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European leveraged finance: From survive to thrive
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Five factors driving leveraged finance in 2022

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HEADLINES

  • Supply chain risks are going to be of increasing concern for lenders 
  • Inflation and interest rate rises may influence deals, even if they do not shift the market
  • Private equity (PE) is still on a spending spree that will influence debt market decisions
  • Lenders searching for yield will finance riskier credits on the right terms
  • Terms and documentation will continue to be influenced by credit quality, sector and rating

It was a year of rebounds in 2021, from the early hike in refinancing activity to the subsequent surge in M&A and buyout deals, as well as frenetic activity in the PE space, all of which contributed to a noteworthy uptick in leveraged loan, high yield bond and direct lending issuance.

The drivers underpinning this activity—from the deep pool of credit in the market to investors chasing higher-yield deals—continue to influence borrowing and lending decisions, including the changing levels of acceptable credit risk to the terms and documentation being put on the table. 

What does this mean for borrowers and lenders for the next 12 months? Here are five key trends that will drive activity in the market in 2022.

A key component of 2022 lender due diligence will be assessing supply chain risk and its potential impact on credit quality, in the same way that lenders scrutinised borrower exposure in the first months of the pandemic

 

1. Supply chain risk will be a significant blip on the lender radar

A key component of 2022 lender due diligence will be assessing supply chain risk and its potential impact on credit quality, in the same way that lenders scrutinised borrower exposure in the first months of the pandemic. At the time, lenders did not restrict their diligence to sales and EBITDA, doing far more work on understanding borrower markets, business models and downside risks.

Similar frameworks are now being applied to supply chain risk, as global shortages of key commodities (e.g., CO2 and oil) and components (e.g., semiconductor chips), as well as tight labour markets in areas such as logistics and shipping, increase the chances of business disruption and lost sales across European businesses. 

Some argue that this disruption is the short-term result of economies opening up post-COVID-19, generating a sudden rise in demand and creating a temporary bottleneck. For example, in the US, analysis from Debtwire Par, published in November 2021, shows imports increasing 20% year-on-year and 0.6% month-on-month, to an all-time high of US$289 billion by September (compared to US$260 billion in January 2021). 

At the same time, according to data from the Marine Exchange, there were 81 container ships in the waters surrounding the ports of Long Beach and Los Angeles—which, combined, handle 40% of the cargo containers entering the US. Pre-pandemic, it was rare for a single ship to have to wait for a berth. 

Any supply chain disruptions such as these in the months before a transaction may well form a red flag for some lenders, as it is not optimal to be forced to address supply chain issues and amend models in the period immediately following the funding of a deal. Such risks may increase business costs and delay tight delivery schedules, to say nothing of the potential loss in customers.

Borrowers will need a plan to address any supply chain concerns investors may have, whether shifting to local supply chains or ensuring enough of a stockpile to lock in prices until such shortages are worked out.

 

2. Inflation and interest rate rises will need to be watched carefully

Low interest rates supported the growth of leveraged finance markets in the past decade and helped lenders and borrowers navigate any disruption caused by the pandemic. The market, however, is becoming choppier, with inflation risks coming to the forefront and some effects being seen in the US and Europe. It is still unclear whether rising inflation is a short-term phenomenon, but interest rate rises are clearly on the cards. 

In a scenario where rates start to tick upwards, the question is whether a higher cost of capital will reduce borrower appetite and make leveraged finance credits less attractive for lenders. 

The answer depends on the speed and degree with which rates rise. Most investors will still have cash to deploy and will still be looking for attractive returns on risk. Inflation and interest rates may be back in the frame, but the risk/return picture will not necessarily change if rates rise, especially with enough warning. 

In November 2021, for example, European Central Bank President Christine Lagarde stated that 'conditions to raise rates are very unlikely to be satisfied' in 2022. 

In the UK, it's been a slightly different picture. The Monetary Policy Committee (MPC) held off raising rates for most of 2021 but, in November, when asked when it could happen, the governor of the Bank of England and chair of the MPC, Andrew Bailey, said, 'from now onwards'. Then, just one month later, that prediction came true, with the MPC voting to raise interest rates from 0.1% to 0.25%. 

The US Federal Reserve has also made it clear that they are likely to follow suit as soon as March 2022, which could have knock-on effects for borrowers and lenders in Europe as well.

If and when interest rates start to rise in the EU, volumes may drop off slightly as opportunistic borrowers fall away, but the fundamentals underlying the leveraged finance proposition will remain very much the same.

 

3. The PE spending spree has a way to go yet

Buyout-backed deal flow will remain a driving force in leveraged finance markets in 2022, as financial sponsors continue to raise, deploy and distribute capital at unprecedented levels. European buyout loan issuance soared 81% year-on-year to €66.7 billion in 2021, with high yield buyout provision ratcheting up 120% to €15.1 billion.

European exit and buyout value reached US$613.2 billion in 2021—the highest annual total on Mergermarket record, up 47% on its previous record year back in 2007 and more than triple in size from levels a decade ago. With global dry powder reserves topping US$3 trillion, there is little sign of PE's growth trajectory slowing down.

A bursting pipeline of buyout-backed financing deals coming to market—including the large debt packages that will be required to fund Clayton, Dubilier & Rice's £10 billion buyout of supermarket chain Morrisons and KKR's €33 billion bid for Telecom Italia (should the deal go ahead)—will provide lenders with a steady flow of work well into 2022.

 

4. Lenders searching for yield will broaden net and finance riskier credits 

Although COVID-19 variants, as well as the prospect of rising interest rates and inflation, all pose significant challenges for debt markets in the coming year, investors will remain open to backing the right lower-rated credits to lock in yields.

Lenders still have large pools of capital to deploy and are actively seeking opportunities to invest. For example, new CLO issuance in Europe climbed 75% to €38.5 billion in 2021, reaching a record monthly high of €6.3 billion in November. 

Lenders are still leaning towards high-quality issuers but have broadened their net in the past 12 months to include a higher proportion of credits with lower ratings. 

In the absence of higher-rated credits issuing debt at increased interest rates—which was a feature of the market's initial reaction to COVID-19 as borrowers topped up liquidity lines—B-rated credits accounted for a larger share of overall issuance in 2021 than in 2020. 

In 2022, investors will remain open to taking on more perceived risk in return for the higher pricing these issuers are offering. A wildcard will be whether the major ratings agencies see fit to downgrade a material number of credits as events unfold in 2022 and beyond.

 

5. Perspectives on credit quality will continue to affect terms and documentation

Even in a red-hot market, borrowers are not having it all their own way. Leveraged loan and high yield bond pricing moved higher in 2021, as did the number of margin flexes in syndication processes.

In 2022, if a higher volume of lower-rated credits come to market, lender and sponsor views on credit quality will determine what terms and pricing are made available.

Top-tier sponsors will continue to push hard for documentation flexibility on popular credits, and lenders will be willing to give more ground in these situations. Convergence with the looser US term loan B structures will continue apace on sought-after deals. For example, in limited cases, sponsors may be able to exclude revolving credit facilities from leverage limit calculations.

For deals that do not fly off the shelves, however, lenders and borrowers will be more prudent. Mid-tier sponsors will likely be more flexible and accept tighter documents and higher prices to close their deals, as a pragmatic tone will run through the market to continue to get deals done.

 

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European leveraged finance: From survive to thrive

 

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