Accordion's Quarterly Turnaround & Restructuring Market Update: Q3 2023
Accordion's Quarterly Turnaround & Restructuring Market Update | Q3 2023
The Accordion View
Q3 2023 was another strong quarter for credit markets, with underlying fundamentals proving better than many had feared against the backdrop of sharp and rapid increases in base rates over the last 12 months. To date, many portfolio companies have at least partially offset the impact of higher interest costs with increases in revenue and EBITDA, utilizing cost-cutting measures where needed. However, warning signs continue to flash against a more muddled economic outlook and a higher-for-longer interest rate regime. Issuers will need to contend with outsized (albeit shrinking) maturity walls in 2024 and 2025 in a challenging and more expensive refinancing market and are actively taking measures to push out maturities where possible. Defaults remain low, but both distress levels (measured by trading prices) and downgrade activity are elevated versus prior years.
On the consumer front—a key driver of GDP—consumer wallets still face significant pressure, with COVID-era savings now essentially wiped out with increases in credit card and other delinquencies. Consumer confidence and sentiment remain stubbornly below pre-COVID levels, with the resumption in student loan payments likely to take a bite out of consumer spending.
It continues to appear that turnaround and restructuring activity will remain high, with this cycle driven by balance sheet challenges and liability management. Unlike prior restructuring cycles, during the global financial crisis and COVID, a sharp and sizeable increase in defaults still looks unlikely. Rather, we expect high interest rates combined with unsustainable capital structures to drive a steady yet modest increase in distress over the mid-term, with maturities in 2024/2025 as a potential restructuring trigger.
Consumer Chronicles: Savings Slowdown, Auto Ailments, Menacing Mortgages, Rising Rents
After the flush years of consumer spending immediately post-COVID—with consumer purse strings loosened by government stimulus, rising stock prices, soaring real estate values, and historically low unemployment—2023 and 2024 look to represent a period of return to normalization. The chart to the right details savings as a percent of disposable personal income, which was 3.4% in September 2023, below long-term median levels after the COVID surge. Inflation remains high (+4% year-over-year change in the CPI excluding food/energy in September 2023), though most employment measures (unemployment, job openings, etc.) continue to look robust. Credit card delinquencies, as shown in the chart to the right below, are also beginning to rise from COVID lows.
Auto lending is another useful gauge of consumer spending, with total outstanding auto loan balances modestly declining year-to-date with amortization of existing loans and lower issuance. As shown in the chart below, lenders are tightening credit standards versus the COVID-period, despite softening demand for auto loans. The days of easy consumer access to ‘loose credit’ are largely over, and we anticipate continued softness in this area of consumer spend.
Housing markets (and associated costs) have also experienced drastic changes in 2023. Through September and measured by year-over-year changes in relevant price indexes (per the Federal Reserve), the equivalent cost in “owners’ rent” has outpaced rent increases since early 2022. Elevated housing expenses appear to be cementing for at least the mid-term, and consumers’ income and savings will face continued pressure if these costs persistently climb at rates surpassing general inflation. Many homeowners now face golden handcuffs, where they are locked into fixed-rate mortgages at rates that are materially lower than today’s market. Property and/or geography moves may prove financially challenging for many in today’s housing market and credit environment.
Restructuring Roundup: Amend & Extend, or Amend & Pretend?
With higher financing costs and a tougher new issue market, many issuers could face hurdles refinancing debt maturing over the near-to-mid-term. We expect lenders may be tempted to ‘kick the can down the road’—extending the maturities of troubled credits hoping for a turnaround instead of forcing a loss. This trend is already broadly visible in the leveraged loan market, where amend to extend activity through September 2023 has surpassed that of any other year back to 2015. We expect a similar trend likely holds true in private credit.
Amend to extend transactions allow an issuer to push out maturities without the cost of re-entering the issuance market, and lenders may receive a modestly higher spread versus their initial pricing, combined with incremental fees. There is a balance, however, between 1) pushing out maturities and allotting time for a stressed portfolio company to ‘right the ship’, and 2) delaying the inevitable. The proportion of amend to extend activity that falls into the latter versus the former remains to be seen.
