DEBT CAPITAL MARKETS EXECUTIVE SUMMARY MIDDLE MARKET

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1 MARKET INSIGHTS 2Q 2018 DEBT CAPITAL MARKETS EXECUTIVE SUMMARY Middle market clients have a unique borrowing opportunity, with banks competing to originate new loans for clients. In the leveraged loan market, borrowers were able to raise institutional loans at spreads as tight as L+175; high yield spreads are also tight, despite recent volatility in the markets. Investment grade borrowers are evaluating capital needs alongside the ability to repatriate cash, and both lenders are borrowers are active, setting a new first quarter loan volume record. MIDDLE MARKET The middle market was a surprise in the first quarter of 2018, with volume meaningfully down after a record The volume decline presents an interesting opportunity for borrowers. Total syndicated issuance registered $32.2 billion per Thomson Reuters data, broken out between sponsored volume of $15.25 billion and non-sponsored volume of ANNUAL INSTITUTIONAL MM LEVERAGE $17 billion, with non-sponsored volume marking the lowest level since 1Q M&A-driven volume surprised to the downside despite optimism around tax cuts, limiting the overall volume. With non-sponsored volume down, middle market companies have the opportunity to raise capital from lenders that are increasingly trying to meet their lending goals. Increased competition To originate, lenders are competing on price and looser documentation, which includes EBITDA add-backs and covenant-lite structures for institutional deals. Middle market loan funds are driving the competition. After 1Q 18, middle market capital raising for direct lending funds is already ~2/3 of 2014 and 2015 volume, and is around almost ~1/3 of 2016 and 2017 volume. In 2017, the market was focused on hold levels and a willingness to take down an entire transaction. This year is shaping up to reward, at least in the short-term, lenders who are willing to take bigger hold sizes and also stretch on documentation and leverage. NON-SPONSORED 1ST LIEN SPREADS Source: Thomson Reuters LPC Debt Capital Markets 1

2 Debt Capital Markets 2 It s no surprise, then, that lenders are reporting larger hold sizes. According to data from Thomson Reuters, banks in the $25 $50 million band for max hold size are migrating to the $50 $75 million range for max hold, while more non-banks are willing to hold >$100mm. On the pricing end, spreads are generally flat, with increases in LIBOR driving borrowing costs up. As we noted in the investment grade section, the market is migrating away from LIBOR to possibly SOFR, a secured overnight funding rate. As of this writing, SOFR is roughly in line with daily LIBOR. In short, middle market borrowers have an opportunity to tap a lender pool that is anxious to originate new loans, while at the same time being able to lock in favorable pricing and potentially hedge out future rate increases. ASSET-BASED LENDING In asset-based lending (ABL), first quarter volume totaled $17.4 billion. The strong first quarter issuance keeps pace with 2017 volume of $90 billion, the fourth-highest annual total on record. The market remains issuer-friendly, as arrangers continue to take larger hold positions alongside more club-type syndications. The continuation of the supply/demand imbalance has driven flexibility and more borrower-friendly structures. For example, in syndicated ABL deals, we are frequently seeing the inclusion of First- In, Last-Out (FILO) tranches, which provide incremental liquidity at the cost of premium pricing over the traditional revolver. The FILO was most typically utilized in the retail industry, but has recently been accepted in the broader ABL market. In addition, the excess demand in the market has created borrower-friendly enhancements in financial covenants, advance rates, voting rights and liquidity triggers. On some deals we re seeing in the market, companies are able to raise more capital than they need. As a result of oversubscription, some borrowers are increasing the tranche size and taking down the extra capital. L+125 bps is now the market benchmark for high-quality ABL credits. Robust capital raising by direct lenders in the middle market creates the opportunity for these lenders to play a bigger role across unitranche, Term Loan B, second lien and mezzanine tranches. While we expect to see more ABL lenders partnering with direct lenders to provide one-stop shop financing solutions for middle market issuers, we re also seeing lead arrangers/bookrunners pursue larger deals to help offset the direct lender origination model. ABL DRAWN SPREADS Capitalizing on excess demand over supply, sponsors continue to assert more control over the documentation process leading to more favorable borrower-friendly provisions. Too many lenders are chasing too few deals, and pricing on ABL deals is near record low levels Source: Thomson Reuters LPC

3 Debt Capital Markets 3 LEVERAGED / HIGH YIELD The leveraged loan market kicked the new year off in strong fashion, with $167 billion of new-issuance tallied in the first quarter, up 29% quarter-over-quarter. Institutional loan volume led the way, up 32% from 4Q 2017 to $129 billion. Robust activity in the quarter was mainly due to an increase in M&A activity; however, refinancings continue to be noteworthy. NEW-ISSUE LEVERAGED LOAN VOLUME INSTITUTIONAL NEW-ISSUE AND REPRICING VOLUME While late 2017 saw a few institutional loans print sub-l+200, the proverbial L+175 floodgates opened in 1Q18. In fact, the volume of L+175 issuance in 1Q 2018 was in line with L+200 volume cleared in 1Q A spike in LIBOR and tightening collateralized loan obligation liabilities helped facilitate the spread compression. INSTITUTIONAL NEW-ISSUE AND REPRICING VOLUME CLOs, which raise money to invest in leveraged loans, came out of the starting blocks quickly and remain on pace to meet or exceed Wall Street expectations for First quarter CLO volume was the busiest first quarter on record, with $32 billion in new issuance. Source: S&P Capital IQ LCD

