August 4, 2022 |
GSAM Perspectives
Menu
Our services in the selected location:
- No services available for your region.
Your browser is out of date.
PREPARING FOR THE RISING TIDE OF RATES
September 1, 2022 | 12 Minute Read
Stephanie Rader
Global Head of Private Credit Client Solutions and Product Strategy
Stephanie Rader
Key Takeaways
- Buyout activity has risen to record levels, with transactions increasingly backed by leveraged loans that feature floating rates.
- As the interest expense rises on floating-rate debt, it represents additional income and an inflation hedge for creditors but an increased cost to the underlying company at a time when input prices are rising.
- In aggregate, sponsor-backed companies are well positioned to absorb the impact of rising rates; however, investors should understand how to assess potential areas of weakness within their portfolio.
Buyout activity has reached unprecedented levels in recent years, due in large part to relatively cheap and readily available debt financing. High leverage levels have been manageable with rates at historically low levels, but many buyouts are backed by floating-rate leveraged loans, with investors opting for the flexibility that private credit can offer compared to traditional debt products—a trend that was on display during the disruptions of the pandemic. At the same time, many investors have been drawn to private credit in a search for yield while interest rates were at historically low levels.
As rates have begun to rise, investors and borrowers have new factors to consider stemming from the floating rates associated with most private debt products. While floating rates provide additional income for investors, they also represent an increased cost to the underlying company at a time when input prices are rising, with inflation and rates inherently interlinked.
How are leveraged loans priced?
Floating rates are established using a reference rate plus a spread. Reference rates are repriced at a regular interval, often including a floor, then added to the pre-determined spread to calculate interest payments. Spreads have ranged from 400-500bps over the last decade for leveraged loans backing buyouts, with narrower spreads for larger deals.
The London Interbank Offered Rate (LIBOR) historically has been the reference rate of choice, but a high-profile scandal has prompted a wide-scale shift to an alternative. New leveraged loans were prohibited from using LIBOR as of year-end 2021, but outstanding loans are allowed to maintain LIBOR references until June 2023. While there are several reference rates to choose from, the Secured Overnight Financing Rate (SOFR) has become the preferred metric, commanding 98% market share in January 2022, as the market made a rapid regulatory-induced move from LIBOR. SOFR is reported on a daily basis, with the rate compounded to calculate one or three-month Term SOFR, which is used to price loans. While the market remains fundamentally unchanged, the shift has required some changes. For example, most loans now include a credit spread adjustment because SOFR is a risk-free rate, unlike LIBOR.
Almost All New Loans Reference SOFR
Source: Leveraged Commentary & Data (LCD). Data excludes add-ons. Data through January 31, 2022.
Current Environment
The daily SOFR rate—now the main reference rate for leveraged loans—surged in mid-March when the Federal Reserve raised rates for the first time since 2008. Rates have continued to rise and are expected to go further, with the market pricing in SOFR to rise above 3% in the coming years.1 The rise in rates comes as debt used in buyouts has risen to historically high levels, at 6x EBITDA,2 leading some market commentators to draw parallels to the buyout boom and bust of the mid-2000s. While certain metrics today appear similar to that period, there are fundamental differences and, in aggregate, companies are well positioned to absorb the impact of rising rates for several reasons.
Reference Rates Have Increased Sharply in 2022 and Are Expected to Rise Further
Source: Goldman Sachs Marquee. As of June 17, 2022.
First, although debt levels in buyouts may be elevated, so are equity cushions. For new deals, equity has represented roughly 45% of the purchase price in recent years, compared to about 30% in 2007. With valuations at historically high levels, the equity cushion serves as a buffer to lenders if asset prices fall. Companies with high-yield debt—an imperfect proxy for the leveraged loan market—have fortified their balance sheets during the favorable environment of recent years, with cash-to-asset ratios at decade highs. Furthermore, private equity sponsors have a record amount of capital to deploy, serving as a ballast to invest more equity if needed to secure additional credit financing. This assumed funding and liquidity backdrop is one potential reason why sponsored bonds have tended to outperform in periods of weaker macro risk appetite.3
The Backstop Provided by Private Equity Sponsors
Source: iBoxx, Goldman Sachs Global Investment Research. Returns are rates-hedged. As of June 17, 2022.
Second, virtually every leveraged loan borrower took advantage of low rates in recent years and refinanced. As a result, no leveraged loans are maturing in 2022, and the amount coming due in 2023 has fallen by about three-quarters since the start of 2021. While more difficult to quantify, a subset of firms will have utilized interest rate hedging to mitigate rising rates. Additionally, many borrowers also likely took advantage of attractive swap rates over the last year to term out a significant portion of their floating-rate debt.
