2010 began with optimism in the loan market, a dramatic shift in sentiment compared to the start of 2009 when the market was still in a state of paralysis. While the primary loan market did not open up until late in 3Q09, by year end, conditions had improved dramatically, setting the stage for a potentially faster-than-anticipated recovery in 2010. 

In the middle market (overall deal size <=$500 million and borrower sales size <=$500 million), 4Q09 issuance reached $25.8 billion, its highest quarterly level since 3Q08. This level is up 37% from 4Q08, the first year over year increase in quarterly loan issuance since 2Q07. Despite its triumphant finish, issuance is still far off from historical highs. At $71 billion, 2009 middle market lending is the lowest level since Thomson Reuters LPC began tracking the middle market in 2000 (Fig. 1).

Fifty-eight percent of lending activity came from amendments and refinancings, but the pace of these financings decreased significantly by year end (Fig. 2). In 1Q09, 74% of middle market lending came from amendments, with the bulk of it coming from majority vote amendments. Given the dire state of the loan market at the beginning of the year, companies and arrangers avoided putting existing bank groups at risk by opening up the deals to 100% vote amendments. In 4Q09, amendments still made up a hefty 47% of middle market lending, but the majority were done via 100% votes and just a fraction through majority vote amendments.

Both sponsored and non-sponsored lending showed signs of recovery in 4Q09, but issuance was still down in both market segments for the year. At $58 billion, non-sponsored issuance fell 26% from 2008’s level. Sponsored issuance took a bigger hit and fell 42% year-over-year to just $13 billion.

But the story of the year was the return of liquidity into the loan market. A vast majority (88%) of respondents to Thomson Reuters LPC’s Quarterly Middle Market Survey say that capacity increased in the middle market in 4Q09, relative to the previous quarter.

The large corporate loan market benefited from a robust high yield bond market that led to $74 billion in paydowns, in turn, plowing liquidity back into the loan asset class. While some of this trickled into the middle market, the majority of middle market liquidity came from built-up cash throughout the year, improving bank operations, the pressure to meet year-end budgets and the return of some lenders to the middle market.

Banks look to put money to work
In the non-sponsored market, demand increased from regional banks, local banks and foreign banks.

“With very limited activity through the first nine months of the year, many institutions had fallen short of their lending goals and were scrambling to do deals,” says one lender who focuses on the non-sponsored market.

Moreover, portfolios had shrunk dramatically.

“Not only did banks witness major runoffs, but there were also a lot fewer drawn credits due to the limited amount of economic activity which curtailed lending needs,” says one banker.

So banks’ appetite for loans increased dramatically in 4Q09, and dealflow improved somewhat.

In turn, non-sponsored issuance of $19.5 billion in 4Q09 was up 18% from 4Q08, and 34% from the previous quarter (Fig. 3). While most of the activity came from refinancings and amendments, M&A lending reached $1.75 billion in 4Q09 topping the $1.4 billion total reached in the first three quarters. For the year, M&A loan issuance was down 70% from 2008’s $10.4 billion.

Return of M&A is highly anticipated in 2010
Despite negligible figures in 2009, lenders expect that M&A will make a comeback this year.

“Companies are having M&A conversations and are out there evaluating options, and looking at who is underwriting,” says one banker in the Southeast region.

Another lender says increased M&A activity will be driven by sellers that have waited too long and cannot afford to wait anymore, and from the fact that financing is now available for those buyers comfortable pulling the trigger. While some lenders are optimistic and say M&A could go through the roof this year, others are more cautious and say M&A will gradually come back in the non-sponsored arena.

Lenders also expect new dealflow to come from increased working capital and capex needs that will return as the economy heals. So far, however, most say they have not seen many companies ramping up their business.

Competition heats up – spreads tighten
With little new dealflow and increased liquidity in the market, lending was competitive and terms deteriorated. Most lenders say that there still is discipline and the loosening that has taken place in the middle market is far from that seen in the broadly syndicated loan market. But there are some that are surprised at how fast competition has come back and say it is just a matter of time before deals turn very aggressive.

