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
Private equity (PE) deal value in Europe dropped from US$599.2 billion in 2021 to US$369 billion in 2022
Private debt fund structures in the region will ensure that buyouts and deal financings continue despite a tough market
Debt funds have appetite to fund large-cap as well as mid-market transactions
Club deals are becoming commonplace, as direct lenders take on bigger deal financings and diversify risk in their mid-market portfolios
European PE dealmaking declined in 2022—down 38 per cent year-on-year, according to Mergermarket—as macro-economic uncertainty intensified, valuations became increasingly volatile, and financing tightened.
Under the circumstances, the outlook for 2023 is uncertain. To what extent will structural incentives encourage sponsors and lenders to continue doing deals? How will an expanded universe of debt providers be able to overcome the obviously difficult macro-economic conditions?
Financial sponsors will not be sitting on their hands in the months ahead, even with a possible recession on the horizon.
Sponsors need to continue investing their limited partnership (LP) commitments through the cycle to deliver the expected returns. A downturn can also open new opportunities—dollar and euro-denominated funds will see potential value in chasing UK assets due to weaker sterling, while that same phenomenon, coupled with depressed values of some listed companies, may encourage more take-private deals.
The fact that financing is more expensive and difficult to secure could make dealmaking more challenging, but not enough to override the existential requirement for financial sponsors to sustain activity. As firms look ahead to the new year, here is a five-point checklist on what to expect from deal financing in 2023:
1. PE funds will keep deploying capital (and so will debt funds)
Regardless of whether syndicated loan and high yield bond markets reopen for buyout financings or not, in the months ahead, private debt funds will continue to serve as a steady source of acquisition financing. According to Deloitte, European private debt assets under management have increased five-fold in the past decade. With debt funds adopting similar fund structures used in the buyout space and sharing some of the same types of institutional investors, private debt fund managers should be similarly compelled to keep deploying their large capital pools across the cycle.
For most of 2022, private debt has been the best option available to sponsors, including for large-cap transactions that would usually be financed with syndicated loans and bonds.
According to Debtwire Par, more than ten transactions earmarked for potential syndication in 2022 were bankrolled by direct lenders, either in full or in part. So long as investors in the syndicated loan and high yield markets remain cautious, sponsors should be ready for direct lenders to take a firmer stance on pricing and terms—many direct lenders may become more selective before underwriting new deals in 2023.
With debt funds being the go-to option for sponsors in recent months, a key question for financial sponsors will be at what point high yield and loan markets come back into the frame, issuing new debt at a margin that is competitive with the offering of debt funds.
2. More sponsors are joining the club
Historically, direct lenders have preferred to do deals by themselves, but with new opportunities emerging to take on bigger deals, direct lenders have joined forces and undertaken club deals in increasing numbers.
A club of direct lenders, for example, funded a more than £3 billion refinancing for Hg and TA Associates-backed software company Access. The direct lending arm of The Carlyle Group and HPS financed Clayton, Dubilier & Rice's acquisition of the UK, Ireland and Asia operations of French services business Atalian.
One of the more recent examples is EQT Infrastructure's efforts to acquire Trescal, specialists in calibration services based in France. The sponsor reportedly secured more than €600 million in commitments from a private credit club that includes Apollo, CVC Credit, Goldman Sachs, KKR Credit and Park Square-SMBC. The deal was also dual-tracked—Marlborough Partners was mandated to arrange bank-supplied staple financing, with direct lenders standing by. In the end, however, EQT Infrastructure opted for private credit providers, a noteworthy break from its historic reliance on bank-led financing.
For sponsors, the emergence of direct lender clubs marks a "back to the future" moment, as putting a direct lending club together is akin to marshalling old-fashioned bank lending clubs.
Direct lender internal processes are typically faster and nimbler than those of banks, so getting direct lenders to move in the same direction should be more straightforward than the more challenging bank club processes of earlier years. Nevertheless, bank club deal experience will prove valuable as sponsors focus on how to corral lenders in anticipation of more of these transactions in 2023.
3. Debt-raising dynamics will have to change
As direct lending club deals become more commonplace, the dynamics of intermediated acquisition finance raising processes will have to change.
In the more benign liquid markets of the past ten years, sponsors have set up financing processes as auctions. They have specified their terms and lenders have competed to get in on deals. With a surfeit of lenders ready to fund deals in 2022, sponsors have been able to pit them against each other to land the best financing package.
This competitive structure has worked well when a single lender underwrites a deal, but when deal sizes increase and more lenders are required, it becomes increasingly difficult to herd lenders through a process.
In borrower-friendly markets, sponsors can (within reason) limit the time available to direct lenders, as well as their scope to comment on terms. When markets are tighter and lenders can be more selective, however, it will be increasingly challenging for sponsors to let direct lenders fall by the wayside if they want more time or have more complex documentation requirements. On larger credits, even a lender that will only hold the sort of minority stake that would not ordinarily afford it much influence may have to be accommodated.
Sponsors may have to relinquish some control over the process timetables if they hope to keep all lenders onboard.
4. Speed will be of the essence
While syndicated loan and bond markets have been choppy and may remain so in the near term, financing windows will still open—albeit intermittently—and sponsors should be prepared to move quickly.
Windows for issuance opened in 2022 when the outlook on inflation and interest rates improved and issuers, including Hunkemoeller, Fedrigoni, EnQuest and Cirsa, managed to navigate the market turbulence to secure high yield financings.
Although there is limited activity at present, European high yield bond and leveraged loan markets have become far more efficient in recent years. For example, if issuers are well prepared and have updated their disclosure, they could be prepared to launch a high yield bond offering in a matter of weeks and not months. Such windows will continue to open in 2023, providing financing opportunities for nimble sponsors.
5. Be ready to refinance when the time comes
Should inflation and interest rates top out, as trends late in 2022 suggested, secondary pricing in loan and bond markets is likely to recover, and markets for primary issuance will revive. As soon as they do, sponsors that agreed to tighter covenants, higher pricing and lower leverage multiples to finance deals in the past 12 months should lay the groundwork to refinance.
Given the higher proportion of deal financings done by direct lenders in 2022, sponsors looking to refinance when market conditions improve should be particularly mindful of deal terms. Direct lenders putting their money to work over a set period and planning to hold debt to maturity will typically include pre-payment fees and non-call provisions in documents. Sponsors should be very clear about what is required to refinance or reprice, and not assume that they will be able to roll into another structure whenever they choose without some financial pain.
White & Case means the international legal practice comprising White & Case LLP, a New York State registered limited liability partnership, White & Case LLP, a limited liability partnership incorporated under English law and all other affiliated partnerships, companies and entities.
This article is prepared for the general information of interested persons. It is not, and does not attempt to be, comprehensive in nature. Due to the general nature of its content, it should not be regarded as legal advice.