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
M&A leveraged loan issuance in Western and Southern Europe is down 69 per cent year-on-year, while high yield is down 81 per cent
Buyout loan and high yield bond issuance is down by 9 per cent and 52 per cent respectively
Dislocation between buyer and vendor expectations on M&A deals expected to weigh on deal activity in 2023
After a blow-out year in 2021, European leveraged finance issuance for M&A and leveraged buyouts has declined through the course of 2022, as deal activity has tailed off in the face of unprecedented geopolitical and macro-economic volatility.
In 2022, leveraged loan issuance for M&A in Western and Southern Europe dropped by 69 per cent year-on-year, with high yield M&A issuance falling by 81 per cent during the same period, according to Debtwire Par. Issuance for leverage buyouts has proven more resilient, with loan issuance down by just 9 per cent year-on-year, though high yield fell by 52 per cent during the same period.
Buyout issuance remained steady through the first half of 2022, as the market worked through an overhang of deals from the previous year and private equity (PE) firms continued to deploy significant levels of dry powder despite the conflict in Ukraine and rising interest rates. Notable deals in the first six months of 2022 include Spanish slate miner Cupa Group pricing a €480 million term loan B (TLB) to back a US$1 billion buyout by Brookfield and Triton securing a €735 million TLB to finance the acquisition of cancer pharmaceuticals company Clinigen, according to Debtwire Par.
Through the second half of the year, however, buyout issuance has fallen away as PE tapped the brakes on new deals. European buyout deal value overall dropped from US$124.3 billion in Q2 2022 to US$25.8 billion in Q4 2022—the lowest quarterly total since the first round of COVID-19 lockdowns in Q2 2020.
Buyout loan and bond issuance has declined in line with this drop in buyout volumes. In Q4 2022 2022, loan issuance for buyouts dropped to just €4 billion, according to Debtwire Par—a far cry from the €26.7 billion of issuance posted in Q3. High yield markets, meanwhile, saw no buyout issuance at all in Q3, with just €1.6 billion in issuance recorded in Q4.
M&A headwinds build
Moving into 2023, PE and M&A deal activity is expected to remain subdued, limiting demand for deal financing.
Vendors that were planning to sell assets in 2022 have pushed back deal timetables or pulled sales processes altogether as the gap between buyer and vendor pricing expectations has widened.
In the past year, the average earnings multiples paid for European mid-market companies declined from 11.6x EBITDA to 10x EBITDA, according to the Argos Index. Vendors have been reluctant to sell businesses at discounts to the valuations that were available relatively recently. Buyers, however, have become more cautious and are unwilling to pay yesterday's multiples for companies that now face heightened uncertainty and downward pressure on earnings.
When deals do go ahead, it is also taking longer to get buyers and sellers over the line. According to insurance advisor WTW, in the first six months of 2022, 60 per cent of transactions took more than 70 days to close, compared to just 54 per cent during the same period in 2021, and this may continue in 2023. Increased regulatory scrutiny—including new foreign direct investment regimes in a number of jurisdictions—is only adding to these delays, contributing to flatter M&A and buyout debt issuance.
Securing debt to finance deals has also become more challenging and expensive, which in turn has constrained the amount of capital buyers can corral to reach vendor price tags. Sponsors arranging debt packages to fund buyouts have seen pricing on buyout loans climb from 4.24 per cent at the start of 2022 to 5.47 per cent by the end of the third quarter before falling to 4.89 per cent in the fourth quarter. Sponsor-backed issuers have also had to offer deep original discounts (OIDs) to lure in buyers, with OIDs widening to 8.81 per cent in the fourth quarter.
Financing big-ticket transactions, meanwhile, has proven particularly challenging, with banks still trying to clear credits that have been stuck in syndication from their books. Bloomberg figures estimate that US and European banks are still holding more than US$40 billion in buyout debt that has not been syndicated. Until these positions are exited, capacity to underwrite new transactions will be limited.
While M&A may be somewhat muted for at least the first six months of 2023, pockets of activity will continue to deliver deals. Sustained weakness in the British pound against the US dollar and euro, for example, has been noted by US buyers. Listed companies in the UK that are undervalued could be trading at attractive discounts for US buyers investing dollars.
Companies with strong cash flows, particularly in healthcare, such as UK-based specialty diagnostics company The Binding Site—sold to US corporate Thermo Fisher in a US$2.6 billion deal—will also continue to draw interest from corporate and PE buyers.
Among the biggest healthcare deals in 2022 was the €35.5 billion demerger of Haleon—the consumer healthcare group running dental health brands like Sensodyne, as well as treatments for colds, the flu, allergies and pain—which was spun off from pharma giant GSK. The deal accounted for more than two-fifths of European consumer deal value in 2022, according to Debtwire Par.
High-quality deals that do emerge from these pockets of activity will also find that financing is available, with direct lenders continuing to lend and eager to deploy into a market where they can be selective and benefit from rising base rates as well as wider margins.
Even for jumbo financings, direct lenders have shown that they can move beyond their core mid-market offering to deliver sizeable debt packages that would usually be the preserve of syndicated loan and high yield bond options. Access Group, for example—a business software company backed by PE firms Hg and TA Associates—secured more than £3 billion for a refinancing, including a £1 billion acquisition finance line. The direct lending arm of Carlyle and private debt manager HPS, meanwhile, provided funding for Clayton, Dubilier & Rice's acquisition of the UK, Ireland and Asia operations of French services business Atalian.
Direct lenders have been able to negotiate better pricing and documentation, including tighter provisions around call protections and unrestricted subsidiaries, and include debt servicing covenants. Dealmakers, noting the changes in the market, have also been willing to take on lower leverage multiples and put larger equity cushions in place to give lenders comfort and move deals to completion.
These shifts may mean that debt packages are not as generous for lenders as they were a year ago, but, for good deals, financing is still available.
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