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US leveraged finance: Navigating choppy waters

What's inside

Borrowers and lenders are seeking new opportunities in the face of growing market volatility

Foreword

After cresting record levels of activity last year, US leveraged finance markets slowed in the first half of 2022 as lenders and borrowers adapted to a rapidly shifting geopolitical and macro-economic backdrop—deals continued to be done, but stakeholders reset expectations as debt costs rose and investors became increasingly risk-averse.

US leveraged loan markets are in a very different place than they were just six months ago.

Since the beginning of the year, lenders and borrowers have been forced to contend with soaring inflation, rising interest rates, supply chain constraints and an increasingly volatile geopolitical backdrop following events in Ukraine. The contrast with the frenetic levels of activity observed in 2021—characterized by abundant capital, low pricing and buoyant refinancing—is stark.

Macro-economic headwinds took their toll on activity levels. Leveraged loan issuance dropped by a fifth year-on-year in the first half of 2022. The impact was even more pronounced in the institutional loan issuance space, which was down by almost two-thirds on the same period in 2021, as increasingly risk-averse investors tapped the brakes. Some issuers that would have otherwise dipped their toes into leveraged loan markets opted to hold fire instead and await calmer waters.

In the face of these challenges, however, there have been positives. Cash-rich private equity firms continue to close deals and secure financing, cushioning the dip in year-on-year new money issuance. Loan issuance intended for buyouts, while suffering some decline, has also proven resilient. Collateralized loan obligations (CLOs)—the largest investors in leveraged loan assets—have also remained active, even as supply in the primary loan market dried up.

Even as markets take a moment to pause and recalibrate, the door remains open for issuers to secure financing on good terms from debt investors who are eager to put funds to work.

High yield, high costs

For high yield bonds, various headwinds, including rising inflation and interest rates, created a challenging market landscape for fixed rate instruments in the first half of the year. High yield bond issuance dropped to levels not seen since the start of the pandemic, falling by more than three-quarters year-on-year as cautious investors stepped back. According to Lipper funds data, in the first half of 2022, almost US$30 billion left the asset class.

Even in the face of volatile market conditions, stronger high yield issuers have kept a close eye on pockets of opportunities. More than a dozen others have joined the fray since, capitalizing on an improved landscape in June to bring new deals to market. These include Tenet Healthcare, which raised US$2 billion in senior secured notes, and Kinetik Holdings, which priced US$1 billion in senior unsecured notes. Both issuers raised the capital for refinancing.

As we enter the second half of the year, volatility is likely to continue weighing on the market, but investors and borrowers are already adjusting. Activity levels may not hit the buoyant highs of a year ago, but stronger credits should continue to secure investor support. There is no escaping the fact that costs have gone up for issuers accessing the more challenging markets, but patience, adaptability and nimble execution continue to be a successful formula when doing so.

Resilient US leveraged finance markets navigate volatile backdrop

  • Leveraged loan issuance reached US$612.5 billion in H1 2022, down on the US$755.5 billion recorded in the same period in 2021
  • High yield bond issuance also dropped, year-on-year, from US$267.6 billion to US$63.6 billion—though markets began to open again in June
  • Since January, the US Federal Reserve has raised interest rates four times, taking the benchmark federal-funds rate to a range between 2.25 and 2.5 percent
US LevFin 2022

From rising costs to ESG ratchets: Five trends that will drive leveraged finance in 2022

  • Pricing will increase, but issuers will continue to seek borrower-friendly terms and documentation
  • Lenders and investors will pause to assess the impact of inflation and ongoing interest rate rises
  • Direct lenders will take advantage of the volatile backdrop to grab market share from broadly syndicated leveraged loans and high yield bonds
  • ESG opportunities will persist, but lenders will ask more questions
US LevFin 2022

The fund finance market takes flight

  • Fund finance activity soars as PE managers access facilities in ever-greater numbers
  • The market is positionedto grow seven-fold by 2030, reaching an estimated US$700 billion
  • Fund finance products are rapidly evolving from simple bridging facilities into increasingly sophisticated tools used for NAV and GP financing
  • New entrants are growing market and broadening provision to more PE sponsors
US LevFin 2022

Buyout issuance leads the way despite a choppy M&A market

  • In the US, buyouts totaling US$235 billion were announced in H1 2022, far above pre-pandemic levels, year-on-year, going back to 2007
  • Loan issuance for buyouts climbed in the first half of the year, reaching US$94.5 billion
  • High yield buyout issuance enjoyed a strong first quarter, hitting US$7.4 billion, before bond market activity decreased in Q2
US LevFin 2022

ESG: A sustainable approach in turbulent times

  • ESG-linked debt issuance reached record levels in 2021 before macro-headwinds slowed issuance levels
  • ESG-linked KPIs are increasingly a feature in debt structures
  • ESG debt facilities, historically more common in the European market, are expanding rapidly in North America
  • Lender and regulatory scrutiny of ESG compliance and benchmarking is intensifying
US LevFin 2022

Inflation and increasing interest rates reshape US leveraged finance markets

  • US inflation for consumer goods hit a 40-year high in June 2022 of 9.1 percent
  • Since January, the US Federal Reserve has raised interest rates four times
  • High yield issuance for the half-year was down 76 percent year-on-year as investors exited fixed-rate debt instruments
  • Loan markets have also been affected, as pricing and original issue discounts widen
US LevFin 2022

SOFR transition progresses despite volatile markets

  • Almost all new activity in the US leveraged loan market has transitioned from LIBOR to the new SOFR benchmark
  • The Alternative Reference Rates Committee endorsement of Term SOFR in 2021 provided a solid foundation for this transition
  • Attention now turns to how legacy loans tied to LIBOR will handle the SOFR switch
US LevFin 2022

