Leverage on private credit transactions has climbed to a record high, with the share of deals closing at 7x or higher increasing 89% year over year in 2021, according to Lincoln International.
Technology deals have led the rise in leverage in recent years, often reaching 6.5x or higher. But now other industries are featuring transactions with higher leverage multiples as well.
"While the average leverage multiple in aggregate remained around 5.0x, in 2021 lenders took new steps to break through the competition, including relaxing covenants and lending at higher leverage multiples than previously thought tenable," Lincoln International said in a Feb. 7 statement.
"Where once technology companies were unique in their ability to raise debt with higher leverage multiples, last quarter other industries — from healthcare and industrials — unlocked access to leverage levels exceeding historical norms," Lincoln International said.
Of the tech deals, many have generated little or no EBITDA.
In fact, a growing share of new private credit financings were structured as recurring revenue loans, according to Lincoln International data. The volume of technology deals underwritten to recurring revenue climbed 62% in 2021 from 2020 levels, Lincoln International said.
"Despite this elevated leverage and prevalence of recurring revenue-based loans, lenders' loan-to-values remain relatively in line with historical levels, indicating that lenders' confidence is boosted by higher equity cushions," Lincoln International said.
In the meantime, lenders have increased their deal hold sizes, leading to more concentrated investment portfolios. The average hold size of transactions closed in the fourth quarter increased 62.3% from the pre-pandemic average, Lincoln said.
An increasingly competitive market is driving the borrower-friendly trends. At the same time, supply chain problems and inflation are a drag on earnings.
"Based on an analysis of a subset of companies which self-reported an impact from supply chain, labor shortage and inflationary pressures, most notably those in the consumer and industrials industries, Lincoln International observed EBITDA margins contracting on average by 3% in the fourth quarter," Lincoln International said.
"Anecdotally, Lincoln has observed situations in which shipping costs have increased over 100% year over year or companies have been forced to seek out alternative methods of shipping."
Despite this, many companies are reporting strong revenue growth. Demand was higher than some companies could fulfill.
"Revenue is growing faster than earnings. People are budgeting for that to continue," said Ron Kahn, co-head of Lincoln International's Valuations & Opinions practice.
The private companies tracked by Lincoln remain optimistic, even if they have lower growth forecasts for 2022.
"Private market valuations in 2022 hinge on whether companies can keep pace with the growth experienced in 2021. Based on self-reported 2022 private company budgets, revenue is expected to grow 9.7% and EBITDA is expected to grow 6.2% — a decrease of 2.8% and 2.0%, respectively, year over year. However, these growth targets indicate that private companies do not expect business headwinds to curtail growth," Lincoln International said.
These private companies are not feeling "panic" about inflation as public companies have, as reflected in stock market volatility.
"Our clients believe that cost pressures will subside, and today's price increases will be passed on to end customers," Kahn said.
"However, should businesses fail to mitigate cost pressures, enterprise value compression in 2022 becomes a real possibility."
The data was released as part of the Lincoln Private Market Index (Lincoln PMI), previously called the Lincoln Middle Market Index. The Lincoln PMI is based on Lincoln International's proprietary private market database and tracks the enterprise value of private U.S. companies, primarily private equity sponsor-owned.
The Lincoln PMI ended 2021 at a record after enterprise values grew 3.9% in the fourth quarter. This was driven by the performance of these companies: Revenue of these companies grew 5.5% in the last 12 months quarter over quarter, while EBITDA grew 3.4% on average.
The private credit market grew by 7.9% in 2021 according to Lincoln International's Senior Debt Index, which tracks returns.