Momentum from the fourth quarter continues, but lingering pandemic-era uncertainty means that lenders remain risk averse. Cyclical industries and areas with Covid exposure, will be out of favor until there’s certainty the rebound will hold. Recession-resistant sectors such as software, business services, logistics and healthcare will attract even more attention.
Lenders and deal professionals entered 2021 with an abundance of hope. The fourth quarter, thanks to pent-up demand, represented one of the most robust dealmaking environments in recent memory. However, given the challenges of 2020, it’s easy to overlook all of the questions still facing the credit markets.
Will the vaccine rollout mark a return to normal? How will the administration change impact key markets? Most importantly, should investors be wary of a credit cycle that hasn’t yet capitulated?
The lingering uncertainty ironically provides some clarity around the mindset of middle-market lenders.
To help put the market in perspective, the disruption last year helped to reset terms, not necessarily in favor of lenders, but reflective of a more balanced market approach. Spreads increased by 25 to 100 basis points versus the pre-Covid era; leverage multiples trended lower even as deal multiples stayed static; and documentation has gotten stronger in favor of lenders, with a focus on minimizing cash and other collateral leakage and maximizing liquidity.
But even as lenders regained negotiating power, three factors will distinguish the deals that get done from those that don’t.
Identifying Covid- and Recession-Resistant Sectors
The lingering uncertainty means that lenders remain risk averse. Cyclical industries and areas with Covid exposure, will be out of favor until there’s certainty the rebound will hold. Recession-resistant sectors such as software, business services, logistics and healthcare will attract even more attention. Software, in particular, should enjoy a steady tailwind as the disruption actually proved out the resiliency of subscription revenues in a recession scenario. Investors may be more discerning in the healthcare sector as in-patient services still have a mixed outlook, but there’s an argument that the administration change in the Senate could address shortfalls in state Medicaid budgets.
10 months of post-Covid performance is instilling some confidence as investors extrapolate out earnings and sales trajectories for the next year. The catch is that the extraordinary circumstances have created short-term blips in performance that may not reflect future cash flows. Stimulus money pulled forward demand and in certain areas may not be sustainable. Disruption of supply chains have created downward pressure on top-line revenues.
Borrowers have again become more creative as it relates to add-backs or pro-forma earnings that don’t seem to be based in reality. We are even seeing requests for Covid-related add-backs. Lenders, in turn, will sharpen their pencils when underwriting.
Optimistic, Yet Remaining Cautious
One silver lining was that the pandemic stress-tested the softer areas of due diligence. Management either stood out as decisive and willing to take calculated risks or floundered in the face of uncertainty. Likewise sponsors either rose to the occasion, through being communicative and adaptable, or alternatively, fell down and either did not support their portfolio companies or went MIA during the depths of the disruption. All of this is useful information in how to handicap future performance following an extended bull market that covered up certain shortcomings.
The fundamentals will always come out on top. We expect deal flow to continue to remain strong as we begin 2021. However, the financial community will monitor the pandemic that could alter growth expectations for 2021. In times like this, it is important for PE sponsors to have a strong partnership as well as open and frequent communications with their lenders.