Documentary developments in tighter times

  • Investors are focusing on pricing and original issue discounts to manage risk, but are starting to push back on documentation
  • The flight to quality among investors is driving bifurcation between the terms available to higher and lower-rated credits
  • Direct lenders are offering flexible structures to win deals
US LevFin 2022

A volatile situation: Europe versus the United States

  • Leveraged loan issuance in the US dropped by 19 percent year-on-year in H1 2022
  • High yield bond activity in the US was down 76 percent year-on-year during the same period, hit by inflation and rising interest rates 
  • Combined leveraged loan and high yield bond issuance in Western and Southern Europe was down more than 65 percent year-on-year, as events in Ukraine hit the markets 
  • Pricing is moving in favor of lenders across the board
US LevFin 2022

Conclusion

Taking stock at this point in the year may make for slightly sobering reading for some, but the cyclical nature of the market means that, even as activity slows in one area, it can (and usually does) pick up in another—but what does this mean for leveraged finance markets in the months ahead?

US LevFin 2022
US LevFin 2022

The fund finance market takes flight

Insight
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4 min read

Key Takeaways

01

Fund finance activity soars as PE managers access facilities in ever-greater numbers

02

The market is positioned to grow seven-fold by 2030, reaching an estimated US$700 billion

03

Fund finance products are rapidly evolving from simple bridging facilities into increasingly sophisticated tools used for NAV and GP financing

04

New entrants are growing market and broadening provision to more PE sponsors

Fund finance is positioned for record levels of growth as private equity (PE) general partners (GPs) tap traditional subscription and net asset value (NAV) financing lines in greater numbers.

This market—which began with simple bridge-type subscription lines—is rapidly developing into an increasingly sophisticated product, offering GPs a series of financing options at the fund level.

As fund finance offerings have evolved, more GPs have used the product and valued the liquidity it provides for portfolio companies and investors at key stages in the fund life cycle. This has driven up demand and encouraged new providers to enter the market alongside incumbent bank and alternative debt providers, making fund finance available to a wider pool of GPs.

Fund finance is also gaining traction across a wider set of private market funds as providers become adept at structuring collateral packages around the different profiles of various alternative asset strategies. Fund finance is now a regular feature in private credit, the PE secondaries market, real estate and buyout funds, with venture capital managers beginning to explore how the product could be used in their funds.

7x

17Capital forecasts show that NAV finance is on track to grow from US$100 billion today into a US$700 billion market by 2030

NAV financing spurs market growth

A primary driver of fund finance growth in recent years has been the development of NAV facilities, which enable GPs to borrow against the NAV of the assets held in their funds.

By borrowing against portfolio companies at the fund level, managers have been able to make distributions to their limited partners (LPs) earlier without having to exit crown jewel assets, and to provide additional financing to portfolio companies after fund investment periods have expired.

Managers and lenders have also found ways to use NAV facilities to enhance returns by back-levering assets, whether as part of the original acquisition financing or on a post-deal basis.

NAV facilities have been applied with increasing frequency in GP-led fund restructurings. In these GP-led deals, managers extend holding periods by shifting assets from a current fund into a new vehicle, giving LPs the option to roll their stakes or cash out. Secondaries investors (managers that trade stakes in private capital funds) funding these transfers are using NAV credit lines to finance a portion of their equity investments and boost returns.

With investment bank Jefferies recording growth of 94 percent in GP-led deals in 2021, there is strong underlying deal flow available to NAV lenders active in this area.

Such has been the growth of NAV financing that investors are now clamoring for exposure to the strategy. For example, 17Capital—one of the first NAV finance providers in the market—closed an inaugural NAV fund in April 2022 at a hard cap of €2.6 billion, well ahead of the €1.5 billion targeted by the firm on launch. 17Capital forecasts show that NAV finance alone is on track to grow into a US$700 billion market by 2030, up from US$100 billion today.

The bright prospects for NAV lending have been further underscored by the fact that asset manager Oaktree acquired a controlling stake in 17Capital earlier this year in a high-profile deal in the market.

As fund sizes and the market grow, NAV lenders will be able to finance larger portfolios and tailor loan-to-value (LTV) ratios to the particulars of the portfolio.

The typical LTV ratio for NAV facilities issued to portfolios has been between 20 percent and 30 percent, but higher LTVs are not unheard of. When it comes to back-levering deals with credit support from the relevant fund, LTVs can run substantially higher.

Ongoing innovation

The uptake of NAV funding lines, however, has not limited the pursuit of new and innovative developments among providers. Hybrid facilities, single fund and asset deals, and GP financing are some of the additions to the suite of fund finance options.

In hybrid facilities, the size of a fund finance package will be determined not just by the NAV of a fund's portfolio, but also any uncalled commitments still available to the manager from LPs.

Structuring these deals has proven challenging due to the different types of collateral involved, but lenders have navigated the differing credit review requirements to lay on hybrid facilities across the life of a fund.

Lenders have also responded to the growth of special accounts and single-asset deals in private markets by tailoring loans for these situations.

For NAV and subscription lines provided to funds with a single LP, lenders have gotten comfortable with LP concentration by enhancing the due diligence process. Lenders have also taken a granular approach to appraising the creditworthiness of portfolios to provide NAV facilities to single assets within a portfolio, but not others.

These innovations are driving expansion in the uses of fund finance and the types of assets it can cover, and bodes well for the market's growth trajectory.

This publication is provided for your convenience and does not constitute legal advice. This publication is protected by copyright.
© 2022 White & Case LLP

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