During the past year, as inflation and rising interest rates have prompted investors and borrowers to recalibrate risk thresholds, finance acquisition has been going through a bumpier ride than previously. What’s in store for this year and beyond?
After delivering unprecedented levels of issuance in 2021, the European debt markets have calmed, as central banks in the UK and Europe moved to curb surging inflation by raising interest rates.
With British inflation reaching a four-decade high, the Bank of England upped interest rates in mid-December to 3.5% – the highest since 2008. The European Central Bank (ECB) also raised interest rates to 2% – a more than 10-year high – to combat record inflation of close to 10% across the Eurozone.
As interest rates have climbed, so have debt costs. According to Debtwire Par figures, the margins on European institutional loans have widened from just over 4% at the start of 2022 to 5.29% by the end of the third quarter, while high-yield bond yields almost doubled from 6% in Q1 2022 to 11% by Q3.
Rising debt costs, coupled with increasing investor caution, have deterred borrowers from coming to market unless absolutely necessary, which has driven down European syndicated loan and high-yield bond activity.
According to White & Case’s Debt Explorer, European high-yield bond and leveraged loan activity dropped by 52% year on year to $248bn in 2022.
“When you look at the large cap syndicated loan and high-yield bond markets, it is clear that volumes are down significantly from last year, with a notable slowdown through the course of 2022,” says Sandra Kylassam-Pillay, debt advisory director at Interpath. “Lenders and investors have concerns around how robust forecasting and cash flows are for businesses and the impact of rising interest rates on the sustainability of existing capital structures. Investment banks have also underwritten deals that they have not been able to fully syndicate so appetite to underwrite new deals is reduced as a result.”
Impact on M&A
Sliding loan and bond issuance has had an impact on European M&A activity, European M&A deal value has fallen by almost a quarter (19%) year-on-year to $781bn over the first nine months of 2022, with Q3 representing the slowest quarter for activity since the deal flow cratered following the first round of COVID lockdowns, according to White & Case’s M&A Explorer.
Dealmakers have taken a general pause to assess the market’s direction, putting many deal plans on hold. Financing that is more expensive and harder to come by hasn’t helped, but there simply haven’t been enough deals coming forward in the first instance to sustain the M&A and buyout lending volumes recorded in 2021.
“M&A deal valuations have shifted downwards, which has impacted deal activity. On the buyside, dealmakers have less visibility on earnings and what forecasts to structure off. Vendors have been willing to delay exits rather than sell into an uncompelling market,” says Fenton Burgin, head of UK corporate finance advisory at Deloitte.
Meanwhile, lenders – especially banks – have also prioritised existing customers over new relationships, according to Robert Connold, debt and capital advisory partner at Deloitte. “Lenders have been very supportive of existing clients and the quality bar for new clients has been moved higher. New deals will still be done, but in lower volumes, with the relationship with the financial sponsor a key deciding factor,” he says.
Debt funds into play
However, although capital markets have been challenging and deal activity and valuations have come off 2021 levels, the European acquisition-financing ecosystem is in a relatively strong position when compared with previous credit cycles. Liquidity is undoubtedly tighter than it was, but lending for deals has not ground to a halt by any means. The growth of Europe’s private debt fund industry over the past decade has been a key factor behind the market’s resilience.
“What is clearly different now versus the global financial crisis is the abundance of direct lenders in the mid-market,” Kylassam-Pillay says. “Direct lenders won’t deploy all the time for all clients and they will be selective, but they provide a significant pool of liquidity and capacity that wasn’t there in the global financial crisis.”
European private debt first started to gain traction in the years following the 2008 credit crunch. The then almost entirely bank-led market shuttered entirely as clearing banks pulled in lending and focused on rebuilding their balance sheets. Debt funds stepped in to fill the gap and there has been no looking back since.
According to the Deloitte Private Debt Deal Tracker, the European private debt asset has expanded more than five-fold during the past decade, with assets under management swelling from $36.2bn in 2012 to $187bn in 2022. Head count across the industry has more than doubled since 2016 and the number of lenders Deloitte tracks has climbed from 20 to 68.
Unlike syndicated loan and high-yield markets, where debt is underwritten by investment banks and then sold down to investors, private debt funds take and hold debt through to maturity and finance deals from capital committed to their funds by investors.
