Q2 2021
Expectations begin to soar as economies rebound
Michelle D’Souza
As an asset class, direct lending has more than proved its resilience, but players recognise Europe is not yet entirely out of the pandemic woods
Direct lenders have a lot to feel optimistic about. Vaccine rollouts across Europe are progressing, there is greater visibility on recoveries, and there is a strong runway for M&A and leveraged buyouts.
But doubts still linger. Market sources express caution over elevated leverage, inflation fears and possible future stress in portfolios in the event strict coronavirus restrictions are reinstated.
It’s never been busier
David Ross, managing director and head of private credit at Northleaf Capital Partners, says three factors are driving expectations of high volumes in the near term. “Performance of underlying borrowers has been strong across the board; borrowers are achieving healthy margins and have ample liquidity,” he says. “This existing base of borrowers is looking to buy and grow, so there’s strategic demand for credit there.”
Supply-demand dynamics with PE and private credit dry powder is another component — there is a huge supply of €150 billion in dry powder floating in the market.
Finally, enterprise values are elevated, which makes finding attractive relative value and risk-adjusted return more challenging, but it also leads to higher demand for private credit. “If people are paying 20x multiple, and levering seven times, the size of the equity and debt tranches increases,” says Ross.
Floris Hovingh, managing director at Alvarez & Marsal’s debt advisory team, agrees. “Deal flow was up significantly in Q2 due to pent-up demand — the taps got turned on in Q4 and it hasn’t stopped,” he says. “There has been lot of buy-side activity and we are now busy again working on sell-side for projects launching in September.”
He says much of the activity is on the new deal side, but some PE firms are looking to take advantage of buoyant debt markets to refinance stronger companies whose positions improved during the pandemic and pay themselves a dividend.
Blair Jacobson, partner and co-head of European credit at Ares, explains his group has never been busier, and the deal pipeline is getting more diversified as the M&A landscape broadens. “As the market recovered in Q3/Q4 2020, M&A deal flow was focused on safer sectors that weren’t COVID impacted, like software and healthcare. That broadened out to lockdown impacted sectors — like dentistry and vet care — and now it’s going a step further, where there are companies that are trying to take advantage of COVID rebounds from further lockdown-impacted sectors.”
With lenders eyeing similar defensive assets, some European direct lenders have also pushed the boundaries from a geographic and deal flow perspective to avoid competitive terms and pick up a premium.
Alex Griffith, partner at law firm Proskauer, says the firm is seeing an expansion of origination across Europe: “We are regularly doing deals that are in jurisdictions that, perhaps 12-18 months ago, we wouldn’t have touched, for example in Eastern Europe and a number of smaller Mediterranean countries.”
He adds, “Direct lending as a product offering is much more widely accepted — partly because regs have opened up to allow direct lending, and partly because people are looking for money when other sources, such as banks, are pulling back.”
London-based Griffith also says direct lending products are being offered for a wider group of purposes, adding that there have been an increased number of non-sponsored deals alongside new sectors such as sports finance. “Sports finance wasn’t an industry direct lenders traditionally looked at, but as sports franchises have commercialised, direct lenders have found creative funding solutions.”
Public to private deals increased, with Morrisons becoming a feeding frenzy, while Ares helped delist TalkTalk.
Direct lenders raising larger funds and their ability to speak for a large capital size while remaining diversified has also led market participants to forecast the growth of mega €1 billion deals in the region. Ares, for example, raised the largest ever European direct lending fund, with €15 billion to deploy. Larger sponsors and corporates now know that direct lenders can offer credible solutions versus capital markets.
Competitive terms
Sponsors and debt advisors continue to push headroom into covenant numbers. Lenders say headroom is around 35%-40% on deals, with term sheet stages at 40% and terms being squeezed back down to 30%-35% by the time they get to the documentation. Flexibility on synergies, which has been prevalent in the large-cap market for several years, has also made its way down to the upper middle market on several deals.
“We’ve seen sponsors trying to widen the scope of synergies, looking beyond just the usual acquisition and disposal activities to a much wider set of actions and with a longer period of time to achieve them than the 12 months previously set for these goals, with some direct lenders agreeing to maybe 18, even 24 months,” explains Griffith.
