With interest rates at decade highs and floating-rate-heavy capital structures bearing the brunt of ballooning debt servicing costs, LCD analyzed the first-lien capital structures of leveraged buyouts, finding that while overall leverage on debt backing US LBOs has dropped in 2023, so too has the "debt cushion," which has shown to be an important factor on recovery rates in cases of default.
Looking at new-issue loans backing leveraged buyouts, the buffer of subordinated debt in this year’s (albeit thinner) sample has fallen to just 9.7%, from an already relatively low watermark of 17.9% in 2022.
During times of near-zero interest rates in 2014 and 2015, when this buffer was arguably less important, this cushion was at 27.1% and 25.5%, respectively.
For reference, LCD defines ‘debt cushion’ as the share of debt that is subordinated to the first-lien term loans. A lack of debt cushion has historically had a negative impact on the recovery rate of senior debt in the event of a default.
In the priority waterfall of creditor claims, the higher the seniority, the higher the recovery. But this benefit is weakened significantly when the buffer of junior debt thins.
Bank loans with more than a 75% subordinated debt cushion, for example, historically give a 94% average discounted recovery. This recovery drops by as much as 20 bps, however, when that debt cushion thins to 50% or less.
First-lien leverage on loans backing US LBOs in 2023 has eased to 4.7x, from a record high level of 4.9x in 2022, but this is still elevated. In 2021 — the last big vintage of LBOs before rate raises and market volatility set in — first-lien leverage was also a lofty 4.7x. To put that into context, first-lien leverage averaged 3.9x 10 years prior.
For the bank loan class, leverage can be kinder in terms of recovery if it creates a cushion. However, in an effort to keep debt costs low, borrowers to a greater extent not only relied on first-lien debt (which is cheaper than junior debt) when leverage ratcheted higher in 2022, but also relied more heavily on the first-lien portion as overall leverage retreated in 2023. Case in point, for the 2023 LBO cohort, the drop in total leverage was more pronounced, falling to 5.3x, from 5.9x in 2022, in comparison to the decline in first-lien leverage to 4.7x, from 4.9x in 2022.
Leverage limelight
This trend carries over when looking at the capital structure of all new issuance. First-lien leverage for all funding purposes eased to 4.1x in 2023, from 4.3x in 2022. This compares to overall leverage of 4.7x, which fell from 5.3x in 2022, showing again that decline in leverage was driven by a reduction in debt subordinated to first-lien loans.