Debt Capital Market Update – Q4 2023

• Early December saw the FOMC hold interest rates flat, pointing to easing inflation and slowing GDP growth in 2024.
• Economic indicators driving Fed decision making include CPI which came in at 3.1% for November, and JOLTS, which reports the number of open jobs fell from, 9.4mm in September to 8.7mm (forecasted: 9.3mm) in October, representing 1.3 open jobs for each jobseeker.
• So, when will interest rates come down? Inflation subsiding will lead to rate decreases; the Fed is targeting core inflation of 2.0% (2.4% in 2024, 2.2% in 2025, and 2.0% in 2026). The Fed needs to find the middle ground between over tightening (leading to a recession) and inversely under tightening (resulting in elevated inflation).
• The market moved immediately with spiking bond yields and soring stock prices, but we believe the Fed will not move this quickly. Inflation dropping has been largely due to oil, and we believe the Fed will want to see both a slight increase in unemployment and a slowdown in growth before a cut will occur.

JOLTS

Consumer Price Index

2-Year Minus 10-Year Treasury Spread

TKO Miller Debt Capital Market Analysis

• Leverage multiples dipped slightly to 3.6x in Q3 of 2023 (as shown in the below left graph), down from 3.9x in 2022 and down even more for companies at the bottom end of the lower middle market (2.9x for companies in the $10-$25mm enterprise value range).

Total Debt/EBITDA Multiples

Debt and Equity Contribution by Year

• The cost of debt has risen significantly in 2023 for middle market companies (as shown in the bottom left graph), hampering M&A and internal growth initiatives (e.g., new equipment, facility expansion, etc.).
• This has led to a softening in M&A valuations (an inverse relationship between valuation and leverage multiples) and an increase in the necessary equity contribution needed for a transaction (as shown in the top right chart).

Senior Debt Pricing – Splits by Period

Senior & Sub Debt Pricing Trend

TKO Miller Commentary

1. Corporate interest expense hit bottom in 2023 and will increase with refinancings in 2024 – improving profits and margins. Together with higher wages – companies are going to feel the pressure.  
2. Debt availability has, affected to date, primarily financial buyers (i.e., private equity) because new debt has to be raised for each transaction. Prolonged higher rates however, will begin to impact all acquirers as interest expense impacts margins and ROI calculation.
3. Banks credit standards have tightened due to the risk of a recession, overall operational challenges, and a decrease in loan demand and ability to resell.
4. Companies looking for debt should cover the widest possible universe of lenders and think outside the box, such as non-banks and non-regulated lenders (debt funds, asset-based lenders, unitranche lenders, insurance companies, pension funds, family offices, etc.).