Some market participants express concern over elevated leverage in deals, with one source citing an 8.5 cov-lite unitranche facility Belgian industrials asset Desotac, financed by Macquarie and Blackstone Credit. But others argue that while leverage is in the top decile of historical periods, free cash flow and loan-to-values are in a moderate position, driven by low interest rates and strong margins.
“All in all, we are in an environment that’s okay — as long as we see consistent deleveraging from these borrowers, which is the intent,” says Ross. “I don’t see any catalyst for broad dislocation or borrower difficulty, but there may be concerns if continued levels of elevated leverage persist.”
Lenders hold their breath
Direct lenders have prided themselves on supporting businesses through the pandemic and sources say there has been pause over the last quarter with defaults and restructurings.
“We had a spate of work over last summer and by the end of last year there were a few assets that weren’t going to work from a capital structure perspective. They had run out of money and sponsors were out, so there were a couple of instances where lenders took the key in Q4,” says one source. “Since then, however, it has quietened down.”
At the time of writing, daily COVID cases in the UK are steadily declining. But as the economy reopens and new coronavirus variants emerge, it’s not inconceivable that governments could reintroduce some restrictions if cases begin to climb, which could put pressure on businesses.
“Direct lenders were very forthcoming in helping out businesses, but maybe this time around there may be more pressure on them to recover their debt and exit from challenged structures,” says Griffith. “I’m not aware of much investor pressure on them to be more reactive and aggressive, and perhaps that will make the decision for them — until their LPs and stakeholders say, they will continue to try and keep things going.”
Lenders also have strong relationships with sponsors they would prefer not to tarnish, and clearly they are incentivised to find a route out in a good way rather than bad way, he says.
“We’ve heard managers saying if they get into another lockdown, they might not be able to cope again — they burned all their bridges and did everything they could the last time around,” says one source. “There could be some casualties if we did.”
“Lenders are just holding their breath slightly,” says another direct lender, adding he wouldn’t be surprised if there were a few more casualties throughout this year unless the economy flies. “Some of these businesses are now gearing up again and they need a lot of capex and working capital to take on staff and get going again. That’s not cheap, and I can see that effort from a financial perspective really hurting some businesses. People may get caught out.”
Ares’ Jacobson says conventional wisdom in direct lending is that when a company gets stressed, a sponsor will support them once and usually twice in terms of additional liquidity support. “Three times, however, gets a lot tougher — so it will depend on the company, situation, sector, and it’s hard to generalise,” he explains. “Sponsors have a different calculus than we do, so the market could see problems in some of the harder affected sectors.”
He adds that Ares is considering stress testing all of its portfolio companies so it can see what happens if 2022 looks like 2020, given there are still so many unanswered questions about the pandemic: Will vaccines work as effectively against variants? Will cases rise? Will lockdowns be reinstated?
Inflation and Libor
Inflation has been front of mind of late, but direct lenders say that, while they are keeping an eye on a potential rise, they are not terribly concerned about it having a marked impact on their portfolio. In addition, direct lending loans are floating rate.
“Inflation is intertwined in the labour and commodities aspect of portfolio companies and most of our companies are service companies,” says one direct lender. “We’re not seeing a major impact — most of these companies can raise prices to help compensate.”
“Equity markets have been booming and, in general, inflation is not the friend of equity markets,” says another direct lender. “Depending on where things get to in the next several months, could we see some equity market pull-back as a result? Yes. We are mindful of loan-to-values. If that denominator shrinks, our risk theoretically goes up.”
The deadline for the Libor transition is also approaching. Up until relatively recently, Libor transitioning was just an ad hoc occurrence that was being done in conjunction with deals that needed tweaking. But by the end of this year, all deals need to reference the Sterling Overnight Indexed Average (Sonia).
“Libor transitioning will be a headache for direct lenders for the rest of the year, with all portfolio deals requiring to move over to Sonia,” says Griffith. “That may take up some bandwidth in the funds who are keen to do origination.”
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European Direct Lending Perspectives
Q2 2021
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