Credit Market Update
High-yield bonds posted a total return of (1.2%) during October, following a +0.5% return for Q3 2023, according to the BofA Merrill Lynch High Yield Index. Although spreads were largely unchanged in Q3 (ending the period at 403 bps versus prior quarter-end at 405 bps), spreads widened significantly in October to 442 bps. Over the past four months, the impact of the rapid rise in Treasury yields, escalation of geopolitical tensions in the Middle East, and weak equity markets was largely offset by a better-than-expected third quarter earnings season and the belief that the Fed has concluded its interest rate hiking cycle. LTM returns through October are pacing at 5.8%, ahead of the 10-year annualized return of 3.8%. Issuance remains weak with only $41B in new US issuance in Q3 and $144B through YTD October. Despite a strong September ($24B), October returned to weak issuance ($9B) and 2023 is on track to be one of the worst years of high-yield issuance post-GFC. Low issuance tends to be of benefit to the high yield market as interest income often gets recycled back into the secondary market, which supports prices.
Leveraged loans delivered another solid quarter, with the LCD Leveraged Loan Index posting a total return of 3.5% in Q3 2023—the strongest quarter of performance since Q4 2020 (+3.8%). Performance was buffeted by lower-rated loans, with the CCC Index posting a total return of 6.0%, ahead of both the BB and Single B indices (+2.2% and 3.8%, respectively). Through October, the Leveraged Loan Index has delivered an LTM total return of 11.9%, ahead of any year since 2016 (+10.2%) and above the 20-year average of +5.5% with loans benefitting from both the rise in base rates and muted credit issues to date. Spreads on the Leveraged Loan Index sit at approximately 500 bps at the end of October, up modestly compared to September and August (average of +480 bps), though down year-over-year (+560 in Oct-22).
Against this backdrop of performance, issuance has accelerated, with Q3 2023 issuance at its highest level since Q1 2022—though it remains muted when compared to a longer-term horizon. Institutional loan issuance in 2023 through October totals $202b, a pace modestly ahead of the same period last year ($198b) but tracking for one of the worst issuance markets since 2010. Against this canvas, the leveraged loan market has shrunk year-to-date by approximately $10b as repayments generally pace with new issuance and fund flows remain negative. We additionally continue to see more issuers turn to private credit—a trend that is potentially taking new supply out of leveraged loans. Take PetVet Care Centers: a KKR portfolio company that issued a $2.3b, 7-year unitranche package at SOFR + 600 with Blue Owl, KKR Capital Markets, Ares, and Oaktree to refinance existing syndicated debt. PetVet follows Hyland Software (Thoma Bravo) and Finastra (Vista Equity Partners), which both refinanced syndicated debt with private credit facilities in September. In previous years, issuers of this size would be prime candidates for leveraged loans, but the growth in private credit—combined with the added flexibility/optionality in private credit for the issuer—continues to drive a shift away from leveraged loans.
Defaults remain in line with historic levels (LTM rate of 1.4% versus the 10-year median of 1.6%), though this is not to say warning signs are not flashing. Issuers remain pressured by both the rise in base rates and pressing maturity needs in a difficult refinancing market. The chart to the right shows the distress ratio of the leveraged loan index (% of leveraged loans trading < 80% of par), which currently is 5.1%, and, for the 13th straight month, ahead of the 10-year median of 3.0%. Downgrades similarly continue to outpace upgrades over the last year and a half, with approximately 20% of leveraged loan issuers downgraded over the last 12 months. The leveraged loan market could remain more challenged than the high-yield market: leverage is generally higher, credit ratings are generally lower, the CLO market (the largest buyers of leveraged loans) is experiencing reduced issuance, and coverage ratios are deteriorating given the floating-rate nature of the asset class.
Private Credit (BDCs)
In a continuation of last quarter’s trends, private credit fundamentals remain healthy—at levels even surprising to private credit fund managers. Defaults have not meaningfully increased, and portfolio companies generally continue to show positive revenue and EBITDA growth.
