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
Global infrastructure debt refinancing issuance reached US$222.8 billion in 2022, versus US$260.7 billion in 2021
Infrastructure issuers have been shielded from rising debt costs as most capital structures are hedged or have fixed interest rate charges
Rapid growth in provision of infrastructure finance from private debt providers adds to the options open to borrowers
Telecoms infrastructure and energy transition key drivers of activity
In the face of rising interest rates and macro-economic uncertainty, infrastructure finance has proven relatively resilient when compared to the dislocation in other debt markets.
Infrastructure's fundamental characteristics as an asset class anchored by predictable, long-term revenue streams that are often linked to inflation have positioned the sector well to withstand recessionary risk and choppy markets. Investors nervous about inflation and its impact on company profit margins have seen infrastructure as a safe haven and continue to allocate capital to the asset class.
European infrastructure deal activity has remained robust as result, with private equity (PE) investment in European infrastructure climbing to more than US$40 billion by the end of Q3 2022, reaching a five-year high, according to Pitchbook.
Large infrastructure transactions, such as Blackstone's €21 billion acquisition of "last-mile" logistics asset Mileway, have continued to progress, and infrastructure managers have attracted significant support from investors when raising new funds. Global asset manager player Brookfield announced a US$21 billion first close for its flagship infrastructure fund in November 2022, while Antin has raised €5 billion towards its fifth fund, which is targeting €10 billion and will be the infrastructure-focused manager's largest vehicle ever. Ardian Infrastructure also launched its latest Europe-focused flagship fund—Ardian Infrastructure Fund VI—with a €10 billion target, targeting brownfield transport, environment, renewables and energy assets in Europe.
With funding continuing to flow into new infrastructure vehicles, demand for assets and valuations has held up in the face of volatility, with vendors maintaining high valuation expectations. CK Infrastructure Holdings, fronted by Hong Kong billionaire Li Ka-shing, for example, pulled out of a £15 billion deal to sell British electricity distributor UK Power Networks to a consortium led by KKR and Macquarie because the buyers were not willing to go ahead when the selling price was increased.
Infrastructure lenders open for business
With deal activity and valuations holding up and infrastructure managers still raising new funds, the pipeline of opportunities for lenders to finance infrastructure deals has continued to flow.
According to Infralogic, for example, global infrastructure debt refinancing issuance across loans and capital markets came in at US$222.8 billion in 2022 versus US$260.7 billion in 2021. Although down year-year-year, the drop in infrastructure refinancing issuance has not been as steep as that observed in leveraged loan and high yield bond markets overall. Infrastructure debt refinancing issuance remains above pre-pandemic levels.
In addition to traditional bank, private placement and capital market financing sources, infrastructure dealmakers have been able to turn to a growing cohort of infrastructure debt funds to source capital for deals.
According to Infrastructure Investor, capital raised by infrastructure debt funds mushroomed from approximately US$80 billion to more than US$139 billion between 2020 and 2022. The growth in the number of private infrastructure debt players has driven the development of a wide spread of financing products (including junior debt strategies) targeting a mix of infrastructure deals. These range from classic infrastructure assets such as utilities, roads, rail and ports into other areas such as broadband roll-out, data centres and logistics, which offer investors different risk/reward metrics.
The ability of infrastructure lenders across all categories—banks, capital markets and funds—to continue lending has also been boosted by the stability of issuers and infrastructure portfolios.
According to ratings agency Fitch, issuers of infrastructure and project finance in Europe, the Middle East and Africa are well placed to navigate rising debt costs and refinancing. More than four-fifths of the issuers tracked by Fitch either have fixed rate interest rate structures or floating rate structures that are hedged against rising rates. Most issuers also have access to bank and capital markets and processes in place to refinance borrowings well ahead of maturities.
Data centres and the energy transition drive deals
Looking ahead to 2023, infrastructure's solid foundations and inflation-hedging attributes should sustain deal and financing activity, particularly in the telecoms infrastructure and energy transition sub-sectors.
With remote working, data analytics and digitally enabled service provision now embedded across all industries, there has been a huge demand for data centre and other telecoms infrastructure to support this accelerating usage.
As a result, despite a significant slowdown across wider M&A markets, activity from trade buyers and PE firms in the data centre space, for example, has barely missed a beat. Data from Synergy Research forecasts that data centre M&A value in 2022 could exceed the record US$41 billion in activity registered in 2021. Big-ticket data centre deals secured in 2022 include KKR and Global Investment Partners teaming up to buy CyrusOne for US$15 billion, while, on the strategic buyer side, DigitalBridge made an US$11 billion bid to take Switch private.
Robust data centre M&A activity has filtered through to debt markets, with lender appetite to finance transactions where enterprise value multiples are still running strong at approximately 25x EBITDA—and occasionally higher. These deals have tapped a range of financing pools, including acquisition, real estate and infrastructure financing. Although sponsors are now turning their attention to building out data centre assets rather than selling on, multiples and debt supply have remained robust when data centres do change hands.
Adjacent technology areas like telecom towers are also expected to generate substantial opportunity. This has already been seen in deals like the €10 billion bid by Brookfield Infrastructure Partners and DigitalBridge for a 51 per cent stake in Deutsche Telekom's tower company, GD Towers, in July 2022. According to Debtwire Par, this was the largest telecom towers-related deal in the past two years, and it may not be the last—Telenor is reportedly preparing to carve out its tower portfolio for next year, while Telefonica's tower business Cornerstone, along with Liberty Global and Vantage Towers, are all potential deals for 2023.
The urgency of tackling climate change, meanwhile, has made investment in infrastructure with a focus on energy transition another busy area that could be relatively insulated from macro headwinds. This is not something governments can afford to delay and—with McKinsey forecasting that the world will have to invest US$275 trillion by 2050 (or US$9.2 trillion a year) to deliver on net-zero pledges by 2050—the runway for infrastructure investors and lenders will be vast. Multiple opportunities to invest in energy transition across the entire risk spectrum are already emerging.
In addition to the priority given to energy transition and the growing demand for investment in data centre infrastructure, the day-to-day financing requirements for capital expenditure and government investment in infrastructure as a tool to support economic recovery will put the finance ecosystem on a sure footing in 2023.