European Debt Finance Intelligence Report 2023Navigating mid-market terms in an uncertain world
2022 was a relatively challenging market, at least compared to a record-breaking 2021. The financial markets were dislocated throughout much of 2022 because of geo-political events. The high yield debt capital markets / bond markets were mainly shut, and several large-cap leveraged deals were hung in syndication. That lack of liquidity saw a number of the larger direct lending funds fill the gap, in turn leaving a partial vacuum in mid-cap liquidity. Additionally, the lack of lender appetite for some assets (or at least at leverage levels seen in 2021), plus the gap between the value expectations of buyers and sellers, saw a number of sales processes flip into recaps/refinancing.
Generally, we saw deals taking longer to commit and/or close, with lenders asking more questions, and taking more time to diligence, potential investment opportunities.
Now we are into 2023, it still feels too early to call.
“Many participants expect a subdued H1 but with momentum picking up as we move through the year. There is just too much dry powder – both debt and equity – for people to stay out of the market for too long.”
Mapping international trends
DLA Piper works on more M&A transactions than any other law firm in the UK, Europe and worldwide, and has done for each of the last twelve years (according to Mergermarket). We have a fully integrated European leveraged finance team operating across all the major financial centres.
Consequently, we have unrivalled access to transaction data. The data referenced in this report is taken from over 100 of our 2021/2022 sponsor-backed European leveraged finance transactions.
In this report, we’ve applied a risk management lens to this data to provide quantitative and meaningful trend analysis and insights on some of the key issues that matter to both lenders and sponsors/borrowers in times of uncertainty.
It comes as no real surprise that it is now relatively common for European mid-market deals to have only one maintenance financial covenant. Documentary convergence between the large-cap and mid-market is by no means a new concept, but our data shows us that the mid-market generally continues to resist the cov-lite structures associated with the large-cap market (save perhaps in some deals in the upper mid-market).
“As a result of the challenging economic environment and the strain this is causing on borrower balance sheets, we expect the upward trend of covenant waivers and resets will continue well into 2023.”
PRICING AND HEDGING
Across the European mid-market, we have seen margin pricing move upwards over the past year, with upfront fees increased in the bank space, and featuring as a competitive negotiation tool in the private credit funds space.
Given current economic conditions, central bank rate rises to try to tame inflation, and consequential increase in reference rates, aggregate interest rates are a critical consideration for all borrowers.
Sponsors have taken advantage of the competitive capital deployment market of recent years to continue to push for increasingly restrictive conditions around loan transferability.
Our data shows that common restrictions include transfers to distressed investors (usually unless a credit-related Event of Default is continuing) or to industry competitors (in all circumstances).
Our deal data shows that equity cures and deemed cures are very much an accepted part of the mid-market landscape. The ability for a sponsor to cure a financial covenant breach by contributing additional capital may be useful in some circumstances (although in practice, in many cases, a sponsor will often look for a broader restructure/reset in return for additional equity).
Mid-market direct lenders: Challenges and opportunities
Lack of quality assets coming to market
Special situation-type funds
Comparing the approach of lenders
In the European mid-market, banks continue to look for ways to compete with private credit. Despite the potential for a meaningful economic downturn, there is still significant competition in the leveraged lending market, and in part, this is due to the ever-growing market share of funds (and the (still) huge amounts of undeployed capital).
As we look back over 2022, we have continued to see a growing number of banks establish affiliated private credit funds in order to try and compete with their counterparts in the direct lending space, at least in terms of amount of capital available from ‘one’ institution. As we look to the year ahead, we expect competitive tensions to remain, and we may in fact see these tensions rise if market uncertainties result in a softening in deal flow.
The direction of travel in relation to ESG is clear and, given the uncertainty in the market, tackling ESG-related issues might well be the key to unlocking long-term viability for some businesses.
While the LMA Leveraged Finance Facilities Agreement does not yet cater for ESG margin ratchet conditions, margin adjustments linked to the satisfaction of pre-agreed sustainability or ESG objectives have been a hot topic of discussion.
Term under the spotlight
A concept first conceived in the US high yield bond market which has, over the years, made its way into mid-market loan documentation as lenders look to protect their yield if a loan is voluntarily prepaid in advance of its stated maturity. While the concept of call protection is a fairly standard market provision, its relevance, scope and application will vary from deal to deal.
In addition, the refinancing risk profile of each deal is inherently different. Lenders may therefore take into account a number of factors before determining the degree of call protection (if any) they deem necessary.
“Arguably, the redeemable nature of a loan is at cross-purposes with achieving a fixed return for investors; however, call protection (among other tools) offers a private credit a way of mitigating that risk.”
Super senior and unitranche lender interactions
Mid-market participants will of course be very familiar with super senior – unitranche structures. This can be a capital structure that works well for all parties – the sponsor gets the leverage it needs from the (usually sole) credit fund, as opposed to a club of bank lenders, and the super senior bank lender benefits from ancillary income, and potentially term facility margin on a FOLO structure, whilst of course being paid first in a downside situation.
“The best outcomes we’ve seen [in distressed situations] – for funders and sponsors – have been on deals when there’s been good engagement with all parties in the capital structure and as a result each one of them has stepped up to provide further support for the borrower.”
It’s market standard for unitranche lenders to benefit from fair value protections. These protections require that the super senior lenders may only release the unitranche liabilities on the implementation of a distressed disposal if the super senior enforcement is:
- by way of a competitive sales process run by an internationally recognised investment bank/accountancy firm;
- a process approved or supervised by a court; or
- where a financial adviser has delivered a fairness opinion (stating that the enforcement proceeds are "fair from a financial point of view taking in to account all relevant circumstances, including, without limitation, the method of enforcement or disposal").
Managing portfolios – documentary terms and flexibilities
Notwithstanding the significant macro headwinds, sponsors have to date successfully managed to hold their ground on terms, but we will be watching this space carefully.
The market has certainly become used to the terms and flexibilities driven by sponsors in recent years and, while we don’t necessarily expect to see the market regress back to the days of multiple maintenance financial covenants and a wholesale tightening of terms, we do expect lenders to exercise caution in the coming months.