MARKET INSIGHTS 3Q 2018 DEBT CAPITAL MARKETS EXECUTIVE SUMMARY Middle market investors continue to compete on price and less restrictive documentation, prompted by a sentiment change in leveraged lending and sizable inflows of direct lending capital. Despite a slowdown in refinancing activity, the leveraged loan market experienced the second-highest total quarterly issuance on record, driven by a wave of new money supply. Investment grade borrowers and lenders remained active in the first half of 2018, as event-driven activity drove capital needs. MIDDLE MARKET LOANS Total middle market syndicated issuance registered $91.1 billion in the first half of 2018, per Thomson Reuters data. Total middle market issuance was up 10% from 1Q 2018, as terms and pricing continue to improve for traditional middle market borrowers. The total issuance is broken out between sponsored volume of $42.6 billion and non-sponsored volume of $48.5 billion. Sponsored refinancings drove close to 40% of activity in the first half of 2018, much higher than the mid-20% area in 2017. Likewise, non-sponsored refinancings have increased 20% against 2017 levels. In general, new money lending in the middle market space has not shown any pick up despite optimism in the economy. Leveraged Lending Guidelines Changing the Middle Market Landscape The Comptroller of the Currency, Joseph Otting, stated in a recent interview, Banks have the right to do the leveraged lending they want, as long as it does not impair safety and soundness. As long as banks have the capital, I am supportive of banks doing leveraged lending. That stands even if leveraged lending activities transgress guidelines. Otting has publicly deemphasized the Leveraged Lending Guidelines (LLG) on a few separate occasions this year. Per a recent LPC survey, regulated middle market lenders are willing to go higher on their leverage thresholds for companies generating strong free cash flow. In general, leverage on LBO deals is at an all-time high as 57% of institutional middle market deals have been leveraged at greater than 6x. There have been notable middle market transactions with leverage profiles greater than 6x completed in the first half of 2018. Middle market institutional issuance has hit its highest level post credit crisis at $16.6 billion for 2Q 2018. 1H 2018 middle market institutional issuance is the highest first half level since 1H 2007, and institutional facilities have a 34% share of middle market syndicated deals. Source: Thomson Reuters LPC Debt Capital Markets 1
Debt Capital Markets 2 60% LPC BANK SURVEY: MAX. TOTAL LEV. TOLERANCE WITH STRONG FCF MIDDLE MARKET LBO LEVERAGE AT RECORD HIGH 60% % of Bank Respondents 50% 40% 30% 20% Share of Middle Market LBOs 50% 40% 30% 20% 10% 10% 0% < 4x 4x-5x5-5.5x> 6x 4Q 16 4Q 17 1H 18 0% 2004 2006 2008 2010 2012 2014 2016 MM Leverage => 6x MM Leverage => 7x Middle Market Loan Funds Continue to Grow On middle market transactions, lenders are competing more on price and less restrictive documentation, which include EBITDA add-backs and covenant-lite structures for institutional deals. In addition to the LLG sentiment change, fundraising in middle market direct lending funds continues to put pressure on i) leverage levels, ii) price and iii) documentation. Middle market direct lending capital has reached $30 billion so far this year, with an additional $14 billion in the pipeline not yet closed. Thus far in 2018, banks are being rewarded for taking bigger hold sizes while also stretching documentation and leverage. ASSET-BASED LENDING After a strong first quarter, asset-based lending (ABL) continued trending upward with $32.99 billion of volume in 2Q 2018. The continuation of the supply/demand imbalance has driven flexibility and more borrowerfriendly structures. For example, in syndicated ABL deals, we are seeing the compression in liquidity trigger levels for acquisitions, investments and restricted payments. The required trigger levels continue to be driven by a two-tier liquidity benchmark which, at the lower tier, requires a MIDDLE MARKET DIRECT LENDING CAPTIAL RAISED $80 $70 $60 $50 $40 $30 $20 $10 2014 2015 2016 MM CLO BDC Public Equity All other direct lending Mezzanine fixed charge test. In addition, the excess demand in the market has created borrower-friendly enhancements in financial covenants, advance rates and voting rights. On some deals in the market, companies are able to raise more capital than initially thought. Thus, issuers have taken advantage of strong lender demand, with many borrowers increasing the tranche size and taking down the additional capital caused by the heavy oversubscription. Source: Thomson Reuters LPC
