Debt Trends

Debt Market Overview

In what must surely now be considered the “new normal”, 2024 was another year characterised by persistent global macroeconomic turbulence and continued ramifications on the M&A and debt markets. Fluctuating interest rates have increased the cost of borrowing in recent years, geopolitical uncertainties including ongoing wars in Ukraine and the Middle East have complicated the landscape, and sponsors and financiers alike were looking to the impending elections on both sides of the Atlantic with the cautious optimism that political certainty might finally kick-start deal activity.

Notwithstanding the macroeconomic conditions, 2024 did see an increase in M&A activity, although the uptake was notably more restrained in parts of the market than was perhaps anticipated. Sponsor-to-sponsor exits, in particular, remained muted, with buyers and sellers globally continuing to struggle to align on valuations. This misalignment is hardly surprising given that the boom of transactions seen between 2019 and 2021 were highly leveraged based on record-low interest rates and cheap debt, acquired at high valuations and with the promise of significant growth expectations. Since then, projected growth has been significantly hampered by poor economic conditions and borrowing costs have soared. Buyout transactions tracked by Pitchbook LCD show that average pro forma leverage fell to 4.6x in 2024, marking a significant de-leveraging from a high of 5.9x in 2022.

2024 marked a strong return of the syndicated market, following stagnant activity levels in the prior two years. Sponsors capitalised on this opportunity to refinance or re-price their existing facilities, particularly with respect to private credit deals from 2022 that had reached the end of their non-call periods, and pushing the ever-moving “wall of maturity” to 2028. Despite the relative scarcity of buyouts, there was also a gentle resurgence of wider M&A activity, particularly at the portfolio level, with sponsors focused on transformational bolt-ons, allowing lenders to “follow their money” on existing financings.

However, the overall cost of borrowing remained high, and this continued to have an impact on borrowers. For the prudent, this led to significant processes that were geared around mitigating the effect of these high borrowing costs, whether through reorganising debt to allow for greater capitalisation of interest or by resetting covenants. For those who were both highly leveraged and with existing weakness in their businesses, this wasn’t enough and the Bank of England reported that global defaults on leveraged loans increased to around 7%, up from around 2% in 2022.

Shifting Terms – A Returning Syndicated Market Takes on Private Credit

Reductions in Pricing

European leveraged loan issuance returned with a vengeance following two slow years that were filled with disruption. Issuances in 2024 were over 100% higher than in 2023, resulting in a record high. Rather than being driven by M&A activity as would typically be expected, this increase in activity was far more reliant on sponsors taking advantage of the lower pricing that became available in the syndicated market to refinance or re-price existing debt.

This sudden return was keenly felt by the direct lenders who have benefitted hugely from the void left by the muted syndicated market experienced since 2022, allowing them to deploy large chunks of capital with good pricing on large-cap deals. With the return of the syndicated market coinciding with non-call periods expiring on existing private credit financings that were structured at the beginning of this downturn, direct lenders found themselves refinanced out of deals or forced to significantly reduce their pricing to overcome the threat of being taken out completely. An estimated €11 billion of private credit deals in the European market were refinanced by the syndicated market in 2024.

Despite this resurgence, private credit products do remain the go-to solution for the mid-market and the increased flexibility means that they retain numerous strategic advantages for sponsor-backed borrowers, even when they come at a higher price.

Competition for Deals and the Impact on Deals Terms

Large direct lenders currently have plentiful supplies of dry powder to deploy as LP allocations to the asset class continue to increase. However, the resurgence of the syndicated markets, muted deal flow, and competition amongst themselves has meant that many such funds find themselves increasingly squeezed out of the large-cap market and instead have set their sights firmly (back) on the mid-market, which has in turn created difficulty for traditional bank lenders operating in the space.

This has led to a shift in documentary terms, with the cov-lite structures more commonly seen in the upper mid-market and large-cap market, pushing down into smaller deals and pressure on smaller credit funds and banks to make similar concessions to remain competitive. Similar pressures have impacted pricing, with average margins tightening to below 6%, representing in some instances, a decrease of over 100 bps from only 12 to 18 months earlier, while arrangement fees have also been seen to drop to below 3%.

Direct lenders have also increasingly been forced to accommodate portability provisions as a mechanism for keeping their capital deployed for longer in familiar assets. While attractive to sponsors eyeing an exit in the near team, lenders were historically far less comfortable with portability as the change of control provided clear opportunity to renegotiate terms. First spotted in refinancing structures and typically accompanied by guardrails, sponsors have recently been able to negotiate the inclusion of these terms in new money deals and in a slower M&A market with limited high-quality assets available, lenders have had to become more receptive.

In the mid-market, borrowers continue to push for PIK toggles and we now expect to see them on every private credit deal; with the typical restriction being a minimum cash pay margin amount of 3-4%. Caps on exceptional items have pretty much disappeared following a brief resurgence between 2022 and 2024. With additional debt for future bolt-on activity being a key focus for sponsors, we now customarily see lenders accepting a right of first offer rather than pushing for a right of first refusal.

