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Leveraged Finance: Monitoring Middle Market Entities Amid COVID-19

The one-two punch of the COVID-19 pandemic and the supply and demand shock in the energy markets have abruptly ended the longest economic expansion in U.S. history, damaging businesses across almost all parts of the global economy. For the full-year 2020, we expect U.S. GDP to contract 5% while our 12-month forecast for the U.S. speculative-grade corporate default rate (including both corporate bonds and loans) was 12.5% by March 2021.

Not surprisingly, U.S. nonfinancial corporates were at the frontline of the effects of the pandemic and experienced significant revenue and earnings losses that affected their creditworthiness. Many entities that issue broadly syndicated loans (BSLs) experienced negative rating actions: within U.S. BSL collateralized loan obligation (CLO) collateral pools, about 31% of companies that issue loans have either been downgraded, had ratings placed on CreditWatch negative, or both, since COVID-19-related corporate rating actions began in February 2020.

Compared to BSL CLOs, middle market CLOs are collateralized by loans issued by smaller, typically unrated companies for which we perform a credit estimate (CE). As COVID-19 rages on, we are monitoring the performance of companies that issue loans that collateralize these transactions, and how they continue to be affected by COVID-19 and the related economic impact.

Monitoring Credit Estimates In U.S. CLOs

Within BSL CLO collateral pools, S&P Global Ratings rates more than 95% of the companies that issue these loans. Since loans within middle market CLO collateral pools often come from unrated obligors, we perform a CE to assess their credit quality. A corporate CE is a point-in-time confidential indication of the likely S&P Global Ratings credit rating (CEs are not actual credit ratings) on an unrated company. These CEs are used as inputs in our rating analysis for middle market CLOs. The CE analysis uses a similar, but not as comprehensive, methodological analytical framework to what we use for corporate ratings. Because they are point in time, CEs are not monitored regularly in the conventional sense, the way a corporate rating would be. However, CLO documents generally require the CLO manager to furnish financial information on the loan-issuing company to us at least once every 12 months so we can update the CE to reflect current conditions and operating performance. In practice, we end up reviewing many of these entities more frequently as a result of refresh requests because multiple CLO managers own a piece of the loan and have different schedules for their maturity calendars. When we refresh a point-in-time CE, we disseminate the updated score to all of the CLO managers that hold the specific credit-estimated loan in their rated CLO portfolio--not just the manager that provided the updated financial information for our review.

Specified Amendments

In addition to our regularly scheduled reviews, S&P Global Ratings may review point-in-time CEs at other times, as and when we deem appropriate. For instance, middle market CLO transaction documents typically contain provisions that require CLO managers to notify us of "specified amendments"--that is, amendments or other changes that have a material bearing or impact on the credit quality of the entity issuing the loan. Different types of events typically trigger a notification to S&P Global Ratings, including:

  • Nonpayment of interest or principal.
  • The rescheduling of any interest or principal in any part of the capital structure.
  • Any breach of covenant(s).
  • The likelihood (more than 50%) of a breach of covenant(s) occurring in the next six months.
  • Material underperformance (more than 20% off base case) either at the operating profit or cash flow level.
  • Any restructuring of debt (including proposed debt).
  • The occurrence of significant transactions (sale or acquisitions of assets).
  • Changes in payment terms--that is, the addition of payment-in-kind terms, changes in maturity dates, and changes in coupon rates.

Credit Estimates Versus Corporate Loans Backing U.S. CLOs

Most of the entities for which we have issued CEs tend to be relatively small compared to the companies that issue loans found in BSL CLO collateral pools. The median EBITDA for entities for which we provided CEs in 2019 was about $20 million. These companies' operations are generally limited in scale and scope and they tend to be in fragmented markets, making their business risk vulnerable. Additionally, a high percentage of these companies are owned by private equity firms and likely to be highly leveraged. This combination of vulnerable business risk and high leverage puts them at the lower end of the credit spectrum. Our CE of 'b-' most represents these companies' credit quality. Even before the COVID-19 pandemic, about 75% of the middle market entities had a CE of 'b-', and over 85% of entities in the CE universe had a score of 'b-' and below. In contrast, at the start of 2020, about 25% of loans held in U.S. BSL CLOs portfolios were from companies rated 'B-' or below.

