Debt Trends

At a Glance

Market Overview

2023 was marked by a continuing confluence of macroeconomic and geopolitical headwinds that combined to depress activity in the primary M&A markets and the debt markets more generally. Persistent inflation, particularly in the first half of the year, coupled with historically high interest rates with the Bank of England raising base rates to a 15 year high of 5.25%, helped to maintain the valuation gap between buyers and sellers and act as a barrier to fresh buyouts with global private equity deal activity dropping approximately 40% from 2022 (itself a slow year) and debt-driven leveraged buyouts declining by 25% across the globe. The Ukraine war and an increasingly unstable landscape in the Middle East continue to impact global trade and are doing little to improve investor confidence. All of this in a year when a significant proportion of the world’s voters (expected to be two billion across 50 countries) will be going to the polls and political uncertainty typically reduces M&A activity.

And yet there are solid reasons for optimism for an uptick in activity in 2024. Base rates have peaked with the forward curve inverting, inflation is tailing-off and there is significant pressure on both sponsors and private credit funds to deploy unspent record levels of fundraising. For sponsors in particular, they need to return liquidity to investors as they look to raise new funds in a challenging environment in which LP allocations are being drawn to mega-funds, with 54% of fundraising in 2023 absorbed by only five funds. Conversations with investment banks reveal bulging back-books and pipelines and with Q4 2023 ending on a strong note, we start 2024 with cautious optimism that there will be a sensible rebasing of valuation metrics and we will begin to see a return to a more active debt market, particularly around potential opportunistic raises in advance of a broader re-opening of the M&A market later in the year.

Coming off the back of a significant downturn in activity during 2022 when leveraged loan and high yield bond issuance dropped 65% and 82% respectively, the story improved slightly in 2023 with a 10% increase in year-on-year total volume. However, this increase was largely accounted for by a doubling of high yield volume and the total volume across both products that was used to fund buyouts fell dramatically by 69% year-on-year. Leveraged loan issuance dropped back a further 20% in 2023 as the syndication risk (and pre-existing holds of hung syndications) remained unabated over the year. These results are hardly surprising given the significant headwinds already mentioned, not least the cost of borrowing with GBP base rate ballooning from 0.25% in early 2022 to 5.25% in 2023 and the average overall yield to maturity of leveraged loans in the European market climbing from 7.5% to 9.5% at the end of 2023.  These results are not necessarily reflective of a lack of liquidity or supply side issues; the demand has simply not been there from borrowers in a high interest rate and uncertain wider macro environment. Against the background of a paucity of new money buyouts and an ever-growing maturity wall to manage, it is little surprise that refinancing rose by 46% in 2023 to take a 60% share of total leveraged issuance through the European capital markets.

Private Credit

With the capital markets remaining muted (albeit showing more positive signs in recent months) direct lenders have been able to consolidate their position as genuine players in the large-cap space. Following the jumbo £4.5bn private credit club financing for the sponsor-backed Access Group in 2022, further big ticket buyouts funded by direct lenders were papered in 2023, including the €4.5bn financing for Adevinta backed by Permira and Blackstone. Pressure on credit funds to deploy record levels of fundraising has only increased in the last year and led to a tightening of pricing as lenders seek to entice borrowers back to the table. For the strongest credits in particular unitranche margins have come down under 6% and certain credit funds are clearly demonstrating an explicit strategic shift towards lower margins for the best assets.

The private credit product is still the go-to solution in the mid-market, especially for sponsor-backed borrowers where credit funds’ appetite for higher leverage, bolt-on flexibility underpinned by committed delayed draw acquisition lines, ability to re-leverage and looser conditions on making acquisitions, all combine to support PE buy-and-build platform investment strategies. Indeed, more than 80% of sponsor-backed deals in 2023 were financed by private credit. Given the proliferation of credit funds in recent years, the market is becoming even more bifurcated with houses that have demonstrated consistently strong returns dominating the fundraising scene and, just as in the private equity space, the emergence of mega-funds attracting the lion’s share of available LP commitments. Smaller funds have been left wrestling with an ever-decreasing pool of available investor capital as well as underperformance issues in their portfolios. For many such funds this will be their first experience of a downturn and with the effect on higher interest rates yet to fully play-through existing highly-levered deals that were papered when base rates were close to zero, there will undoubtably be an uptick in stressed or severely distressed assets requiring a restructuring solution which will see certain credit funds (and their behaviour) tested for the first time. How this plays out will in many cases depend on the particular relationship with a sponsor, coupled with the internal dynamics (including vintage) of the credit fund itself. The private debt community has marketed itself heavily on the relationship angle and its behaviour will be carefully monitored in that respect over the next 12 months.

Despite the success of the private debt product, traditional banks have exploited the difficult conditions of the last 12 months to try and reclaim some market share. With the pressure of higher pricing hitting deals, a cheaper bank solution will continue to attract sponsors willing to sacrifice higher leverage for lower debt servicing costs, especially for assets where buy-and-build flexibility is less crucial to the underlying investment thesis. Traditional banks are also able to provide revolving credit and working capital facilities as well as related ancillary facilities, including hedging capability, and given their vast network of origination they remain an important partner for most credit funds (and a number of strategic partnerships have been established over the years between funds and banks) even when they are not providing the core term debt. Larger banks have also developed dual strategies targeting different return profiles which aim to provide a one-stop shop for the unitranche and working capital tranches.

