A Freeze in Private Junior Debt? Not so Fast.

With capital markets shut and deal activity muted, it would be easy to assume that opportunities in private junior debt are at a standstill, too. However, we are encouraged to see some green shoots even in the cold, dark days of January, and we think their growth this year will be an exciting opportunity.

Much of the activity we’re tracking derives from sponsors keeping their New Year’s resolutions to get their financial houses in order. In reviewing our 2023 junior debt deal pipeline, we have observed an uptick in the number of sponsors who are proactively pursuing new buyouts.

There is a significant amount of private equity dry powder, and valuations for high-quality companies remain at elevated levels. We believe acquirers will not be able to raise as much senior financing as in recent years, and in many capital structures, junior capital will fill the gap.

EXHIBIT 1

Private Equity Dry Powder by Region

EXHIBIT 2

Typical Capital Structure of a Leveraged Buyout with Junior Debt

Extensions and refinancing are also starting to feature. Borrowers are facing reduced interest coverage ratios due to the mechanical impact of base rates being far higher than most had predicted. As maturities come due, we anticipate that many borrowers will have to reduce the amount of senior debt on their balance sheets, resetting coverage ratios back or refinancing their debt. Private junior debt seeks to accomplish this, reducing or avoiding the need for significant new equity.

EXHIBIT 3

The Maturity Wall

We are also seeing some private junior debt deals originate from add-on activity; namely, inquiries from existing borrowers that are either looking to raise additional capital as a cash buffer or pursuing opportunistic, smaller, bolt-on mergers and acquisitions.

We have a growing list of potential opportunities in our own pipeline, with average EBITDA of some $500 million. We prefer to deploy junior capital in larger companies, which we believe are more resilient in low-growth environments, and our current opportunities confirm that demand is strong in this segment.

The economics on offer are attractive in our view, with average spreads at ~10% over reference rates. As these are directly originated private opportunities, they tend to come with a meaningful original issue discount and material call protection.

We believe the next two years have the potential to be a golden vintage for private junior debt, with the opportunity to lend to large, high quality, market-leading companies. Given the likely lack of available senior financing relative to recent market norms, and the pent-up demand for private equity buyouts, we believe the attractive terms and yields available today will be available tomorrow as well.

The market is warming up: Now we wait for the real thaw.