4 Debt Capital Markets 4 Retail fund flows, which in addition CLOs serve as a proxy for investor appetite, turned the corner in 2018 with a net $3 billion inflow to mutual funds and ETFs through the end of March, versus a net outflow of approximately $4.2 billion in the second half of last year. LOAN SPREADS COMPRESS AS LIBOR STEADILY CLIMBS Loan participants agree that there is more room to run when it comes to M&A activity, specifically with privateequity backed volume as firms look to put capital to work as loans backing dividends have dropped in recent months. In all likelihood, we expect another wave of institutional issuers will aim to reprice towards L+175 as the leveraged loan market remains open for business. Single B credits, which touched a post crisis low of 346 bps on first lien all-in spreads, will continue to capitalize on the issuer friendly market and aim for sub-300 levels. With the rise in LIBOR, investors are able to accept lower spreads while reaping higher all-in yield yields than offered only a few months ago. HIGH YIELD SPREADS REMAIN AT HISTORICALLY TIGHT LEVELS While the institutional loan market, and namely repricings, will undoubtedly be part of the broader loan discussion going forward, the pathway (i.e., shorter tenors, covenant protection) to lower institutional pricing and successful syndication could look different across issuers as refinancing and repricing volume trickles down the credit spectrum. In the high-yield bond market, spreads over treasuries, as measured by the Option Adjusted Spread, remain at extremely low post-financial crisis levels. The majority of 1Q 2018 volume has been refinancings, leaving investors hopeful that the eagerly anticipated M&A-driven volume is just around the corner, all while market participants in the high-yield bond market adapt to a new normal of volatility. Sources: St. Louis Fed, Bloomberg

5 Debt Capital Markets 5 INVESTMENT GRADE Following a record year for investment grade loan volume in 2017, borrowers and lenders kept the momentum going in the first quarter. According to data from Thomson Reuters, this quarter s investment grade loan volume was the highest first quarter on record at $198 billion. Although the quantity of deals in the first quarter was smaller than in previous quarters, the average loan size increased to roughly $2.2 billion, backed by large M&A, bolstering total loan volume. New money issuance made up 37% of all investment grade lending. M&A, and specifically a couple of large bridge loans, was a key driver for new money issuance. Term loan issuance also increased 42% year-over-year with roughly a third of term loan issuance related to M&A activity. The main concern from lenders perspectives is regarding capital requirements, specifically those lenders that are finding it more challenging to meet their required return. Pricing We expect pricing to remain roughly flat, with a nod to the fact that lower U.S. tax rates might allow banks to pass savings on to borrowers in the form of a slightly lower spread (~12.5 bps or more per tier). Despite spreads already beginning to decline in the first quarter, rising LIBOR boosted yields. I-GRADE DRAWN SPREADS Refinancing was up as well in the first quarter. The outlook remains strong for the rest of 2018 with more than $200 billion of investment grade loans maturing within the year. 1Q 2018 INVESTMENT GRADE LOAN VOLUME Clients are also focused on LIBOR s replacement. By 2021, LIBOR will be phased out and potentially replaced by SOFR, a secured Treasuries repurchase rate. The repurchase rate captures the short-term interest rate for repurchase agreements backed by Treasuries. While the regulatory bodies are evaluating a few iterations of SOFR, as of this writing, estimates peg SOFR at just under daily LIBOR. Clients are increasingly seeking commitments from larger banks with international capabilities. Borrowers are rationalizing their bank groups in light of spreading ancillary business around and banks abilities to offer domestic and international advice. At the macro level, the Fed raised the Fed Funds rate in March to a range of 1.5% 1.75%, and the market expects another two to three increases this year, plus three more in Source: Thomson Reuters LPC

6 Debt Capital Markets 6 Regulatory Environment Because of tax rate changes coupled with new interest deductibility rules, treasury departments are sharpening their pencils to decide which subsidiaries will allow them to maximize savings from the interest shield while maximizing interest deductions. Additionally, repatriation rules are impacting borrowers, as repatriated cash may limit the need to borrow as much in the U.S. The 15.5% repatriation tax for cash and 8% for certain illiquid assets applies to all U.S. tax-deferred foreign earnings and profits accumulated after 1986 through 2017 and is payable in installments over eight years. The reduction in the tax rate for repatriated cash has investors watching for a boost in M&A activity, and therefore additional loan and bond issuances. At the same time, there s a heightened focus on anti-trust regulation, particularly for mega-m&a. CORPORATE BOND VOLUME INVESTMENT GRADE BOND SPREADS Corporate Bonds Investment grade corporate bond issuances in 1Q 2018 totaled $346 billion, down 12% year-over-year. Despite CVS s $40B deal and AB InBev s $10B issuance, March was a particularly difficult month for investment grade issuers with volatility and inflation concerns escalating. Price sensitivity became the new norm, leading to elevated New Issue Concessions and less movement from Initial Price Talk to final pricing. Consequently, investment grade spreads have risen ~25 bps YTD. PROJECTED 10-YEAR U.S. TREASURY YIELDS Despite some concerns in the market, technicals remain solid with the exception of a few fund outflows recently our desk is hearing that there is not an abundance of cash just waiting on the sidelines, but enough to absorb new supply. The current forecast for the 10-year U.S. Treasury shows less divergence in the near term, but the current implied forward yield is still much lower than forecasts. The current Fed Funds Effective Rate is 1.69%, and Fed futures indicate that the June meeting would be the most likely time to see the next rate increase from the FOMC. Sources: PNCCM, Bloomberg, Informa

7 Debt Capital Markets 7 FOR MORE INFORMATION Visit pnc.com/dcm. Services such as public finance investment banking, securities underwriting, loan syndication, and securities sales and trading are provided by PNC Capital Markets LLC ( PNCCM ). PNCCM, member FINRA and SIPC, is a wholly-owned subsidiary of The PNC Financial Services Group, Inc. ( PNC ) and affiliate of PNC Bank, National Association ( PNC Bank ) The PNC Financial Services Group, Inc. All rights reserved. CIB ENT PDF