European leveraged finance: Choosing the right path
European leveraged finance markets paused for breath in 2022, due to rising interest rates, volatile geopolitics and a tightening of financial markets across the board—but what can we expect in 2023?
Heading into 2023, European leveraged finance markets continue to deal with fierce headwinds, following 12 months of economic and geopolitical volatility that has prompted a general slowdown in issuance. What does this mean for the months ahead?
After the record-setting leveraged finance activity seen in 2021—as companies scrambled to refinance, M&A activity spiked and private equity (PE) went on a shopping spree—it was clear that pace was not likely to continue.
But in 2022, as the tail end of the pandemic worked its way through markets, companies were suddenly faced with a new reality. Conflict erupted in Ukraine, oil prices climbed and supply chains were disrupted. A decade of low inflation and interest rates came to an end across Europe. Financing began to tighten as debt became increasingly expensive.
By the end of 2022, while European leveraged loan and high yield bond markets began to see activity, it was well below normal levels and followed a prolonged period of lower issuances. Leveraged loan issuance in Western and Southern Europe was down 37 per cent year-on-year, while high yield bonds fell by 66 per cent during the same period. The third quarter of the year was one of the lowest quarterly totals for leveraged finance issuance in the region on Debtwire Par record.
In both cases, higher pricing was a major factor as it continued to climb throughout the year. On leveraged loans, almost 40 per cent of all deals saw original issue discounts (OIDs) of two or more points from par—by Q4, it was not unheard of for there to be OIDs in the low 90s on term loan B facilities. On the bond side, pricing seemed to finally peak by the end of the year, but only after six quarters of consistent rises.
Eye on the prize
At the same time, there were a few bright spots for leveraged finance markets throughout the year.
First and foremost, buyout activity remained active in the first half of 2022 before dropping off in the second half. Notable deals include KKR’s €3.4 billion-equivalent acquisition of independent beverage bottler Refresco and Bain’s purchase of human resource consultants House of HR, backed by a €1.145 billion term loan and a €415 million note.
Second, new money financing represented a significant proportion of total issuance early in the year, as issuers raised term loan facilities to partially refinance drawn revolvers and fund new acquisitions. As with everything else, however, headwinds meant that most of the new money facilities issued towards the end of the year were smaller add-ons.
Third, CLOs continued to perform consistently (though they were not immune to the general slowdown in the market). Overall, there was €26.1 billion in issuance in 2022—down 32 per cent year-on-year but, in November alone, there was almost €3 billion in new CLO issuance, well above historical monthly averages, according to Debtwire Par.
The path ahead
While there are still shadows on the horizon, the cyclical nature of leveraged finance means that there are always new opportunities. The key is to be prepared.
For example, inflation is starting to plateau in many jurisdictions, but interest rate rises may continue—in the UK, for example, in December, the Bank of England raised the benchmark to 3.5 per cent, up from 3 per cent. This was the ninth consecutive hike since December 2021, placing the rate at its highest level for 14 years. Companies will need to consider their options carefully to get their costs under control.
For those looking to pro-actively manage their debt, amend-and-extend facilities may be the best place to start. Small add-ons and maturity extensions will help many find their way through the forest until macro-economic conditions improve.
Those with the highest-quality credits will reap the benefits of the liquidity available in the market by upsizing as well as via likely tighter pricing during syndication (when compared to balance sheet lending). For example, Debtwire Par reports that French telephony firm Iliad and automotive supplier Valeo entered the market with €500 million notes, and both were upsized during syndication to €750 million.
While this points to a potentially bifurcated European market in the months ahead, where solid credits remain healthy and those already struggling may face an uphill battle, liquidity on the equity and debt ledgers remains strong, and leveraged finance activity is likely to pick up further to address their respective needs.
Hitting the brakes: European leveraged finance battens down the hatches
Leveraged loan issuance in Western and Southern Europe reached €183.4 billion in 2022, down by 37 per cent year-on-year
High yield bond activity was down 66 per cent during the same period, at €50 billion
Loan margins were up by 0.64 per cent by the end of the year, while average yields to maturity for high yield bonds climbed by nearly 3 per cent
UK leveraged finance markets have come through a challenging period in 2022, with issuance across leveraged loan and high yield markets declining as rising interest rates, inflation and the conflict in Ukraine hit activity.
UK leveraged finance issuance in 2022 fell by just over 50 per cent year-on-year, tracking the drop off in issuance observed across the wider European market. Private debt lending has proven more resilient but has also felt the impact of rate hikes and geopolitical uncertainty, with fundraising markets and deal flow from M&A targets tightening through the course of the year.
The UK market faced a unique set of challenges. As a result, the Bank of England (BOE) hiked interest rates nine times through the course of 2022 to 3.5, the highest level observed since the 2008 financial crisis. The European Central Bank (ECB), meanwhile, upped rates four times in 2022, with its benchmark rate now sitting at 2.5 per cent to 1 per cent below the BOE level.
UK lenders and borrowers were already contending with political volatility, in the form of successive changes of prime minister and a catastrophic "mini-budget" in late September 2022. This catalysed a slew of collateral calls and forced sales of UK government bonds, requiring the BOE to step in and backstop bond markets to prevent the dislocation from spreading into other parts of the economy. Financing conditions are expected to remain calm in 2023 in the UK, with limited impetus to kickstart markets back into life.
But there are some early signs of green shoots. For example, after raising rates in December 2022, the BOE argued that inflation may have peaked, slowing from the four-decade highs recorded earlier in the year. Assuming inflation has topped out as predicted, there will be more scope for the UK central bank to halt or slow any further interest rate rises.
A change in the direction of travel on rates will provide issuers and investors with more certainty, help debt prices in secondary markets to recover and encourage primary issuers to come forward and test market appetite for new debt issuance.