Lastly, thanks to strong balance sheets, equity cushions, and recent refinancings, default rates are at historically low levels. While defaults are somewhat backward-looking, distress ratios—a more forward-looking indicator—also remain muted. Even if the economy slows, it’s likely that defaults will remain relatively low in the near term.4
The Distress Ratio Continues to Hover Around 2.5% as the U.S. Default Rate Remains Low
Source: Leveraged Commentary & Data (LCD). As of June 17, 2022.
Rising Rate Stress Test
While significant near-term stress seems unlikely, if the economic slowdown worsens or extends for a meaningful period of time, certain companies will inevitably encounter struggles. Rising raw material costs and labor rates have already translated into higher prices for consumers and are starting to impact profitability, particularly in companies with high energy or transportation expenses. Rate increases are now also putting pressure on margins with higher interest expense. For companies with relatively high debt loads, investors are paying close attention to the interest coverage ratio (EBITDA / interest expense) as a key metric to evaluate repayment ability.
Companies’ ability to pass along the increased interest expense to customers to balance the increasing denominator is always limited, but that is particularly the case in the current environment as inflationary pressures have already driven up labor and material costs. Firms can bolster EBITDA by introducing new products and services with more attractive margins—a challenge in an inflationary environment. As a result, the only mitigation available to management teams facing cash flow challenges will be to find cost reduction elsewhere.
EBITDA Addbacks
EBITDA is the preferred metric for pricing buyouts and gauging a company’s cash flow available to repay debt, but the metric is susceptible to subjectivity. Addbacks are expenses that are explicitly removed from the financials, with certain add-backs easily categorized as one-time costs (e.g., transaction costs), while others (e.g., nonrecurring operating) are less tangible. The purpose of add-backs is to provide a more accurate view of the assets, typical operations, but this also opens an opportunity for misleading accounting practices.
An analysis by S&P Global Market Intelligence, which provides data on the debt market, found that “marketing EBITDA (including addbacks) generally does not provide a realistic indication of future EBITDA and that companies also consistently overestimate debt repayment.”5 These findings have real implications for investors, as EBITDA often serves as the basis for calculations of leverage and financial health.
The plurality of addbacks in recent years have come from expected cost savings, which may be particularly hard to achieve amidst heightened inflation. As a result, firms that have historically relied on margin expansion, rather than top-line growth, to drive returns may encounter challenges in the current environment.
EBITDA Addbacks Have Risen in Recent Years
Source: S&P Global Market Intelligence. As of February 8, 2022.
Stress in prior cycles has generally been concentrated in commodity sectors like energy, but the macro backdrop makes that less likely today. The companies currently showing the most weakness are in legacy sectors like broadcasting and publishing, which face long-term structural challenges. Debt loads are currently higher for technology buyouts, at 7x compared to 6x for the broader market, and that segment now accounts for a record-high 37% of the buyout market.6 Higher growth prospects for technology can justify higher valuations and leverage, particularly for companies with strong cash-flow profiles through contracted revenue. Regardless of the sector, however, differentiation has been on the rise between firms as the operating environment has grown more challenging. Proactive management teams have already taken steps to prepare for headwinds, while weaker operators will face mounting challenges to cash flows and operations.
Unlike Prior Downturns, Distress Is Likely to Come from Non-Commodity Sectors
Source: Leveraged Commentary & Data (LCD); S&P/LSTA Leveraged Loan Index. Represents sectors with an index share of 1% or higher. As of May 2022.
Technology has been a major theme in the buyout space, not only as an investment, but also as a means of enhancing existing manual processes and inefficient models. The pandemic has accelerated this phenomenon in noticeable ways, including telehealth, remote work, and contactless ordering and checkout. Technology is also being deployed to streamline back-office operations across industries including logistics and finance. The combination of multiple inflationary pressures will likely spur further focus on the implementation of deflationary technology solutions, and may in fact change the calculus around the capital investments required today.
"Companies can work to control interest expenses by refinancing or issuing new equity, but that takes time. As rates rise, it has an immediate impact on the interest coverage ratio of every company regardless of the underlying operations."
On the other side of the equation, once the loan terms are locked, the interest expense is dictated by how market forces move the reference rate. Companies can work to control interest expenses by refinancing or issuing new equity, but that takes time. As rates rise, it has an immediate impact on the interest coverage ratio of every company regardless of the underlying operations. Some back-of-the-envelope math, based on aggregate industry data, illustrates the potential impact of rising rates on interest coverage ratios
and earnings.