The Expansion of Private Credit into Fund Financing

Private credit has also become an increasing source of fund financing more generally, in particular net-asset-value (NAV) based products. In part, dedicated NAV lending funds have responded to opportunities in the market as bank balance sheets continue to be constrained. Much like at the asset level, these funds are often able to offer competitive pricing, sector expertise and flexible terms. Revolving facilities do remain challenging for many of these lenders, but more are now able to offer the flexibility of a deferred and/or limited number of additional drawings (beyond a single upfront drawing).

ESG

A staple of the financing market since their advent in recent years, sustainability-linked loans increasingly appear to be more heavily favoured by lenders than by sponsors. Given that currently ESG loans have been found to provide reasonably negligible financial benefit while placing a heavy time burden on management teams to demonstrate their compliance and come with the risk of accusations of greenwashing, it remains to be seen how these products can now evolve to revitalise and then maintain their earlier popularity.

Fund Financing

Subscription finance (secured on funds’ uncalled capital commitments) continues to dominate the fund finance market. Limited bank liquidity for these facilities and fund finance products generally has impacted their availability and pricing for some sponsors in the post-COVID era. These constraints remain an issue, and many lenders are monitoring any impact of the Basel 3.1 capital requirements, but there was some evidence of easing in 2024, partly as private credit continued to break into other segments of the fund finance market and eased demands on banks.

The NAV market continues to grow and, by some estimates, over $100 billion of capital has now been deployed. In part this reflects sponsors’ and funders’ increasing familiarity with these products, but there are also structural factors at play. In particular, although M&A activity is recovering, asset hold periods remain long and GPs remain under increasing pressure to return cash to their LPs. Some NAV facilities continue to offer an opportunity to borrow to return some of that value, albeit not without controversy and not universally. More commonly, NAV facilities provide liquidity for funds to hold and work assets for longer in the search for enhanced returns. Common use cases include the funding of follow-ons, follow-ups and capital expenditure, either in addition to asset-level debt (and with a different return profile for the sponsor, whose interest is more leveraged than other shareholders) or where it is not available sufficiently quickly or on attractive terms. For distressed assets, NAV facilities may also play a role in financing asset-level financing covenant cures, funding assets requiring restructuring or refinancing asset-level debt approaching maturity.

Sponsors have also been increasing their use of continuation vehicles and these vehicles are well suited to both NAV and “hybrid” facilities (which combine the features of both subscription and NAV facilities). All of these facilities can be used to partially bridge the gap between the capital committed to new continuation vehicles and amounts owing to the investors which have chosen to “cash out”.

Looking Forward to 2025

More Friendly Macroeconomic Conditions

As we look forward to 2025, it is clear that the continuing recovery of the loan markets will remain heavily linked to the success of the M&A market. Globally, interest rates look to be stabilising which is expected to drive dealmaking by enhancing the feasibility and returns of LBOs. This activity is much needed if financing activity is to maintain momentum year-on-year. Conversely however, in the UK, the full scale of the impact of the new Labour government’s budget set in October 2024 remains to be seen and there remains a serious risk of the UK falling into a period of negative growth and high inflation, albeit this was narrowly avoided in December 2024. Sluggish economic growth would delay further meaningful base rate decreases and is unlikely to improve business performance to the point where sponsors can justify their high valuations, extending the valuation gap that has been central to reduced activity thus far.

When combined with the extensive refinancing and repricing activity seen in 2024, a falling base rate would allow leveraged issuers to improve coverage ratios. Should the rate environment become more favourable, we can expect a rapid increase in the number of deals and exits of all sizes. Undoubtedly, sponsors remain under serious pressure to return capital to investors – data from Bain & Co. shows 53% of companies in buyout portfolios have now been held for four years or more and despite the increased familiarity with continuation funds that have made this easier to weather, a brighter exit market remains highly desirable.

Dividend Recaps

Should borrowing costs decrease but the economic environment in some way remain hostile for exits, sponsors may look to dividend recapitalisations in an attempt to return some capital to investors quickly, while also maximising overall returns by undergoing the ultimate exit when conditions improve.

Power to Remain with Borrowers

Given the record levels of dry powder held by direct lenders and new entrants to the market, we expect the decrease in pricing to continue and the further adoption of large-cap terms in the mid-market.

RCF Lenders Taking Term Debt

With difficulties continuing in placing revolving facility debt into a unitranche structure, we expect to see more hybrid-all senior deals or bank lenders taking up increased participations on senior debt, either on a pari passu or super senior basis.

Spectre of Regulation

Hovering above all this is continued intense regulatory attention on the private capital market and particularly its use of leverage, which has become more innovative in a stagnant market, as well as the rapid expansion of the private credit markets. This growth and competition in the market, and the resulting changes to both pricing and non-pricing terms that we detail above, including looser covenants, has heightened concerns from some parties that risks are growing as to future losses. In 2024, the Prudential Regulation Authority began to tackle this through a thematic review of banks’ risk management practices that govern their private sector exposure, with concerns that banks are now exposed to risk at all layers of the capital stack, while the Institutional Limited Partners Association, the trade body for institutional limited partners in the private equity industry, issued much anticipated guidance in respect of NAV-based facilities. A common theme so far has been calls for greatly increased transparency, whether that be with respect to valuation practices or the use of leverage.

Historically private by nature, echoing their name, the private markets are now approaching an inflection point where their contribution to the UK economy has become of such significance that some elements of that privacy at least, may now have to be sacrificed.