Interest-coverage ratios have been top of mind for leveraged loan market participants this year given the substantial impact rising rates have on the $1.4 trillion floating-rate asset class. In the last 12 months, 90-day term Sofr has risen to 5.2%, from roughly 1.3%, pushing the yield-to-maturity on newly issued loans to single-B borrowers above 10% for the first time in more than 20 years.
Against this skyrocketing cost of debt, risk appetite for new buyouts has remained subdued. Sponsors raised just $11.4 billion of financing in the broadly syndicated loan market for this purpose in the year to May 15, the slowest pace in 11 years.
Clearly, dynamics in the new-issue leveraged loan market have changed dramatically over the past year.
But what about existing LBO loans? How are buyout financings undertaken earlier in the credit cycle — before rates began to shoot skyward — faring, specifically around meeting what are now starkly steeper interest expense obligations?
With this question in mind, LCD set out to estimate how much interest-coverage ratios have changed on the 20 largest LBOs financed in the broadly syndicated loan market in 2021, before rates started to rise.
At the closing of each buyout in 2021, these deals had an average debt-to-EBITDA ratio of 6.4x and interest-coverage ratio of 3.5x, based on financials collected by LCD for each transaction. Recalculating interest expense using today’s base rate results in an average coverage ratio of 2x, assuming EBITDA is unchanged.
In 2021, three-month Libor was under 0.25%, but all the LBOs in LCD’s sample had a Libor floor of either 0.5% or 0.75%, bringing the base rate to at least those levels. In mid-May, by contrast, both three-month Libor and Sofr have topped 5%.
LCD’s analysis is based on adjusted pro forma EBITDA, as provided in the Information Memorandum (IM), which could include various adjustments, cost savings, or synergies. In LCD’s best case scenario, which assumes that EBITDA rose by 10% from pro forma levels at closing of each deal, the interest-coverage ratio stands at 2.2x, using today’s base rate. However, if the borrowers’ EBITDA came in below 2021 levels, whether due to weaker earnings, unrealized cost savings or other reasons, interest coverage falls below 2x. For example, if EBITDA is off by 10%, the ratio falls to 1.8x. In the worst case scenario, which assumes EBITDA falls by 30% from 2021 levels, interest coverage averages just 1.4x for LCD’s 20-name cohort.
A few notes on methodology:
- The analysis is based on the 20 largest buyouts financed in the US broadly syndicated leveraged loan market in 2021. Size is based on total transaction size (debt+equity).
- Current interest expense is re-calculated using the pro forma balance sheet at closing of each loan in 2021, as outlined in the IM.
- For the base rate, LCD used current three-month Libor for simplicity. Since 2021, some loans already have transitioned to Sofr, with many falling back using contractual fallback language. Loans with hardwired fallbacks transition to CME Term Sofr + ARRC credit spread adjustment (CSA), which is very close to 3M Libor.
LCD’s 20-name 2021 LBO cohort includes loans from nine sectors; the tech industry has the highest representation, with six names. Eight of the 20 transactions are secondary buyouts, while seven are take-privates. The cohort has a median transaction size of $5.7 billion, including $1.9 billion of first-lien loans. The median pro forma EBITDA of the cohort stood at $461 million at closing.
Given the large size of the LBOs in LCD’s analysis, more than half of the sample raised financing in the high-yield bond market, alongside leveraged loans. Nine out of 20 relied solely on first-lien and second-lien term loans, making these debt stacks entirely floating-rate. As a result, the effect of rising rates was more pronounced here — the re-calculated interest-coverage ratio declines to 1.6x using the current rate and 2021 EBITDA, versus 3.3x at closing. If EBITDA falls by more than 10% from levels outlined at closing, interest coverage declines to below 1.5x for this nine-deal sample.
The sample of 11 transactions that included fixed-rate debt had average interest coverage of 3.6x at closing in 2021 and 2.3x using the current base rate, a less drastic decline versus senior-only deals. Also, even if EBITDA declined by 30% from the base case scenario, interest coverage on these deals remains above 1.5x.
Featured image by Gorodenkoff/Shutterstock
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