With large sums of dry powder available to them, debt funds have been able to continue deploying capital throughout the recent period of market dislocation, with Deloitte figures for the first half of 2022 recording a private debt deal count of 423, a 23% uptick on the first six months of 2021.
The growth of the industry and private debt fund sizes over the past decade has also meant that private debt managers have been able to expand beyond their core mid-market offering and start taking down larger credits that historically would have had to turn to banks and capital markets to secure capital of sufficient scale.
Join the club
Private debt players, however, have demonstrated their ability to form lending clubs and provide finance for sizeable transactions. Debt funds HPS and Carlyle Group, for example, joined up to provide financing for Clayton Dubilier & Rice’s €2.7bn acquisition and merger of outsourcing businesses Atalian and OCS Group.
“Debt funds have become good at working together on club deals,” Connold explains. “They will have similar requirements around leverage ratios, pricing and covenants, and their investment committees follow similar approaches to writing business. It makes the process of legal documentation relatively straightforward and efficient.”
Private debt players are also moving to help clear the backlogs of debt that haven’t been syndicated, buying up these tranches of debt, often at discounts, from underwriting banks.
“It has been interesting to see some of the large direct lenders step in to help investment banks shift some of the paper they had underwritten. It remains to be seen whether this is a long-term solution, but it has provided some temporary relief,” Interpath’s Kylassam-Pillay says.
Future challenges
Moving into 2023, however, M&A markets are expected to remain challenging and private debt funds won’t have it all their own way either.
Fundraising across all private markets strategies will be tough, as underlying investors consolidate alternative investment exposures. Over the first six months of 2022, pension funds and sovereign wealth funds offloaded $33bn worth of private funds stakes, according to Jefferies, almost double the $19bn recorded over the same period in the previous year.
For private debt funds this will not only make it more difficult to secure their own funding, but could also squeeze private equity deal flow – a key source of transactions for private debt managers.
Rather than face fundraising markets, private debt managers – many of them already ahead of deployment schedules after an active 2021 – can now afford to take a breath and raise the bar on the quality of transactions they are willing to conduct.
“A number of debt funds over-deployed through the course of 2021 and are opting to sit tight rather than deploy all their capital and then have to go out fundraising in an uncertain market,” Connold says. “The focus is on supporting the existing portfolio, being highly selective and negotiating higher pricing and lower leverage.”
This is not necessarily negative, however, as a downswing in the credit cycle will take some of the heat out of the market and, from a lender perspective, improve the backdrop for underwriting. Rising interest rates will also ensure that, despite a cooler fundraising market, private debt managers will still be able to gain traction with investors, who in turn will note how rising rates are improving the margins private debt lenders can negotiate when deals do progress.
The M&A market will also continue to deliver opportunities, albeit at a slower rate than 2021, for lenders to consider. For example, privates – especially in the UK where a softer pound has made UK assets highly attractive for buyers investing dollars – are expected to remain robust, as are corporate carve-outs, with strategic buyers focusing on core business and off-loading non-core divisions.
“M&A markets have encountered headwinds as a result of inflation, the squeeze on consumers and geopolitical tensions, but we are in no way facing the kind of slowdown observed following the 2008 global financial crisis,” Deloitte’s Burgin says. “Banks are relatively well capitalised, corporates have preserved cash and private equity firms have substantial amounts of dry powder available to them. As inflation peaks and interest rates stabilise, digitalisation, energy transition and environmental, social and governance will remain long-term drivers of dealmaking.”
Crypto questions
The past 12 months have not been the easiest for cryptocurrencies. The US dollar price of Bitcoin has fallen by almost two-thirds during the past 12 months and the high-profile collapses of cryptocurrency exchanges, most notably FTX, have sent shudders through the market.
But it’s not all bad news. Sean Kiernan is the founder and chief executive officer of Greengage, a banking services platform that facilitates payments and business-to-business (B2B) lending, including against cryptoasset exchange tokens. Despite all the turbulence, he believes there is a long-term role for blockchain and crypto technology within the mainstream lending mix.
“We work with a range of partners, including credit funds and family offices, and introduce them to the world of crypto,” Kiernan says. “The flagship product on our platform facilitates lending of fiat currencies secured against cryptoassets – it is very similar to traditional securities lending and borrowing. A family office, for example, provides capital from its balance sheet and we facilitate the transaction.”
