ratings of B-minus or lower by S&P Global Ratings.

Companies majority-owned by private equity funds—which are not required to publicly file financials or publicly disclose material impacts to their operations—make up 92% of all B-minus rated index loans. This, of course, is just one downgrade from the substantially risky triple-C rung of the ratings ladder. In the highly speculative share of the loan index, 82% of CCC+ rated loans, and 85% of CCC flat loans, are via sponsor-backed companies.





As a share of the full index, B-minus and lower rated loans from sponsored companies are nearly 27% of the $1.4 trillion of loans outstanding. This compares to 3% for non-sponsored entities.



This observation in the secondary market comes, of course, as leveraged buyout funding in the primary market has increasingly migrated into the B-minus bucket in recent years. In 2019, more than half of leveraged loan volume raised to fund buyouts came from borrowers rated B-minus by at least one ratings agency. In the year to date, this share rose to a record 68%, from around a 55% average in the preceding three years.

It stands to reason that sponsored companies funding in the new-issue market do so sporting much higher leverage levels, by 1.5 turns, in fact.

According to LCD data, sponsored transactions (excluding refinancings) were 6x levered at issuance in 2022, and 5.9x in 2021.

Non-sponsored companies tapped the new-issue market with an average debt to EBITDA of 4.4x in 2022 and 2021. Coming due Another profiling for risk is when these loans need to be repaid. LCD data shows that both sponsor-backed companies and non-sponsored companies made good use of cheap and readily available debt markets to refinance and extend institutional term loans.

Only 8% of non-sponsored loans outstanding are coming due between now and the end of 2024, similar to 9% of all outstanding sponsored loans.

However, noting that loans are marked as current on the balance sheet if the debt comes due within twelve months, the next big jump in maturities for sponsored companies is $70 billion that comes due in 2024.



In absolute terms, sponsored companies have $209 billion of institutional loans due before the end of 2025, versus $117 billion for non-sponsored. Paying up Looking at where the market prices this debt, LCD data shows that leveraged loans backing non-sponsored companies are, on average, priced 111 bps higher in the secondary market, at 97.28 over a five-year period through Sept. 30. This compares to 96.17 for their sponsored, generally lower-rated counterparts.

On Sept. 30, however, this differential was at more than 200 bps as investors continue to seek safety in better-rated facilities. The bifurcation between the two cohorts is the largest since May 2020.

By way of reference, the differential between loans backing sponsored and non-sponsored companies widened by nearly 450 bps in March 2020 during the pandemic market crash, and by 580 bps in March 2009 as loan defaults skyrocketed.



Looking at the corresponding underlying nominal spread, as of Sept. 30, sponsored companies paid, on average, 91 bps more, at 390 bps over the benchmark rate.



In a look at how default activity has trended between private and publicly held companies, LCD's data shows that in the most recent periods of elevated defaults—the aftermath of the 2020 crash, and the oil price-driven uptick in 2016—sponsored companies defaulted at a lower rate than non-sponsored entities. Conversely, away from these periods, sponsored companies generally exhibit higher default activity than publicly held companies.

One big caveat, however, is that LCD's criteria do not include distressed exchanges, which are more likely to preserve the equity stake held by private equity owners and their control of the company, a particular pain point for PE firms during market downturns.

Over a longer period of time for payment defaults and bankruptcies, the average default rate of private-equity-backed loans since 2011—the beginning of our data series tracking by issuer count—is almost on a par, at 1.50% for sponsored companies, versus 1.57% for non-sponsored.

Again, to caveat, adding back distressed exchanges would lift this rate, though losses from distressed exchanges are significantly less in general. LCD’s analysis of S&P Global Market Intelligence’s LossStats database shows that term loans defaulting through the bankruptcy process gave a discounted recovery rate of 68.9% across the 34-year history of LossStats data, versus 89.8% for distressed exchanges.





This article originally appeared on PitchBook News