) Debt Capital Markets 3 Capitalizing on excess demand over supply, sponsors continue to assert more control over the documentation process leading to increasingly more borrower-friendly provisions. With too many lenders chasing too few deals, pricing on ABL deals is nearing record low levels L+125-175 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. We are seeing lead arrangers/bookrunners pursue larger financing commitments to help alleviate syndication risk and compete with ABL lenders partnering with direct lenders for one-stop shop financing. LEVERAGED / HIGH YIELD The pro rata and institutional leveraged loan market rolled at a blistering pace in 2Q 2018, with total loan issuance of $202 billion, which marked the second-highest quarterly amount on record, according to LCD. A frenzy of institutional M&A lending drove the leveraged loan market to nearly all-time quarterly highs, as M&A lending as a percentage of overall institutional activity rose to levels last seen in 2007. Overall, credit spreads continued to compress throughout the second quarter, especially on lower rated deals as issuers looked to reduce pricing to and below the L+300 threshold. For stronger rated credits, the repricing wave for BB issuers to L+175-200 slowed amid a new supply glut as softness in secondary loan market, as well as broader market conditions, impacted investor sentiment and appetite for lower spread paper. NEW-ISSUE LEVERAGED LOAN VOLUME Regarding demand, CLOs, in the wake of recent risk retention rulings, broke $68 billion of volume for the first half of the year, which is 30% higher than this point last year, according to LCD data. Retail fund flows, which in addition CLOs serve as a proxy for investor appetite, experienced nineteen-straight weeks of inflows to mutual funds and ETFs though the end of June. Market participants largely view that both supply and demand for leveraged loans will continue to be strong in the second half of 2018. If new money supply dominates volume, and broader market volatility remains a theme, we expect that investor pushback may be prevalent on an idiosyncratic rather than systemic level, as we have seen in certain cases in 2Q 2018. Refinancings, while slower in 2Q 2018, should opportunistically gain ground throughout the second half of 2018 and stronger rated credits will LENDING TOWARDS M&A LEADS 2Q 2018 INSTITUTIONAL LOAN VOLUME $225 $200 $175 $150 $200.0 $180.0 $160.0 $140.0 ($ in billions) $125 $100 $75 ($ in billions $120.0 $100.0 $80.0 $50 $60.0 $25 $40.0 $20.0 2Q 11 3Q 11 4Q 11 1Q 12 2Q 12 3Q 12 4Q 12 1Q 13 2Q 13 3Q 13 4Q 13 1Q 14 2Q 14 3Q 14 4Q 14 1Q 15 2Q 15 3Q 15 4Q 15 1Q 16 3Q 16 4Q 16 1Q 17 2Q 17 3Q 17 4Q 17 1Q 18 Institutional Pro rata $- 1Q 12 1Q 13 1Q 14 1Q 15 1Q 16 1Q 17 1Q 18 M&A Other Source: S&P Capital IQ LCD
Debt Capital Markets 4 keep their scope focused on L+175. Covenant-lite structures are a trend that will continue for the foreseeable future in the institutional loan market. Market participants also anticipate a modest ascent in default rates over the next eighteen months although not rising above the long-run 3.0% historical average. In the high yield bond market, spreads over treasuries remain at extremely low post-financial crisis levels. The majority of 2Q 2018 volume has been refinancings, with large M&A trades seen in investment grade missing in this space and frequent sessions of volatility continue to impact high-yield market risk tolerances. ($ in billions) NEW-ISSUE CLO DEMAND CONTINUES AT ROBUST PACE $40 $35 $30 $25 $20 $15 $10 HIGH YIELD SPREADS REMAIN AT HISTORICALLY TIGHT LEVELS 950 bps 850 bps 750 bps 650 bps 550 bps 450 bps 350 bps 250 bps $5 150 bps Dec-14 Mar-15 Jun-15 1Q 15 Sep-15 2Q 15 Dec-15 3Q 15 Mar-16 4Q 15 Jun-16 1Q 16 3Q 16 4Q 16 1Q 17 2Q 17 3Q 17 4Q 17 1Q 18 Sep-16 Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Jun-18 INVESTMENT GRADE LOANS Coming off the heels of a record year for investment grade loan volume in 2017 and a strong 1Q 2018, the 2Q 2018 INVESTMENT GRADE LOAN VOLUME second quarter of 2018 continued to climb higher marking the highest quarter on record with $332 billion in loan $350 volume, according to Thomson Reuters data. Issuers took $300 advantage of a robust M&A environment, which acted as a key driver for 2Q 2018 issuance, and set a quarterly record $250 of $184 billion, driving 1H 2018 M&A lending volume to a record $363.5 billion. Bolstered by event-driven activity, media and financial services were the two highest issuing sectors this quarter at $77.7 billion and $68.6 billion, respectively. In tandem Issuance ($ in billions) $200 $150 $100 with heightened M&A and event-driven lending activity, 1H 2018 new money, refinances, term loan and bridge loan $50 volume surpassed 1H 2017 levels. Year to date, new money issuance is at the highest levels since 2003, comprising 37% of issuance (compared to refinances comprising 63%). $- 4Q 10 2Q 11 4Q 11 2Q 12 4Q 12 2Q 13 4Q 13 2Q 14 4Q 14 2Q 15 4Q 15 4Q 16 2Q 17 4Q 17 Sources: S&P Capital IQ LCD, Bloomberg