Interest coverage ratios currently are strong on an aggregate basis, with the average above 5.5x heading into 2022. Loans backing leveraged buyouts have lower interest coverage at 3.7x, but that is historically high for the cohort. Using that as a baseline, the illustrative example shows that interest coverage ratios remain above 2x even if rates rise to 3.5%, which is possible given current forecasts.
Rising Rates Have an Immediate Impact on Company Financials
Source: Goldman Sachs Asset Management. For illustrative purposes only.
While these data points can be reassuring, investors need to look beyond headline figures to understand how their portfolio holdings are positioned. The bottom quartile currently has interest coverage of about 1.6x; historically, this is a strong figure from the bottom tier of companies, but these businesses have little wiggle room as markets shift. Indeed, the results from the above scenario analysis are much different if a starting interest coverage ratio of 1.5x is used. In this case, earnings turn negative and the interest coverage ratio drops below 1x as rates rise from 2.5% to 3.0%.
In addition to being a helpful metric to gauge a company’s ability to repay debt, the interest coverage ratio can be included as a covenant on a loan. Covenants in general have become much less common, with cov-lite loans now representing nearly 90% of the market. Under cov-lite loans, lenders still have recourse when borrowers encounter difficulties—but only when the issuer takes certain corporate actions (e.g., new debt issuance, acquisition, dividend payment). Knowing where loans sit in the capital stack is also important, as the proportion of first lien loans has risen in recent years, leaving less of a buffer for subordinated debt.7
"Dispersion in performance is likely to rise as weaker operators encounter cashflow challenges and refinancing deadlines."
During the pandemic, lenders showed a high degree of flexibility by granting covenant relief on an unprecedented number of loans in 2020, which has led borrowers to turn to the strategy in 2022 as market volatility has risen and stalled the public high-yield market. Many private lenders have yet to experience a more severe or prolonged downturn that creates real stress in the market, however. As a result, many private credit firms may find they lack the expertise and resources to manage through a complicated workout or bankruptcy process.
The Bottom Line For Investors
Buyout activity and sponsor-backed companies appear to be in good health, but all else equal, rising rates detract from earnings, which impacts valuations—even in private markets where mark-to-market moves are slow. Portfolios need to be analyzed at the company level to understand exposures to specific sectors, regions, client bases, and other factors that can lead to relative strength and weakness. To gather a full picture, investors should understand how General Partners are calculating leverage and assessing risk at both the asset and fund level.
On EBITDA addbacks, certain aspects of underwriting and valuation can be somewhat subjective. Investors should understand the assumptions that are being made when loans are underwritten and added to portfolios, particularly as the macroeconomic environment presents more headwinds and uncertainty. Dispersion in performance is likely to rise as weaker operators encounter cashflow challenges and refinancing deadlines. The most challenged companies will be those with little short-term pricing power that are facing a crunch from aggressive coverage ratios and too much reliance on addbacks, while being saddled with too much debt. Across private market strategies, leverage is increasingly being embedded at the fund level via capital call lines and NAV facilities.
Despite market conditions, buyout activity has remained at elevated levels. And while traditional debt capital markets have dried up amidst heavy investor outflows, private credit managers have a record amount of dry powder to deploy. Private equity managers have proven their ability to move nimbly to pivot companies and effect changes as market conditions change, while private credit offers flexibility and the customization needed amidst uncertainty. Going forward, success in the buyout market will stem from a foundation of thoughtful underwriting that considered the potential for both higher rates and lower growth, an ability to navigate potential periods of difficulty, and the nimbleness to pivot and adapt businesses to take advantage of technological advancements to drive both top-line revenue and bottom-line profitability.
Related Insights
-
-
August 16, 2022 | GSAM PerspectivesEurope: Recovering into a New Regime
August 16, 2022 Europe is primed to enter positive rate territory in response to inflation running at a 40-year high. Investors must also navigate structural forces such as aging demographics, decarbonization and digitization that look set to place Europe in a new macro regime. Read More -
August 26, 2022 | GSAM PerspectivesThe New Macro Realities for Real Estate: How Inflation, Rates and Recession Present New Risks and Opportunities
August 26, 2022 The rising-tide-for-all environment in real estate seems to have ended, likely to be followed by a period of more uncertainty and dispersion. In a quickly changing macro environment, real estate investors need to focus on diversification and understanding a portfolio’s underlying drivers of return and sources of risk. Explore why we believe, more than any other time in the last decade, that investors need a nuanced real estate strategy to position themselves to be rewarded with more alpha opportunities as dispersion increases. Read More
Start the Conversation
Committed to providing you with the insights you need to build your practice.