However, unlike loan structures in the BSL market, most loans held in middle market CLOs have financial maintenance covenants that allow the lender greater ability to monitor the company and, where needed, intervene more quickly. Also, given the overall lower credit quality of middle market entities to begin with, 'AAA' rated tranches of middle market CLOs typically have substantially more subordination than a typical BSL CLO 'AAA' rated tranche.

Credit Estimate Monitoring In The Time Of COVID-19

Given the current economic disruption, we received around 100 specified amendment notifications from middle market CLO managers in the end of first quarter through the second quarter. We reviewed the CEs of all of these entities, along with other selected CEs from middle market companies in sectors we view as most affected by COVID-19 containment measures, including oil and gas, entertainment, fitness, gaming, restaurants, aerospace, auto, and retail. We sought information from CLO managers on the company's liquidity (cash and revolver availability), sponsor infusions as applicable, and other possible funding sources such as loans from the Paycheck Protection Program (if the entity was eligible to receive them).

In the light of the speed of the downturn, we considered this information on liquidity and reviewed the borrower's creditworthiness. We looked at whether the entity had upcoming financial obligations in the next 12 months and, if there was no indication of refinancing plans, lowered the CE to 'ccc' or 'ccc-' depending on how we viewed possible default scenarios, including loan maturity dates. Even if there were no upcoming maturities and we viewed a payment default as unlikely in the next 12 months, we reviewed whether the entity's capital structure was sustainable. For this purpose, we looked at factors such as leverage metrics among other factors. Where we received notifications of a bankruptcy filing or payment default with no forbearance agreement, we lowered the CE to 'd'.

Credit Estimate Actions

We lowered CE scores to the 'ccc' range based on our 'CCC' methodology, and scores to a 'd' where there were bankruptcies or nonpayment of interest without a forbearance agreement. We lowered entities to 'sd' (selective default) in instances where the company missed or deferred an interest payment (without adequate compensation) and subsequently refreshed the CE based on revised payment terms. We lowered CEs on a total of about 70 entities to 'ccc' range. Additionally, we issued 'd' scores to about 15 names. Table 1 shows the CE distribution before and after we initiated the CE reviews. We have also received specified amendments in the third quarter and from a process standpoint, we will do a similar analysis on those companies as well.

Table 1

Credit Estimate Distribution
Score Beginning of Q2 2020 End of Q2 2020
bb+ 0.31% 0.19%
bb- 1.28% 1.19%
b+ 0.97% 1.03%
b 11.19% 8.48%
b- 74.45% 70.83%
ccc+ 8.78% 12.91%
ccc 1.53% 3.14%
ccc- 0.93% 0.88%
cc 0.11% 0.01%
sd 0.06% 0.38%
d 0.40% 0.97%
Note: Dollar weighted as held in U.S. CLOs. sd--Selective default.

Chart 1


The five sectors with the most downgrades made up about 47% of the total CE downgrades. As expected, the sector with the most actions was hotels, restaurants, and leisure, which were most affected by business closures and other containment measures.

Table 2

Top Five Sectors By Scores Lowered
Hotels, restaurants, and leisure 18.26%
Health care providers and services 8.70%
Textiles, apparel, and luxury goods 6.96%
Aerospace and defense 6.09%
Commercial services and supplies 6.09%

Looking Ahead

Many middle market companies that took a hit due to the pandemic were able to address their immediate liquidity through sources including existing cash on the balance sheet, revolver draws, sponsor infusions, and tapping into the Paycheck Protection Program. However, in the medium to long term, their performance and recovery will depend on how the pandemic is dealt with and the speed of an effective vaccine or other health care response. Even if the spread of the virus is addressed and containment measures lifted, there will likely be challenges in the form of permanent shifts in behavior (e.g. social distancing becoming commonplace or people avoiding crowds), which will severely affect business performance of consumer-facing sectors (fitness, entertainment, dine-in restaurants, travel, and nonessential brick-and-mortal retail).

This report does not constitute a rating action.

Primary Credit Analysts:Ramki Muthukrishnan, New York (1) 212-438-1384;
Robert E Schulz, CFA, New York (1) 212-438-7808;
Stephen A Anderberg, New York (1) 212-438-8991;
Daniel Hu, FRM, New York (1) 212-438-2206;
Secondary Contact:Michael S Neiss, Toronto (1) 416-507-2572;

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