The drop in corporate valuations and the weaker price of sterling relative to the US dollar and euro, meanwhile, could drive significant interest from overseas buyers on UK take-private deals in 2023.
Appetite for UK take-private deals has remained strong in 2022, despite macro-economic headwinds. According to Dealogic, UK companies valued at more than £40 billion were already taken off UK public markets in the first nine months of 2022. Public-to-private transactions are expected to continue providing a pipeline of M&A deals and financing opportunities in 2023.
Stalled issuance, growing concerns around rising costs, supply chain bottlenecks and the conflict in Ukraine—it's been a whirlwind of a year, with many remaining challenges for the year ahead
Secondary market developments will drive primary market prospects
Restructurings may rise as maturities approach and cash balances run low
Sponsors will find it tougher to source financing, but we may not see a terms evolution
European leveraged finance markets have been completely reconfigured in the past 12 months. Inflation, rising interest rates and geopolitical uncertainty have squeezed liquidity and seen high yield bond and leveraged loan issuance decline as borrowing costs have climbed.
The wave of prolific refinancings secured in the hot market of 2021 has run its course and M&A-linked issuance has also fallen away as dealmakers pushed the pause button to assess the impact of macro-economic headwinds on deal targets.
What does this mean for borrowers and lenders in the next 12 months? Here are five key trends that we think will drive activity in the market in 2023.
1. Amend-and-extend (A&E) arrangements will increase
As leveraged finance markets have tightened, borrowers have no longer been able to rely on refinancing to push out loan and bond maturity walls or secure capital on more favourable terms.
With refinancing effectively off the table, borrowers with credits approaching maturity will look to A&E their existing debt tranches with amendment and extend deals and/or exchange offers. These deals will offer lenders a consent fee and a higher coupon in exchange for extending loan maturities by 12 to 24 months. Borrowers will also bring lenders onboard by putting equity injections, deleveraging, more covenant protections and/or additional credit support on the table. While common in the loan world, this trend likely will expand into the bond market as shorter-term extensions balance both immediate maturity concerns but also investor concerns over long-term commitments in an uncertain market.
In Q4 2022, German generic drug manufacturer Stada and UK consumer credit group NewDay were among the first high-profile bond credits to make A&E offers to lenders. Spanish paper manufacturer Lecta also turned to A&E during the same period, confirming that it had received consent from lenders to amend-and-extend its €115 million senior facility agreement.
Debtwire Par's inaugural mid-market survey, conducted in Q4 2022, confirms this trend is likely to continue in the months ahead. According to the survey, 32 per cent of respondents say they expect to see more A&E mitigation strategies employed in the next three to six months, second only to covenant waivers.
Expect more A&E to follow suit in 2023.
2. Pause in mega-market deals will open the door for mid-market financing to dominate
Inertia in syndicated loan and high yield bond markets has made it challenging for mega-market private equity (PE) firms to finance jumbo deals, which has seen a decline in big-ticket M&A value. Mid-market M&A, however, is proving more resilient.
According to data from Mergermarket, mid-market M&A deal value in Western Europe (deal valuations in the US$5 million to US$999 million range) slid by 13 per cent year-on-year in 2022, whereas deal value for US$1 billion+ transactions was a third off 2021 levels.
With capital markets expected to remain difficult to access for a time, mid-market M&A financing—which is currently predominantly provided by direct lenders that still have large dry powder cash piles to deploy—is set to remain available and help to sustain mid-market deal volumes. With the opening of a new year, banks are also expected to become more active in these markets.
With megadeals on hold for now, large-cap financial sponsors will be more likely to pursue smaller transactions, providing an additional boost for mid-market financing demand.
Dealmakers and lenders will also remain open to pursuing and financing public-to-private deals, an area that has remained active for M&A due to currency fluctuations and lower stock market valuations.
3. Secondary markets will determine primary market prospects
European primary leveraged finance markets will only reopen on attractive terms when secondary markets improve.
As macro-economic headwinds intensified through 2022, European debt traded at ever deeper discounts. According to Debtwire Par, European leveraged loans were pricing at an 11 per cent discount to face value in secondary markets in September and October. This compares to discounts of less than 2 per cent at the start of the year.
Until discounts narrow, the prospects of a rebound in primary markets will be slim and will only be used where necessary or opportunistically for the right deals. So long as credits trade well below par, secondary market trades will remain significantly more attractive than refinancing opportunities and new money deals—even when issuers are prepared to offer wide original issue discounts. Spreads will have to narrow to incentivise lenders to get back into the game on the primary side.
4. Restructurings loom on the horizon
While it may be the main option of choice as described above, A&E will not be an option for all borrowers—lenders will favour credits that are performing well in stable sectors and demand generous sweeteners if A&E transactions are to proceed. Certain CLO investors, meanwhile, may not be able to extend maturities as their weighted average tests may restrict them from rolling debt. Meanwhile, PE firms will only invest resources in A&E deals if they believe portfolio companies have realistic prospects of returning to growth in the medium to long term.
Covenant-lite debt packages will provide credits that are under pressure with some breathing room, but this may just mask problems, leading to harsher restructurings in the future when maturities approach and cash balances run low.
Distressed debt funds, meanwhile, are marshalling new pools of capital and buying up discounted debt in anticipation of more distress and special situations where money can be put to work.
5. Sponsors will hold ground on terms
PE firms may find it more difficult and more expensive to source debt in 2023, but there are no signs of any major evolution in terms and documentation.
Cov-lite structures and flexible terms have become embedded in the market. Pragmatism will be prevalent on deals as key points of focus reach a compromise—but, with the penalty of increased borrowing costs, this will likely be seen as compensation enough, rather than the market turning back to old school documentation.