A Brightening Picture?

When writing for last year’s publication in spring 2023, there was no consensus on whether stress in the banking and wider financial sector in Europe and North America (triggered, in particular, by the travails of Silicon Valley Bank and Credit Suisse) had run its course or was a forerunner of more to come. We were pleased to observe that, in general, jittery markets calmed and, whilst there are areas and assets which remain on many “watch lists”, contagion did not spread wide and fast.

Nonetheless, interest rate hikes by central banks responding to inflationary pressure – and the predicting of (and sometimes pontificating on) if and when interest rates cuts will follow – continue to have many and various impacts on financial markets and their participants. Add to this the effect of (ensuing) economic and (separate) geopolitical instability on trading conditions and it was unsurprising that a slowdown in mergers and acquisitions activity – especially that driven by private equity – continued through 2023 and into 2024. Both the supply and demand for debt financing for acquisitions in the UK were affected – generally in proportion to how leveraged the proposed transaction would be. And so far, there has not been a lot of evidence of private equity sellers willing to drop prices to make leverage multiples (and absolute debt quantum) more palatable for prospective buyers – so-called narrowing of the valuation gap.

As the ultra-low rate environment which persisted during much of what might be described as the “boom” years of 2020 and 2021 has receded, the reckoning with a “new normal” of higher rates has more than begun. However, at a transactional level, (i) it remains difficult to gauge even near-term rates volatility (with implications for acquisition finance, including in relation to hedging strategies and refinancing risk) and (ii) constraints on otherwise free cash flow can be just too hard to bear for some businesses that, until fairly recently, might have been targeted or put up for sale (with creative financial engineering – including the use of “payment in kind” (PIK) interest and net asset value (NAV) financing discussed below – only able to soften, not remove, these hard realities). The prospect of lower returns due to a higher cost of debt is not an encouraging environment for private equity sponsors.

Whilst these challenges for sponsors and borrowers are not without concern to existing and prospective creditors, significant volumes of debt financing for acquisitions remain available. The attraction of floating rate loans on a higher reference rate as an investment (particularly in inflationary times), and manageable levels of default (so far), have added further capital to that already available to be deployed – luring arranging banks to return to the broadly syndicated leveraged loan (and high-yield bond) markets with the promise of CLO vehicles and other investors again hungry for paper. With this, it has been interesting to observe the rekindling of competition between banks and ever more established credit fund managers to finance large acquisitions. A number of recent and noteworthy take privates of public listed entities are a headline barometer of the improving health of financing markets. With deal processes often being run to pitch lenders in direct competition (whether to form part of a syndicate or to provide financing via an alternative structure), fear of missing out is again percolating. Consequently, the risk-driven upward repricing witnessed in 2022 and much of 2023 is abating – indeed, cheaper debt has been refinancing out more expensive credit fund debt in larger deals. Lenders must hope that laser focus on situation-specific credit quality (cue the need for robust due diligence) and broader underwriting standards will see them through any straitened economic, and/or geopolitically turbulent, times to come.

Prudence in the Midst of Some Exuberance

Weighing those factors that we can in the balance, absent further geopolitical shocks (which is not assured), we expect to see some increase in mergers and acquisitions activity through 2024 into 2025, particularly if and when long-anticipated base rate cuts eventuate – with associated rosier prospects for debt markets ready to finance it (and other event-driven capital raising).

Significant liquidity is waiting to be deployed

Deployment is a necessary part of the investment thesis – for both private equity and private credit funds. Many private equity funds have huge reserves of “dry powder”; and capital has been flowing into direct lending credit funds (as well as the CLOs and others investing in primary syndications and secondary trading of bank-arranged facilities). The attraction of the asset class is well shown by the wave of consolidation among credit fund managers and CLO platforms seeking the natural advantages of scale in a maturing market – a vibrant field for M&A in its own right!

Equity investors need to see returns on capital

This has certainly led to some sponsors being significantly more focused on selling than buying. The injection of leverage at fund level (NAV financing) at a cheaper price than at operating company level (due to the risk diversification inherent in portfolio-wide collateral), and re-leveraging performing operating companies to pay distributions to shareholders (so-called dividend recapitalisations), can usefully stave off pressure to sell at the wrong time.

The outlook is more stable

The flow of PE exits should increase with the stabilising of economic expectations steadying projections and, therefore, valuations. Anecdotally, it would seem that notably stark mismatches in the valuations of sellers and potential buyers are already less common than during 2023.

