European leveraged finance: From survive to thrive
European leveraged finance markets rebounded in the past 12 months, driven by enthusiastic refinancing activity and a resurgent M&A marketplace, setting the stage for a healthy year ahead
European leveraged finance markets look remarkably healthy as we enter 2022. This may come as a surprise, after 12 months of economic volatility underpinned by everything from a new COVID-19 variant to growing inflationary pressures. What does this mean for the months ahead?
The start of the new year is full of positives in the European leveraged finance market. There has been a clear shift from survival to growth strategies among lenders and borrowers, setting the stage for significant activity in almost all sectors.
The numbers paint a clear picture. European leveraged loan issuance climbed more than 25% in 2021, year-on-year. High yield bond markets in the region were even more enthusiastic, with issuance for the year up 47% on 2020's total.
Ongoing government support in the EU and the UK helped companies that might otherwise have fallen victim to the pandemic stay afloat. Low interest rates and pricing sparked a wave of refinancing. CLO activity—most of which was intended for refinancing and resets—pushed new CLO issuance up by 75% year-on-year.
A bottleneck of demand as well as significant private equity dry powder also brought a flood of new deal money into the market. Companies that were once hesitant to sell encountered enthusiastic buyers aggressively looking for targets. Buyers, meanwhile, found themselves in a better position to judge whether a potential target was likely to struggle or grow in 2022 and beyond. Lenders reaped the benefits, with high deal volume in which to participate. At the same time, unlike many other industries, European direct lending funds avoided any significant downturn in deployment and deal activity due to COVID-19. According to data from Debtwire Par, direct lending issuance in the region reached €36.2 billion in 2021, surpassing 2020's full-year total of €21.4 billion. This provided a liquid and competitive market for finance products.
Possibilities and pitfalls
Set against this positive backdrop, does the future look entirely bright for leveraged finance? Not necessarily—some challenges remain, and each may have an impact on European issuance.
For example, climbing COVID-19 case numbers driven by the Omicron variant may convince some corporates to hold on to their reserves. Any resulting new lockdowns or restrictions could also be the final straw for businesses that have already struggled during the pandemic.
Inflation and attendant interest rate rises are also likely to influence potential borrowing decisions in the coming months. The UK got the ball rolling with its first interest rate rise in three years in December 2021, and the EU may follow suit in 2022—despite claims to the contrary by the European Central Bank.
Any rise in the cost of debt will affect M&A and buyout activity, as well as financing. Some may pause while others—from corporates in good financial shape to PE firms with money to spend—may decide to invest in a post-COVID-19 future. Either way, M&A and buyout deals in the pipeline already suggest that issuance will remain healthy in the first half of the year at least.
And, finally, environmental, social and corporate governance criteria will be on the menu for every European business. New benchmarks due in 2022—from the EU's Sustainable Finance Disclosure Regulation to the European Leveraged Finance Association's updated Sustainability Linked Loan Principles—are already making lenders and borrowers sit up and take notice.
All this activity means the stage is set for companies hoping to thrive rather than simply survive. Lenders chasing higher-yield opportunities will be on the hunt for new investments, and borrowers can be expected to provide lenders with a healthy volume of demand for debt financing in 2022.
From survive to thrive: European leveraged finance looks to the future
European leveraged loan issuance was up by more than a quarter, year-on-year, to €289.7 billion in 2021
High yield issuance reached €148 billion in 2021, up 47% on 2020 (year-on-year)
Refinancing accounted for approximately half of overall leveraged loan and high yield bond issuance for the year
Both M&A and buyout activity saw double-digit year-on-year rises in deal-related issuance
A flurry of activity saw year-on-year leveraged finance issuance in Europe hit new heights in 2021. Can this pace be maintained in the months ahead? Based on pipeline activity and investor appetite for growth, the answer seems to be: Yes.
Leverage loan technology and computer-related issuance in Western and Southern Europe almost doubled from annual pre-pandemic levels to €19.9 billion by the end of 2021
Technology and computer-related high yield bond issuance in the region hit an all-time high of €7.3 billion by the end of 2021
Start-up debt issuance in Europe had already reached a record annual total before the end of Q3 20211
Europe's technology industry went from strength to strength in 2021, with M&A and lending activity in the space thriving as investors across multiple asset classes tapped into the tech sector's non-stop growth and resilience.
The shift to home working due to COVID-19, as well as the rise in digital learning and online shopping and entertainment through both 2020 and 2021, drove earnings growth across the entire technology sector.