Debt Capital Markets 5 As a percentage of revolver issuance, three-, four-, and five-year tenors gapped out while 364-day tenor decreased in 2Q 2018. Event-driven activity boosted the term loan market. Three-year and five-year tenors intersected with each making up roughly 50% of the aggregate term loan issuance, demonstrating issuers desire to add amortizing debt to their capital structure and de-leveraging story. Pricing BBB drawn and undrawn spreads continued to compress in 2Q 2018 following tightening in the BBB- tier earlier I-GRADE DRAWN SPREADS this year. Average BBB undrawn spreads reached the lowest quarterly average since 4Q 2016 at 16.7 bps. We are starting to see tightening in select names across the BBB 300 250 tier as average drawn spreads compressed towards the 125 bps area. The Secured Overnight Financing Rate ( SOFR ), a secured Treasuries repo rate that is favored to replace LIBOR in 2021, was introduced by the New York Federal Reserve bps 200 150 100 50 in April. SOFR futures began trading on the Chicago 0 Mercantile Exchange on May 7th. 2Q 94 2Q 96 2Q 98 2Q 00 2Q 02 2Q 04 2Q 06 2Q 08 2Q 10 2Q 12 2Q 14 BBB A Recession Regulatory Environment Last years uncertainty surrounding tax reform is slowly being alleviated. Bank competition for loans has intensified, and companies are confident that they can more accurately evaluate and analyze potential targets. It still remains to be determined how aggressively the US Government will enforce anti-trust laws during this wave of mega M&A activity. INVESTMENT GRADE BONDS Investment grade corporate bond issuance in 2Q 2018 (ex-ssa) totaled $359 billion, up almost 10% year-overyear. Despite volatility in both the equity and treasury markets, investment grade issuance was steady, aided by jumbo M&A deals. June was a volatile month with volume totaling approximately $121 billion. The third week of June produced over $45 billion of volume, making it one of the five heaviest weeks of the year, but June s final week was the slowest of 2018, with only $3.2 billion of volume. YTD ex-ssa volume totaled $716 billion, down just 2% yearover-year following a record 2017. bps 130 120 110 100 90 80 INVESTMENT GRADE BOND SPREADS 6/30/2017 7/14/2017 7/28/2017 8/11/2017 8/25/2017 9/8/2017 9/22/2017 10/6/2017 10/20/2017 11/3/2017 11/17/2017 12/1/2017 12/15/2017 12/29/2017 1/12/2018 1/26/2018 2/9/2018 2/23/2018 3/9/2018 3/23/2018 4/6/2018 4/20/2018 5/4/2018 5/18/2018 6/1/2018 6/15/2018 6/29/2018 IG OAS Index Sources: Bloomberg, Thomson Reuters LPC
Debt Capital Markets 6 Price sensitivity continued to be a focal point with investors, which led to elevated new issue concessions. Bond spreads also rose during the second quarter, with the US IG OAS Index climbing from 105 bps in early April to 124 bps by the end of June. $200 $160 INVESTMENT GRADE CORPORATE BOND VOLUME The U.S. Treasury yield curve flattened over the last 12 months, with short term rates rising alongside four Fed $120 rate increases, while longer term rates remained relatively $80 stable. While an inverted yield curve has preceded each of the past seven recessions, some investors feel that the $40 yield curve may be a misleading indicator this time around due to monetary policies (i.e. quantitative easing) keeping long-term rates artificially low. Jan Feb Mar Apr May Jun Jul Aug Sept 2016 Volume 2017 Volume 2018 Volume Oct Nov Dec The markets indicate a 90% implied probability of at least one more rate hike in 2018 and 50% implied probability of a second hike. The current median forecast for the 10- year U.S. Treasury continues to diverge from the Implied Forward Yield. The question remains whether an inverted yield curve will cause the Fed to curb future rate increases, or if the continued growth of the economy will lead the Fed to continue down its recent path of rate hikes. U.S. TREASURY YIELD CURVE PROJECTED 10-YEAR TREASURY YIELDS 120 4.00% Spread Differential 100 80 60 40 20 3.50% 3.00% 2.50% 0 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18 2.00% 3s / 5s 5s / 10s 5s / 30s 1.50% 3Q 18 4Q 18 1Q 19 2Q 19 3Q 19 4Q 19 1Q 20 2Q 20 3Q 20 Implied Forward Yield Median Forecast Sources: PNCCM, Informa, Bloomberg
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