Debt is becoming cheaper

Debt availability and competition to lend to borrowers considered “good” credits (in a limited range of sectors less exposed to consumer pressures, including healthcare, technology, and business and financial services) have already started to improve pricing for borrowers. We see that trajectory continuing with:

• the resumption of activity in bank-arranged leveraged loans and high-yield bonds to rival direct lending from credit funds putting downward pressure on margins; and
• anticipated central bank rate cuts lowering currency-specific reference rates, which comprise the floating element of loan interest.

This should, in turn, lower necessary equity deployment and improve returns for sponsors.

There is opportunity in allied event-driven debt capital raising

For less favoured sectors in which mergers and acquisitions are currently out of reach, leveraged refinancings and dividend recapitalisations will feature prominently on the corporate finance agenda.

Lenders, especially credit funds, are generally providing follow-on funding by way of sign-posted incremental facilities for bolt-on acquisitions. Lender-supported “buy and build” strategies are still strongly in evidence. Whilst some leveraged businesses are challenged by the overall load of debt service costs under which they are now labouring, others are thriving and looking for opportunities to consolidate established businesses at attractive valuations – which could be ad hoc if they are the result of financial stress (if not distress) or a rare opportunity to acquire a marquee name.

Acquisitions made in 2023 that were initially funded by an “equity bridge” in preference to the debt terms then available may be looking to refinance (to the delight of sponsors if the economics, and even other terms, of the financing vindicate their decision to postpone).   

However, this does not represent the return of frenetic transactional activity à la 2020 to 2021. We anticipate prudent – even defensive – behaviour on the part of sponsors.

Careful sale processes

No-one wants to risk their asset or reputation being tainted by an unsuccessful process. This may drive the earlier involvement of potential lenders – for “lender education” exercises and even to offer (quasi) stapled acquisition financing that provide comfort to sellers and buyers alike as to price expectations and timely execution (stoking competitive tension along the way).

Discernment (notwithstanding liquidity)

We mentioned above lenders’ need for a laser focus on situation-specific credit quality. Sponsors must also be discerning in picking their counterparties: the value of having supportive lenders during pandemic-related disruption still resonates for many – a bulwark against future unknowns. This is offered as justification for continuing tight restrictions on loan transferability (at least in UK and European deals), which is of some concern to lenders to (potentially) more liquid names, where an option to trade out would offer some downside protection if the outlook for that business worsens in tandem with the economy.

Acceptance of lower leverage

Less focus on absolute debt quantum emphasises the financially sustainable solutions being sought by sophisticated sponsors attuned to the rates volatility discussed above (and should be an easy sell to lenders).

Strategic execution and operational excellence as differentiators

This is particularly pressing for sponsors which can no longer rely on cheap debt to flatter returns to their investors.

A focus on flexibility

Whilst there is less focus on opening leverage, there is (consequent upon the point above) more focus on ongoing flexibility to effect operational and strategic change. Depending on the business, there can be a number of aspects to this, though many converge on – often hotly negotiated – permitted adjustments to the calculation of EBITDA (earnings before interest, taxes, depreciation and amortisation): for the purposes of any relevant financial covenants (typical in the mid-market dominated by credit fund lenders, less so in larger-cap syndicated facilities) and any other tests, such as to determine the margin via a ratchet or regulate permitted incremental debt capacity for (initially uncommitted) follow-on funding, in each case based on a (pro forma) leverage ratio (net debt : EBITDA).

Applying (and stretching) the concept of potential costs and revenue “synergies” consequent upon various structural events brings unease to lenders on the lookout for artificial inflation of EBITDA. But sponsors consider available EBITDA “addbacks” as appropriate recognition of their efforts to grow, and perhaps even turn around, a business – from implementation (not completion) of cost saving and revenue growth strategies (subject to caps and other restrictions). Also, more influenced by the macro-economic outlook than a specific portfolio company’s trading projections, sponsors will be keen that further creative adjustments to EBITDA, such as for any increased interest rate hedging costs, are recognised as risk mitigants for lenders as well as the sponsor/borrower. And it should not be forgotten that close focus on EBITDA adjustments will only bear fruit if the headroom in any relevant financial covenant and other test is rigorously scrutinised against possible downside scenarios.

Open to Opportunities

Turning to more squarely consider the perspectives of (direct) lenders: it has been noted above that they are looking forward to supporting any uptick in mergers and acquisitions activity, though they have little appetite to return to the almost frenzied conditions of much of 2020 and 2021, which resulted in the relaxing of terms and tightening of pricing. A raised bar for credit approval is not (currently) lowering, meaning that, for a given lender, activity will be increased by more deals coming to market rather than participating in a higher percentage of those offered to it – discernment and discretion are seen as critical to successfully navigating a tricky landscape.