“I think everyone is probably a little bit surprised this year how well their portfolios have done. You haven’t seen a big uptick in nonaccruals… [and] year-over-year growth in earnings of our portfolio companies is actually quite strong.” – Brad Marshall, Co-CEO, Blackstone Secured Lending Fund
Ares Capital Corporation (ARCC, the largest publicly-traded BDC) reported portfolio weighted-average year-over-year LTM EBITDA growth of 6% in Q3 2023, with underlying interest coverage flat quarter-over-quarter at 1.6x. Blackstone Secured Lending Fund (BXSL) reported 11% year-over-year LTM EBITDA growth, while the public Goldman Sachs BDC (GSBD, Goldman Sachs BDC Inc) reported underlying interest coverage near unchanged at 1.5x (previously 1.6x). Additionally, Blue Owl Capital Corporation (OBDC) reported year-over-year revenue and EBITDA growth of 10% – 12% in each of the last two quarters, and noted it was broad-based across sectors and portfolio companies. This all matches the trends seen in the Golub Capital Altman Index (an index measuring median revenue and EBITDA growth for 110-150 portfolio companies in the Golub Capital portfolio), which reported year-over-year revenue and EBITDA growth of 8% and 13% in Q3 2023—the highest period of earnings growth in their portfolio since Q3 2021.
Covenant breaches and amendment activity remain subdued. The chart to the right details the average non-accrual rate at cost for five of the larger public BDCs; while non-accruals trended up ~30 bps versus the prior quarter (driven by one particular BDC), it remains well below GFC and COVID levels. Portfolio marks (fair value to cost) additionally did not show major changes quarter-over-quarter, nor did internal BDC portfolio company credit ratings (where disclosed).
In summary, private credit portfolio companies look to be able to offset the effects of higher interest rates. A near-term meaningful pick up in distress looks unlikely, though underlying interest coverage may not yet have troughed. Healthcare, consumer, and housing were flagged as sectors where distress could potentially increase in 2024.
Restructuring activity continues to rise both internally at Accordion and at publicly-traded boutique investments banks. Houlihan Lokey (HLI), as shown in the chart to the right, reported 31 restructuring fee events in Q3 2023: an increase of 30% year-over-year. The increase in restructuring events remains driven by the balance sheet, as opposed to profitability-driven issues that catalyzed restructuring cycles in the GFC and during COVID. Liability management remains the area of most concern given pressing maturity needs, a tougher new issuance market, and higher interest costs. However, the aforementioned trends in consumer spending along with other broad macro pressures indicate that P&L-driven restructuring activity should increase over the near-to-mid-term.
“I think it’s pretty hard to make a case that things do not look good for the restructuring industry for at least the next couple of years just on where certain businesses are performing, where interest rates are, just the maturity wall, a whole host of dynamics.” – Scott Beiser, CEO, Houlihan Lokey
The Accordion Turnaround & Restructuring practice sees a solid outlook for the restructuring environment for the remainder of 2023 and 2024. The amend and extend strategies employed by lenders to stave off potential losses may cause additional borrowers (and lenders) to encourage, seek, or require third party advisors’ input and guidance in either a turnaround or restructuring mandate. Additionally, while credit distress remains fairly low today, we believe a pickup in defaults and credit setbacks is forthcoming and will pace through 2024.
North American bankruptcy filings through the first 10 months of 2023 exceed each of the last two years’ full-year filings—and filings for the first 10 months are the highest of any year except 2020. Key bankruptcies in recent weeks include WeWork, Akumin, and RiteAid. “Chapter 22” filings are in line with historical averages, though well above 2022 levels. Additionally, October 2023 has seen more Prepack and Prearranged plan filings than any year since 2016 (excluding 2020), which indicates that the companies filing have been facing financial headwinds for some time and anticipated a need for restructuring prior to filing.
Bankruptcy filings were most concentrated in the healthcare sector (21% of filings YTD), representing the second highest concentration of any North American sector in the last seven years. Real estate, financial services, and retail were also heavy filing sectors, representing 11%, 9%, and 8% of total filings year-to-date, respectively.
1) Pitchbook LCD.
2) Public earnings transcripts and presentations.
3) St. Louis FRED.