Safe and secure technology was a must-have in every home, which ensured that tech firms were kept busy, lifting revenues and prompting tie-ups. This in turn created opportunities for cybersecurity firms—Dealogic data shows 57 cybersecurity-related M&A transactions in Europe in all of 2020 versus 69 deals in 2021.
Fintech firms were also quick to see the benefits of an accelerated shift to things like online banking and contactless payments. This trend has been growing steadily for years but attracted particular attention in 2021, spurred on by an explosion in special purpose acquisition company (SPAC) dealmaking. As a result, fintech-focused Pegasus Europe and EFIC1 were two of Europe's largest SPAC deals in 2021.
The evolution of business models built on stable recurring revenues (from Netflix to Spotify) and sticky customer bases (from Intuit tax software to Shopify) only added to the sector's appeal for investors looking to mitigate downside risk.
These strong underlying drivers saw the STOXX Europe 600 Technology Index climb 25% in the 2021 calendar year, outperforming the STOXX Europe 600 by around 7%.
M&A activity was equally buoyant for the sector, with the 488 technology buyouts totalling €49.2 billion in 2021, accounting for nearly a third of all European private equity (PE) deals, according to Mergermarket data.
Across all technology verticals, from fintech to cybersecurity, investment levels are moving steadily upwards—a trend that shows no signs of slowing in 2022.
The strong performance of the sector makes it highly attractive for leveraged loan and high yield investors. For technology borrowers positioning their businesses for an acquisition, debt markets have been a useful source of capital to fund their growth before M&A deals clear.
Technology and computer-related leveraged loan issuance in 2021 came in at €19.9 billion in Western and Southern Europe, according to Debtwire Par. This was well ahead of the 2020 full-year total of €13.8 billion and almost double the €10.6 billion in issuance posted pre-pandemic in 2019.
High yield issuance for technology and computer-related credits was equally robust. Debtwire Par data shows that, in 2021, issuance in the region reached an all-time high of €7.3 billion, exceeding the previous annual record of €4 billion posted in 2018 and almost trebling the annual issuance of €1.7 billion in 2020.
Startups are stepping up in debt markets
Lenders are so enthusiastic about hitching their wagons to the technology sector that they are exploring new channels and debt products to increase their exposure to a wider pool of potential borrowers.
Debt provision for startups, for example—which is structured to provide fast-growing companies that are not yet cash-flow-positive with access to debt financing—hit record levels in 2021, as growing interest from tech startups and a rising number of new entrants on the lender side saw issuance climb.
According to figures from database management company Dealroom, European startups raised €8.3 billion in debt before the end of Q3 2021. This is a 41% uplift on the €5.9 billion of funding secured in the 2020 calendar year and ahead of the previous record annual total of €8.1 billion secured in 2017.2
Venture and start-up debt penetration in Europe has been a fraction of that in the US historically, but there are now signs that European markets are closing the gap. Borrowing by startups in Europe has more than quadrupled since 2015, when the market was only worth €1.6 billion, and uptake is now growing at double the rate of the US.3
Debt financing provides start-ups with lines of capital that do not dilute existing shareholders and allows companies to build up their credit history. This is vital for businesses planning to tap into mainstream debt markets later in their development. For lenders, the product provides exposure to a fast-growing technology credit early in the development curve.
Industry surveys show that start-ups that use venture debt products are likely to do so again.4 Given the stickiness of the product, as well as new entrants entering the market and driving down pricing, the growth runway for start-up debt in Europe looks promising.
For mature technology assets that are too large for start-up debt financing but have yet to reach sufficient scale to access leveraged finance markets, the emergence of recurring revenue debt provision has provided a valuable option for raising capital.
Recurring revenue debt unlocks additional funding by providing credit on the basis of repeatable or subscription-based revenues. The product has been a good fit for technology companies that supply business-critical software and services that clients rely on for the day-to-day operations of their companies. Lenders have been able to provide capital to these borrowers using recurring revenue structures, even though the companies are not yet EBITDA-positive.
Terms and pricing vary from credit to credit, but recurring revenue loans will typically price higher than vanilla loans and have a runway of between two or three years. The expectation is for the credits to reach profitability and graduate to conventional cash flow lending options in that time.
This financing strategy has helped fast-growth late-stage, venture-backed technology companies to bridge to an IPO or build profitability.
New lending streams like venture debt and recurring revenue loans have been well received by European technology startups. With lenders eager to tap into the sector's strong growth fundamentals, the year ahead is likely to break more records as European technology companies of all sizes have access to deeper pools of capital than ever before.
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