In blockbuster year for M&A, leverage ratios match record high

In 2021, a record number of speculative-grade borrowers financed mergers, acquisitions and buyouts in the leveraged loan market on the back of insatiable investor demand for the floating-rate asset class. As a result, M&A-related loan issuance clocked in at an unprecedented $331 billion last year, including $147 billion (44%) to companies rated B-minus by at least one credit rating agency, the most ever. With the riskiest borrowers commanding such a notable share of activity, what has happened to leverage ratios in the new-issue market?

On average, the debt/EBITDA ratio stood at 5.6x last year, tying a record high that was first set in 2018, the pre-2021 peak of M&A activity; these numbers are based on pro forma financials at closing of each loan. Leverage ratios retreated to 5.4x in 2020 as investor appetite for risk declined following the onset of the COVID-19 pandemic. Aside from that year, new-issue leverage has stayed at 5.6x since 2018, a half-turn above the historical average since the end of the global financial crisis.

Buyouts and acquisitions/mergers by private equity-backed borrowers carried roughly 1.5 extra turns of leverage in 2021, relative to nonsponsored borrowers, at 6x and 4.4x, respectively. This gap is largely consistent with historical trends. While the average debt/EBITDA ratio is at its highest reading on record for both cohorts, corporate M&A transactions hovered around 4.4x for the last six years while sponsored deals have crept higher by roughly half a turn.

As the average leverage ratio rose from 2020 levels, the share of M&A transactions funded exclusively in the leveraged loan market has declined. Only 25% of loans issued last year did not have any debt subordinated to first-lien term loans at closing of the transaction. That is a four-year low, down from 36% in 2020 and 30% in 2019. The latest reading is roughly on par with the 2016-2018 period.

In addition, the average debt cushion — or the share of debt that does not fall into the first-lien term loan bucket — inched higher last year to 19%, from 17% in 2020, and is now on par with 2018 and 2019.

The share of first-lien-only transactions retreated in 2021 as the size of speculative-grade borrowers' debt to finance M&A activity reached an all-time high. On average, borrowers raised $1.018 billion of leveraged loans and high-yield bonds per M&A transaction last year, the most ever, just a touch above $1.017 billion in 2020 and 13% above the $901 million average in 2018. For reference, the 10-year average stands at $892 million.

M&A transactions ballooned in size last year as the cost of debt fell to all-time lows. The average U.S. leveraged loan new-issue yield-to-maturity fell below 5% for the first time ever in 2021, from over 7% in 2019, while high-yield bond yields fell to just 5.5%, from 7.5%, over the same period.

As a result, the interest coverage ratio of new-issue M&A loans remained at a record-high 4x in 2021, almost a full turn above 2019 levels.

6x EBITDA club

While the average leverage remained under 6x — the debt/EBITDA ratio that 2013 Federal Leveraged Lending guidelines stipulated as worthy of concern — the share of aggressively levered transactions crept higher last year. A record 19% of M&A transactions tracked by LCD had a pro forma debt/EBITDA ratio of 7x or higher at closing, up from 13% in 2020. That figure was below 10% in every year between 2008 and 2018. Another 25% of transactions carried leverage of 6x to 6.9x in 2021, resulting in a combined share of 44% for the 6x-or-higher cohort, up from 38% in 2020 but below the 46% record high in 2019.

The Computers & Electronics sector — LCD's proxy for Technology — had an outsized presence among transactions levered at 6x or higher in 2021, at 23% by count. It is also the largest sector in the new-issue market for leveraged loans overall, although its share is lower, at 18% by count. Indeed, the average debt/EBITDA ratio of M&A-related loans to borrowers from this sector stood at 6x last year, versus the 5.6x average across all sectors.

EBITDA adjustments

LCD's leverage analysis is based on pro forma adjusted EBITDA, which incorporates synergies, cost savings and other add-backs. EBITDA adjustments/add-backs, of course, have been a hot topic in the leveraged finance market in recent years as sustained investor demand for loans has enabled aggressive deal structures, raising overall leverage.

If the average debt/EBITDA ratio has reached a record high based on adjusted EBITDA alone, where would recent M&A transactions stand, based on unadjusted financials? To explore this issue, LCD analyzed leveraged loan transactions, comparing adjusted and unadjusted pro forma EBITDA. Basically, we looked at EBITDA with synergies, then without.

The main reason LCD focuses on synergies for this analysis is that synergies, or cost savings, have become a key issue in today's highly levered market because borrowers and lenders can have starkly different views about whether these synergies can be achieved, or to what degree, and how quickly. As well, synergies are a major component of the overall add-back picture.

The data suggests that regardless of whether synergies are included, leverage ratios are at a record high, while close to half of transactions are levered over 6x. Including synergies, M&A deals were levered at 5.6x EBITDA in 2021. Excluding synergies, the ratio increases to 5.9x. These readings are on par with 2019, after declining slightly amid the pandemic-plagued 2020.