With interest rates at decade highs and floating-rate-heavy capital structures bearing the brunt of ballooning debt servicing costs, LCD analyzed the first-lien capital structures of leveraged buyouts, finding that while overall leverage on debt backing US LBOs has dropped in 2023, so too has the “debt cushion,” which has shown to be an important factor on recovery rates in cases of default.
Looking at new-issue loans backing leveraged buyouts, the buffer of subordinated debt in this year’s (albeit thinner) sample has fallen to just 9.7%, from an already relatively low watermark of 17.9% in 2022.
During times of near-zero interest rates in 2014 and 2015, when this buffer was arguably less important, this cushion was at 27.1% and 25.5%, respectively.
For reference, LCD defines ‘debt cushion’ as the share of debt that is subordinated to the first-lien term loans. A lack of debt cushion has historically had a negative impact on the recovery rate of senior debt in the event of a default.
In the priority waterfall of creditor claims, the higher the seniority, the higher the recovery. But this benefit is weakened significantly when the buffer of junior debt thins.
Bank loans with more than a 75% subordinated debt cushion, for example, historically give a 94% average discounted recovery. This recovery drops by as much as 20 bps, however, when that debt cushion thins to 50% or less.
First-lien leverage on loans backing US LBOs in 2023 has eased to 4.7x, from a record high level of 4.9x in 2022, but this is still elevated. In 2021 — the last big vintage of LBOs before rate raises and market volatility set in — first-lien leverage was also a lofty 4.7x. To put that into context, first-lien leverage averaged 3.9x 10 years prior.
For the bank loan class, leverage can be kinder in terms of recovery if it creates a cushion. However, in an effort to keep debt costs low, borrowers to a greater extent not only relied on first-lien debt (which is cheaper than junior debt) when leverage ratcheted higher in 2022, but also relied more heavily on the first-lien portion as overall leverage retreated in 2023. Case in point, for the 2023 LBO cohort, the drop in total leverage was more pronounced, falling to 5.3x, from 5.9x in 2022, in comparison to the decline in first-lien leverage to 4.7x, from 4.9x in 2022.
Leverage limelight
This trend carries over when looking at the capital structure of all new issuance. First-lien leverage for all funding purposes eased to 4.1x in 2023, from 4.3x in 2022. This compares to overall leverage of 4.7x, which fell from 5.3x in 2022, showing again that decline in leverage was driven by a reduction in debt subordinated to first-lien loans.
This comes as the M&A share of loan volume has plunged to 25% in 2023 — the lowest level since LCD began tracking this data in 2000 — from 63% in 2022.
With the fall in M&A activity, the ratings quality of new issuance has improved, with the share of leveraged loans coming to market with a B- rating declining to 22% in 2023, from an elevated 42% in 2022.
As investors pushed back on risk-taking, and leveraged levels subsequently declined, the LBOs that did emerge in 2023 carried better ratings on average, with 65% of deals rated B/B+ and only 6% rated B-. In 2022, the trend was flipped, with nearly 70% of buyouts rated B- and 31% rated B/B+.
While leverage is creeping lower and ratings quality is improving, companies on average are heading into this higher rate environment with a thinner coverage cushion to service this debt. LCD data show companies funding a leveraged buyout in 2023 came to market with an interest coverage ratio of 2.7x, down from 3x in 2022, and 3.5x in 2021 and 2020.
Meanwhile, the yield required by loan investors to buy into LBO debt soared to north of 10% on average in 2023, from 6.8% in 2022.
However, when translating this to compensation per turn of leverage, first-lien lenders — thanks to a large jump in the underlying base rate — are receiving the highest yield per unit of leverage since 2008.
Looking at yield to maturity, which takes into account spread, the original-issue discount on a loan and the base rate, the yield per unit of first-lien leverage has averaged 248 bps this year, the highest reading since the Global Financial Crisis. This metric stood at 158 bps in 2022 and at just 106 bps in 2021.
Another part of the subordinated debt equation, of course, is high-yield, where issuers have not provided much additional loss-absorbing capacity via the primary markets over the past 18 months. Per LCD data, unsecured high-yield issuance from non-debut companies in 2023 currently stands at just $34.2 billion, after having totaled $55.5 billion in 2022. By comparison, non-debut unsecured high yield issuance was $254.1 billion in 2021.
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