Bifurcated Markets, Processes and Stressed Assets

Whilst the supply side remains robust and underlying liquidity is not of itself an issue, especially in the private credit space, we are seeing the development of a bifurcated debt market with increasing flight by lenders to quality. Capital intensive, cyclical businesses have and will continue to struggle to attract solutions for both acquisition financing and refinancing events and where they are able to do so, borrowing costs will be higher. In many cases where access to traditional leveraged cashflow lending is blocked, sponsors have been turning to alternative solutions such as receivables financing and other asset-backed lending structures, or utilising those products in parallel with traditional cashflow based term debt. We are also seeing the return of more structured solutions, including credit funds investing through the strip into senior and junior subordinated instruments and taking warrants, especially for assets at an earlier stage in their growth life-cycle.

Except for the most competitive credits, processes are taking longer to complete with lenders placing greater emphasis on due diligence and final credit committees now proving to be more unpredictable than in recent years. This more robust approach is partly a defensive reaction to existing highly-levered deals now encountering much harsher economic conditions. The sharp spike in borrowing costs has been a significant contributor to a rise in corporate defaults which have hit a 30 year high, with construction, retail and hospitality being the worst affected sectors. In that context, the restructuring and insolvency capabilities, particularly of (i) credit funds which have large portfolios and (ii) funds with little prior experience of a downturn or how to manage stressed assets, will come under significant pressure. This will be less of an issue for traditional banks given they are well supported by experienced dedicated teams specifically set-up to manage distressed credits.

In the absence of a buoyant exit market sponsors have been laser-focused on portfolio management, especially as the pressures exerted on highly-levered assets over the last 18 months have started to become manifest. Longer than expected hold periods are creating an ever-growing maturity wall and numerous assets have required extensions to their final repayment dates. With high interest rates eating into available free cash, borrowers have been looking to capitalise interest through PIK toggles and minimise their cash pay burden. For those assets whose underlying performance has deteriorated materially, financial covenant holidays, waivers and re-sets have been occupying the attention of sponsors and their lenders, with lenders (for now) generally seeking to achieve a consensual outcome rather than pursue an enforcement strategy.

P2P Markets and Portability

With the valuation gap still suppressing activity in the private markets and dealmakers viewing wider conditions as too uncertain to realise their targeted returns, sponsors have been able to find opportunities in certain sectors of the undervalued public markets.

Where private deals are being executed, especially refinancing with a view to a near term exit, there is increasing attention being paid by sponsors to implementing portable finance structures. These structures allow the survival of an existing debt package without triggering a customary mandatory prepayment of the debt on a change of control of the borrower. This flexibility is subject to certain prescribed protections for the lenders, including meeting pro forma leverage incurrence tests and the identified purchaser appearing on a previously agreed list of approved investors. Securing a portable debt package is attractive to sponsors as it can facilitate an easier sale process when assets are finally brought to market. Lenders, particularly those focused on longer term yield, are increasingly willing to accept them when there is a strong expectation of a short term sale and they are keen to hold on to the paper, although portability still meets with stiff resistance from traditional banks outside of a syndicated financing.

Fund Level Financing

With the slow M&A market and subsequent longer hold periods by sponsors, GPs are under increasing pressure to return cash to their LPs or re-cycle funds to meet other portfolio requirements. Many houses have turned towards fund level financing products in order to meet those liquidity issues, with NAV facilities at the forefront of those solutions. GPs have also been increasing their use of continuation vehicles, and such vehicles are well suited to so-called “hybrid” facilities which combine the features of both subscription and NAV facilities and we expect to see the use of such instruments grow in parallel with the rising number of continuation fund deals.

ESG

Environmental, social and governance issues remain in focus and are often key considerations in the PE investment mainstream, with sponsors noting both that there is a moral imperative in this area, but also that it is good for business and typically value-accretive when looking at an exit, not least because it will attract a wider base of potential purchasers. The interface of ESG with debt has continued to evolve and whilst there remain concerns and criticisms from ESG sceptics around the robustness of instruments and so-called “greenwashing” in the lending markets, these will, in part, be addressed by the application of the new FCA anti-greenwashing rule that will come into force from 31 May 2024. Sustainability-linked loan principles were also revisited in depth by the Loan Market Association in 2023 and the resulting updates have emphasised the importance of implementing external verification of targets and the underlying rigour of the related KPIs that are adopted. That said, from a sponsor’s perspective the pure economic upside of implementing SLLs in terms of a reduction in pricing whilst welcome is typically not, of itself, a sufficiently material incentive to take on the additional reporting requirements and enhanced scrutiny where the business is not already, or planned to be, set-up to target and improve its ESG credentials. The main driver for PE houses to implement an SLL on any given deal will, therefore, be the ESG requirements of the underlying LPs in the fund and the explicit or implicit promises made by the fund GP to those LPs.