2020 in review: When will direct lending’s real test begin?

Q4 2020

Feature

Karis Hustad

Reporter Debtwire

Carl-Johan Kullving

Nordics Reporter Debtwire

The industry spent 2020 in a holding pattern, with direct lenders waiting for the worst of the COVID-19 crisis to dissipate and reveal what parts of their businesses demanded the most attention

There was a certain amount of optimism at the start of 2020. Despite some visible cracks in second and third funds due to underperforming deals, market conditions were good and direct lenders were considering how to build on the success of the 2010s. Still, the industry forecast that a downturn was looming and Europe’s direct lending sector would see its first great test. When the COVID-19 pandemic struck, it seemed the test was about to begin: M&A tanked, fundraising suffered, pricing rocked and the market bifurcated as lenders patched up portfolios and took stock of restrictions ahead.

However, looking back at the last 10 months, it seems the industry has not been so much tested as put in a holding pattern, as government assistance programmes provided a buffer and lenders ran for cover in COVID-resilient industries. By the end of the year, leverage, margins and terms returned to pre-COVID levels.

“We invest with a long-term perspective and with good fundamentals, and I think we would have had a different approach to the sponsors if this was a real macro-economic crisis,” said a direct lender.

Still, the year was not business as usual, with plenty of quirks and lessons learned, as well as one major question that has been left unanswered so far: When will direct lending’s real test commence?

Buffer factors

The financial support and furlough packages introduced by European governments lead some people to argue that direct lending has yet to face a substantial challenge. PE houses were also able to direct cash towards portfolio companies in need of liquidity, with most lenders and sponsors able to work together to address potential covenant breaches and lack of cash flow.

Furthermore, the impact was unequal across industries: virus restrictions slammed certain sectors especially hard, such as travel, leisure retail and restaurants. While some of these have always been risky for leveraged finance, some seemingly certain bets — such as airplane- and airport-related services — did not pay off.

“COVID has been so specific in which industries it hit hard, so it’s difficult to see which direct lenders have been doing a bad job,” said a second direct lender.

Back to core business

While M&A activity dwindled as the pandemic began to surge in Europe, the market saw a recovery in H2. With most banks closed to activity, direct lenders had more optimism and could have a more opportunistic approach to the new deals that were testing the market. “The quality deals were very contested,” said a mid-market fund manager.

Pre-existing relationships between owners and lenders became even more important, as travel bans stamped out physical meetings. Some sell-side advisers also pushed for more transparency in the market by securing staple financing options in sale processes to make sure all PE bidders were able to bid, with lending alternatives secured at an early stage.

EBITDAC attack

While testing the boundaries of adjustments is not new in M&A, 2020’s unique conditions saw another letter affixed to the EBITDA acronym: C. EBITDAC — ‘EBITDA before COVID’ — has started to be used as a measurement. In some cases, sponsors are using the pandemic as an exceptional item, adding back items related to business interruption insurance, restructuring costs and lost revenue.

“People thought this was a joke at first, but no,” said an M&A adviser. “They look at monthly performance during the summer and then compare with performance during the second lockdown to argue what is the real performance of the business without COVID. I know, it’s extreme, but if a company is solid and there is good management, they go ahead.”

Structures that changed

The outbreak of the pandemic also introduced new ways to look at financial structures to create headroom and save space in case further liquidity needs arose. Lenders stood back from FOLOs, only fancied when margins and fees were higher and there was a possibility for a future refinancing. Club deals were also less common, as PE houses sped up auctions by pre-empting the hottest companies.

LP’s hunger for deployment continues

Despite the market uncertainty, LPs were willing to support the asset class. 2020 recorded a fundraising total of €16 billion across 15 funds that had final close. Still, it was a huge drop from 2019, when 23 funds had final close with a total amount of €37 billion, according to Debtwire Funds Data.

“The fundraising has been going very well. The LPs are still trusting us and the business model – that feels good. But I know some competitors that are struggling,” said the second direct lender.

After a quiet start to Q3, the auction pipeline has picked up significantly, with vendors keen to hit the market with assets that were ready for sale pre-lockdown

The year in numbers

Direct lending loan volumes in the mid-market space dropped to €4.1 billion in 2020, far below the €6.5 billion in 2019, according to Debtwire Par. Nonetheless, margins have managed to recover to their pre-COVID levels. Average margins for unitranches averaged 700 bps in Q1 and Q2, dropping to 625 bps in Q3 before rebounding to 675 bps in Q4.

Average leverage levels for unitranches started on an all-time high in Q1 at 6.6x but plunged to 4.1x in Q2. The market saw some recovery in Q3 as levels climbed to 5.5x, ending in the last three months of the year with an average of around 5.3x.

Start of the roaring 20s?

In some ways, it seems the industry has weathered the storm and optimism might return for 2021, particularly with vaccines being rolled out across Europe and Brexit finally done. Government spending on COVID-19 support has created a window for M&A to push forward ahead of March, and companies are preparing for a wave of economic activity as restrictions lift.

However, in the light of emerging coronavirus variants, renewed lockdowns and unguaranteed government support, lenders might need to prepare themselves for another spring of covenant renegotiations, equity injections and restructurings. The pandemic is far from over – and the real test is perhaps yet to come.

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