Unlike other providers, that have held these trades on their own balance sheets and then gone bust when the bottom fell out of the crypto market, Greengage does not take on any balance sheet risk itself, instead focusing exclusively on providing the plumbing in order to facilitate transactions.
While the total figures for crypto-backed lending are not public, Kiernan notes that the roughly comparable decentralised finance (DeFi) market was worth around $200bn at the beginning of the year. Even though the fall in crypto valuations means that the market has contracted subsequently, lenders with large balance sheets continue to show interest in providing crypto-backed B2B finance.
For Kiernan, the blockchain technology that underpins how cryptocurrency works is where the long-term value lies, rather than the speculative day-to-day fluctuations in the values of various crypto coins.
“The underlying infrastructure offers near complete counterparty transparency. If a firm’s financial exposures could be fully laid on to DeFi and/or smart contracts, one would have visibility of all the risk and all of the financial instruments on the books – that can almost transfer the nature of a what a bank is,” Kiernan says. “Some of the more speculative cryptocurrency trades driven by quantitative easing have fallen away, but adoption of the underlying technology is still growing. Some of the big banks are already using it, initially more as a custody play.
“I think things will continue to move quickly in adoption across the financial services space.”
Amend and extend
The combination of cooling capital markets and higher debt costs have put company capital structures under pressure and the risk of debt defaults and insolvencies has come into view for lenders and borrowers.
According to credit insurer Allianz Trade, Europe is expected to see large double-digit increases in insolvencies across all major economies when the final figures for 2022 are assessed, and this will be repeated in 2023; credit ratings agency Fitch is anticipating a rise in defaults throughout the next year as well.
In the benign market of 2021, borrowers were able to refinance credits at very attractive rates, on favourable terms, and push out debt maturities. But as credit markets have since ossified, however, the window for refinancing has closed and borrowers can no longer rely on such abundant liquidity to get them out of a tight spot.
While most credits took advantage of the favourable markets observed a year ago to extend maturities, and covenant-light structures have afforded additional breathing room, some of those borrowers who have debt maturing in the next year will need to act in the coming months.
For now, however, it appears as though lenders are holding off from hardcore enforcement and full-blown restructurings, with liability management and ‘amend-and-extend’ offering the preferred options when credits do come under pressure.
In these ‘amend-and-extend’ deals, sponsors and borrowers are receiving maturity extensions (and avoiding the need to face refinancing in a shuttered market) in exchange for the payment of higher interest coupons, equity injections and the introduction of covenants.
Although lenders are willing to work cooperatively with those borrowers who are in financial difficulties, distressed debt investors are tapping investors for capital and on the lookout for deals.
With publicly traded debt selling at debt discounts to par, distressed debt players are buying up positions in the capital structures of companies under pressure, with a view to driving through harder restructurings and to orchestrate debt-for-equity swaps.
Ready and ABL
Inflation and rising interest rates have put the brakes on most lenders, but one source of debt that is partly insulated in times of volatility is asset-based lending (ABL).
“Volatile economic conditions have always strongly favoured the ABL sector,” says Andrew Rutherford, commercial director at Arbuthnot Commercial Asset Based Lending. “While it is too early in the recessionary cycle to predict the outlook for the market in 2023, conditions for mid-market businesses will remain tough for many. However, I have every confidence that asset-based lending will step up to support them with the quantum and speed demanded by event-driven transactions, as it has throughout every cyclical downturn in the past two decades.”
Unlike mainstream cash-flow lending, the availability of which is determined by interest rates and visibility on company earnings, ABL is focused on lending against assets and is insulated from periods in the cycle when the economy becomes less predictable.
In an environment where liquidity becomes tighter, opportunities to refinance the capital structures of asset-rich companies that have relied on clearing banks and cash-flow lenders will emerge for well-capitalised asset-based lenders.
“Unsurprisingly, as the UK is on the point of entering a recession, there is anecdotal evidence in the market that senior cash-flow lenders, which do not have the underlying strength of asset-backed security, are already tightening up on multiples and offering much-reduced availability,” Rutherford says. “As businesses face concerns about breaching financial covenants with existing loans, the relative flexibility of asset-based lending will become increasingly attractive.”
First published in Corporate Financier, Issue 249, February 2023