“Banks are willing to give in on pricing on deals that are good performers,” says one banker. “If a deal risk-rates well, then pricing is not that important.”

Spread expectations have certainly tightened somewhat. Heading into 1Q10, 45% of respondents say their minimum senior spread threshold was between 200-300bp. In 3Q09, the majority of respondents had a minimum spread threshold of 300-400bp (Fig. 4). Similarly, the majority of lenders expected a 1-2% Libor floor to help boost returns in 3Q09, compared to only 18% in 4Q09. Many banks see Libor floors as one of the first things to go away next year. Even so, some banks say the market overcorrected and returns remain attractive relative to pre-crunch levels.

Amendments have certainly provided banks with a mechanism to increase spreads in return for longer tenors and more flexible terms (Fig. 5).

Lenders say most of the spread compression has taken place in the smaller “clubby” side of the middle market. One northeastern lender says, “In that segment, not only do deals get circled with just two or three lenders, but also banks have very strong relationships with their clients and are stretching terms to maintain them.”

The non-sponsored market has always been a relationship lending space, but as the market collapsed, relationships and ancillary business moved to the top of lenders’ priorities. In 4Q09, there was some loosening on this front, but only up to the point where “a few deals could get done with the promise of ancillary business, whereas in the previous six to nine months it had to be signed upfront.”

So ancillary business remains important and is another pressure point for spreads, as some banks will sacrifice loan spreads for the business.

Pressure builds on structures
While spreads have receded, banks say structures are still fairly tight and that the non-sponsored middle market continues to be credit focused. Nevertheless, there has been a shift in leverage tolerance levels in the middle market. In 4Q09, 83% of survey respondents say they tolerated total leverage of 3 times and above, compared to a much lower 64% of respondents in 2Q09. Senior leverage levels have also stretched. In 2Q09, only 10% tolerated senior leverage of 2.5-3 times. At the end of the year, 48% of respondents say they will participate in deals that have senior leverage in that range.

When it comes to tenor, structures have not shifted too much as most lenders say three years is still the norm. In 2009, tenors contracted significantly. In the traditional middle market, the average tenor came down from 3.5 years in 2008 to less than three years in 2009. In the large middle market, the average maturity in 2009 was also less than three years, a lot shorter than the almost four-year average in 2008 (Fig. 6).

But some lenders say that tenors are also under pressure.

“We have heard a few five-year deals getting pitched, but we are not ready to go back to longer tenors,” says one lender.

While most lenders don’t see five-year deals making a comeback in the near future some see selective five-year deals getting done at the right price.

“We don’t like doing five year deals,” says one lender. “But if we are trying to win a deal in an industry that we like, and it is priced well, we might go for it”.

What happens next?
The end of last year marked the return of liquidity into the loan market and more is expected in 2010. Banks have aggressive budgets in 2010 and the question is − will dealflow be sufficient to meet the demand? Several lenders expect non-sponsored lending to pick up as the economy continues moving forward.

“Volume has to increase, we cannot invest deposits in T-bills forever”, says one lender.
But many risks remain, and some bankers are not sure there will be enough deals to satisfy increased appetite.

To this end, some are increasing hold levels.

“There is not enough new stuff out there, so we need to grab market share,” one lender explains. “One way we did that was by offering higher hold levels. For one deal we upped our previous commitment level from $7 million to $70 million; that is the way we will be able to win refinancings.”
However, others are concerned. Without a significant pick-up in new issue, credit terms will deteriorate.

“Credit committees continue to be in the driver’s seat,” says a banker. “It’s still hard to get aggressive structures approved, but if dealflow does not pick up significantly, there might be a shift from credit to revenue and the market will go back to very aggressive levels.”

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by Diana Diquez, Senior Market Analyst, Thomson Reuters LPC