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.
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.
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.
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
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HEADLINES
European leveraged finance markets saw significant inertia through the course of 2022 as high inflation, rising interest rates and cooling M&A activity put the brakes on leveraged loan and high yield bond issuance. How will these headwinds affect leveraged finance markets in the year ahead?
According to data from Debtwire Par, leveraged loan issuance in Western and Southern Europe was down 37 per cent in 2022, year-on-year, at €183.4 billion, with institutional loan issuance suffering an even steeper decline, down by 67 per cent at €52.9 billion. High yield bond markets in the region have seen similar slowdowns, with issuance down 66 per cent across the first ten months of 2022 at €50 billion.
The steep decline in activity came as the conflict in Ukraine dampened investor appetite for risk and central banks bumped up interest rates to keep a lid on surging inflation. This, coupled with political volatility (including multiple successive UK prime minister changes as well as the ongoing impact of Brexit), meant that markets had little positive momentum on which to rely in changing their risk assessment.
37%
The decline in leveraged loan issuance in Western and Southern Europe in 2022, year-on-year
In the UK, with inflation reaching a 41-year high of 11.1 per cent in October, the Bank of England upped rates to 3 per cent in November and 3.5 per cent in December—the highest level since 2008. The European Central Bank also raised rates to the highest level in more than a decade by the end of 2022, with a 0.5 per cent increase announced in December to tackle inflation that is running above 9 per cent.
As interest rates have climbed, so have borrowing costs. The average margins on first-lien institutional loans were sitting at 4.02 per cent at the end of 2021 but spiked to 4.73 per cent by the end of Q4 2022. European high yield bond borrowing costs almost doubled, with the weighted average yield to maturity for fixed rate bonds up from 4.73 per cent at the end of 2021 to 8.23 per cent in Q4 2022.
Rising borrowing costs and a recalibration of risk appetite from lenders and investors has had a chilling impact on refinancing activity, which was a major driver of activity at the end of 2020 and through 2021.
High yield refinancing deals dropped to just €19.2 billion for the year, a 77 per cent year-on-year decline, while loan refinancing volumes fell 45 per cent from €134.9 billion to €74.3 billion during the same period in 2022.
As the abundant liquidity and low debt costs dried up, and with many maturities already addressed, there has been limited scope for opportunistic borrowers to refinance existing credits on better terms and extend maturities. For lenders and investors, meanwhile, the deep discounts to par that have emerged in the secondary market have blunted the appeal of refinancings. Debtwire Par figures show that European leveraged loans priced at an 11 per cent discount to par in secondary markets in September and October, encouraging investors to pick up bargain secondary market trades rather than support refinancings.
New money deals, meanwhile, have also contracted due to discounts in the secondary market. In order to gain any kind of traction for new deals, borrowers have been forced to accept significantly deeper original issue discounts (OID). This has prompted borrowers to put financings on ice until market conditions improve—and investors still seem inclined to wait for secondary market opportunities even when deep OIDs are offered.
These factors saw new money loan issuance fall 29 per cent year-on-year to €105.3 billion, while high yield new money transactions fell 52 per cent in 2022. Falling European M&A and buyout transaction flow—down 30 per cent year-on-year by the end of 2022—has also knocked new money activity. In loan markets, M&A and buyout issuance dropped by 69 per cent and 9 per cent respectively for the year, with high yield markets also recording an 81 per cent slide in M&A issuance, with buyout issuance decreasing by 52 per cent.
Moving into 2023, loan and high yield activity is likely to continue facing headwinds. There is still limited visibility on when European inflation will peak and interest rates will top out. Lenders and investors will remain cautious while issuers will avoid coming to market unless strictly necessary.
Smaller deals and add-on deal financings—such as UK online retailer THG's £156 million add-on term loan B—will still find a way through loan markets, while high yield markets will open intermittently and facilitate some issuance, as seen with deals including Hunkemoeller, Fedrigoni, EnQuest and Cirsa, which managed to secure financing in the final quarter of 2022.
Overall, the European market will remain challenging. By the end of 2022, the pipeline for deals had slowed to a trickle—Carlyle's purchase of Italian motorcycle gear company Dainese and a refinancing for the UK insurance broker Ardonagh (backed by the Abu Dhabi Investment Authority) were the only deals on the horizon.
When deals do come forward, borrowers may have to scale back their expectations. For example, in October 2022, Dutch artificial turf manufacturer TenCate Grass postponed a €274.3 million add-on to its €315 million EURIBOR+ 500 bps term loan B due September 2028 because of the volatile market conditions.
Borrowers are also expected to run dual-track financing processes more often, with direct lenders in line to pick up an increasing volume of transactions that would otherwise have gone down the high yield bond or leveraged loan route. Italian specialty food ingredients producer Irca, for example, shifted the financing for its acquisition by Advent International from The Carlyle Group from a proposed €430 million high yield bond note to a direct lending package provided by CVC Credit.
Maturities during 2023 and onwards will need to be dealt with in creative ways. Typically, both borrowers and lenders want to avoid a restructuring where possible. This is expected to drive an increase in amend-and-extend deals, both in the loan market where this is more traditional, but also in the high yield market, as seen in the exchange offer undertaken by German pharmaceutical company Stada in October 2022. These deals will see borrowers move to extend maturity walls by offering incumbent lenders higher coupons, additional covenants and/or additional credit support.
Equity injections may also become more common as sponsors see the need to support portfolio companies through a rough patch and to convince investors of long-term value in a business.
The scope for maturity extensions could be limited for certain CLO investors, as their weighted average life tests restrict their ability to roll debt. But when maturity extensions are an option, it is hoped that these arrangements will help to avoid large-scale insolvencies and full-blown restructurings in 2023, with lenders willing to accept more favourable pricing and terms in exchange for maturity extensions rather than crystallising losses.
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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.
© 2023 White & Case LLP
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View full image: European leveraged loan vs. high yield bond issuance (quarterly)
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View full image: European high yield bond pricing—Fixed-rate bonds*
View full image: Original issue discounts (OIDs)* in Europe
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View full image: Benchmark floors on institutional term loans
