Direct lenders in Europe feel relatively optimistic about 2023. But in an unpredictable environment it is far from clear whether managers should prepare for recession or business as usual.
“The market has seen time and time again all sorts of adversity, and I don’t see why it should collapse now,” one debt advisor said. “There are always going to be geopolitical or financial disruptions.”
However, private lending funds and banks are both reliant on private equity for deals, and activity is likely to remain suppressed early in the year.
“It won’t be easy. Deals are scarce, and will remain so until at least 2Q23, while we are going to see companies struggling considerably as energy costs will be even higher,” one M&A lawyer said.
Heavy leverage loads also threaten some businesses as energy prices and supply chain disruptions compound the aftermath of Covid, one banker explained.
“There is €200 billion of debt that needs to be refinanced by 2025, so issuers and debt providers alike will have to come to terms with that, and I hope the context will allow us to do it,” another banker said.
As of Dec. 31, there was €64 billion of loans outstanding in the Morningstar European Leveraged Loan Index (ELLI) due to mature by the end of 2025, according to LCD data. In the US, loans outstanding in the Morningstar LSTA Leveraged Loan Index due to mature by the end of 2025 totaled $280 billion.
As a result there will be significant refinancing this year, which private lenders will be happy to support. Longer holds by private equity as sponsors await a better exit moment will provide a window of opportunity for lenders to step in and extend looming maturities, a debt advisor explained. “For those companies facing periods of stress or near-term maturity, or otherwise lacking the desire to visit the refinancing markets for the time being, the amend-and-extend route seen throughout 2H22 will likely continue, paired with a covenant reset and some increased economics to take account of the change in risk profile.”
“While we may not see a huge wave of restructurings in 2023, we can certainly expect those businesses which are over-levered to need to enter into some form of consensual or other process to reduce their overall debt burden,” said Aymen Mahmoud, a partner at McDermott Will & Emery. “Covenants may not afford lenders a huge amount of protection in view of significant headroom and it may therefore be that solutions are only sought quite late in the day, necessitating a more robust process to ensure viability.”
In a difficult economic setting, private debt could be the big winner, however caution is the main watchword at the moment, and the liquid credit market is still not easy. “We have seen the syndicated loan market effectively shut for new transactions because CLOs were sidelined. And that pushed issuers to move to private lenders without hesitation,” one private debt manager says.
“We have seen a handful of smaller deals, and some CLOs are active, but overall the liquid market is still challenged. We constantly receive calls from sponsors that are looking for a private debt solution,” says Marc Chowrimootoo, managing director and portfolio manager at Hayfin.
“We have not yet seen the full effect that the macro environment, inflation, raising interest rates, the cost of energy and supply chain disruption will have on deals and on the portfolio altogether. But one thing is certain — everybody is adopting a more cautious approach now and monitoring is key,” Chowrimootoo adds. “Ultimately, this means spending more time with borrowers and owners and maybe even reviewing covenants.”
A trend that started during the Covid pandemic—whereby lenders became much closer to issuers and held regular board meetings to avoid a breach of covenants—is also helping to meet today’s economic challenges.
“But if one were to look in a crystal ball for 2023, we might see material differentiation in performance between those who've been disciplined and careful in their credit selection, and those who've been a little less so. So, I think there could be a lot of differentiation between managers,” Chowrimootoo says. What we see now will overflow onto next year, adds Chowrimootoo, while “nothing changes quickly,” he notes.
What we can expect in 2023 is the continuation of trends that started in 2022, sources say, such as more lender-friendly documentation, more conservative leverage, and pricing roughly 50 bps higher than before the war in Ukraine, while cov-lite supply may be difficult to find. For the right asset everything is possible, though it is definitely the end of cheap debt with skyrocketing leverage, sources note.
Club deals are plentiful again, not only because by replacing the broadly syndicated market, direct lenders started to club in order to be able to provide a bigger debt quantum, but also to reduce their exposure in a difficult market. “One reason sponsors have embraced clubbed transactions is that it can be more difficult to raise add-on capital from a sole lender, but it’s also challenging to bring new lenders into a syndicate when the capital structure is weighted towards the original lender,” Chowrimootoo says.
Lending banks are not gone, rather they are just going through a rough patch, and ultimately market participants will have to learn to co-exist. “As a bank you try to insert yourself in the structure with ancillary facilities which would be distributed to banks rather than CLOs, or even provide an RCF,” one lending banker said.
“However, if I lend you an ancillary, you have to give me your next deal. What is fair, is fair.” As for the broader economy, the same source notes: “This is not so bad, I think regulatory constrictions such as those from the ECB are more painful than the economic backdrop for us. The ECB is going through all the banks' leverage and is about to give its conclusions, but to be honest you do not want to increase your book too much because it can backfire.”
The broadly syndicated market has opened up recently. For instance, Ontario Teachers' Pension Plan-backed children’s nursery operator Busy Bees completed a €105 million fungible add-on to its E+375 term loan B due March 2028 at 92.5. J.P. Morgan was sole bookrunner here, with SMBC as administrative agent.
Elsewhere, Babilou priced a €110 million fungible add-on to its E+400 term loan due November 2027, at 95. BNP Paribas and J.P. Morgan were joint physical bookrunners. Babilou is an international childcare provider that operates firstly in France but also in the Netherlands, Germany and Luxembourg in Europe.
Although these are relatively small add-ons, “the pricing here is correct, it is not great but it is getting better,” one advisor said. “If the liquid market opens up, it will give more confidence to sponsors and will trickle down to the whole debt market.”
Meanwhile, private equity funds are still going to attract LPs, in spite of the so-called ‘denominator’ effect. “Europe has been incredibly successful. It started with Covid and coming out of that it is still a success story, which means there's still capital flowing in and we're still seeing funds raised—of which some might look a little bit different as GPs are becoming quite imaginative,” said Keith Miller, global head of private debt at Apex Group. “Indeed, some of the larger managers are bringing new sources of capital, and try to get beyond the mainstream investors.”
Overall, market observers agree that in spite of the market headwinds, the players at stake are strong enough to withhold even durable adverse trends. However, the next few months might be decisive for the weaker players as some portfolios will be more exposed than others. Funds will have to showcase creativity, with some already expanding into the secondary market as it is attracting more LPs who are selling their positions. Similarly, ESG remains paramount for investors, and soon even private debt funds will raise impact funds—just as the market has seen with PE funds.
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This article originally appeared on PitchBook News