Macro-economic and geopolitical reasons for this relative conservatism have been noted above from sponsor and borrower perspectives – fund (and bank) lenders appear more attuned than ever to their counterparties’ challenges. We have also mentioned the knock-on effect of extended timeframes to exit for private equity sponsors, and there are similarly difficult trading and wider economic conditions for many non-sponsored borrowers, which may result in loan tenors – whether initial or as a result of extensions – stretching to continue to support underlying businesses. Although validating the approach of sponsors and borrowers in seeking out supportive lenders as a bulwark against future unknowns, these situations have knock-on effects of their own: lenders realise loan assets more slowly, which can challenge certain credit fund managers’ raising of new funds and prompt their stretching-out of an existing fund’s capacity. They do not feel a need to chase more speculative deals in order to deploy capital; and are willing to drop out of processes in which they are not comfortable.

The counterpoint is that when particularly attractive deals come to market there is strong appetite among lenders, which often results in multiple financing proposals being run hard in competition by sponsors and their debt and legal advisers keen to extract the best terms. For these deals, lenders are generally selected on pricing, though not always: flexibility to grow and, potentially, to return cash to a sponsor or management have also been in focus (in line with what we set out above).

Whilst challenging when entrenched in particularly competitive processes, lenders are making valiant attempts to tighten facility documentation where possible – at least to ensure that any (now) perceived loopholes are closed. Good documentation will not paper over the cracks of a bad credit, but it can avoid unwanted situations arising. There has been much discussion – and consternation – in response to (euphemistically named) “liability management transactions” (LMTs) which, taking advantage of loose documentary terms in US broadly syndicated leveraged loans (for the most part), have been imposed by stressed borrowers on incumbent lenders to the detriment of the priority of the latter’s claims. This would seem to have contributed to something of a broader reappraisal of contractual terms on even this side of the Atlantic (given the cross-border influence of US sponsors and US banks and credit funds), though the specific types of permissions most notoriously exploited in LMTs in the USA are generally not so available under English law governed facility and intercreditor documentation with a Loan Market Association (LMA) framework. 

Credit funds are also looking elsewhere for opportunities – which may involve fundraising for new strategies to increase their assets under management (AUM) or deploying existing funds (with sufficient strategic flexibility) other than towards the “classic” financing (or refinancing) of a private equity-backed leveraged buyout.

We could see private credit taking more business from banks in serving non-sponsored, mid-market corporates. For example, to finance strategic acquisitions of trade buyers. Providing allied corporate credit facilities (including revolving credit, overdrafts, bonds and guarantees and even derivatives) is not suited to most credit funds, though there are established structures to bring in one or more banks to provide these on a “super senior” basis. This may even work the other way, with credit funds being brought in by banks wishing to reduce their mid-market corporate business (whether for regulatory capital or other reasons).

Other situations where private credit might appear attractive include where a founder has invested significant equity and does not want to take venture debt or IPO, or where a corporate has outgrown bilateral relationship banks, been de-banked or is unable to find suitable bank lending.

Where flexibility and differentiation in strategy is particularly attractive in offering a credit-specific solution: structurally subordinated debt, equity and quasi-equity (for example, holdco PIK, equity co-investment, warrants and preferred equity) can all be on the table from credit fund lenders thinking laterally about risk and reward in a challenging trading environment – and some tightening of pricing has made them more viable. These instruments are already a feature of mid-market lending to sponsor-backed businesses not in favoured sectors or with a more challenging “story” – which can markedly alter the lender-sponsor dynamics, providing the former with more influence over structure and terms.

Interest accruing as PIK (ie, compounding rather than cash-pay interest) – whether as part of a senior financing or a separate junior capital instrument – reduces the cashflow impact of regular interest payments, and a separate junior instrument at holdco level reduces senior leverage without the need for more equity to be contributed. As anticipated in last year’s publication, it has been a popular feature. We have, therefore, noted with interest recent suggestions that the competitive advantage it gives credit funds that offer it to borrowers may dissipate as funds increasingly feel pressured to provide returns on capital to investors – they may prioritise cash-pay interest for that purpose.

Intriguingly, the NAV facilities briefly mentioned above as being made available to private equity funds have become a more mainstream product for credit funds as lenders. It is perhaps creativity in managing cashflow restrictions and operational impingements, and in bridging to liquidity events, that is gaining private credit more than a foothold in this increasingly important market allied to that for acquisition finance. 

Still Looking for a Sustainable Footing

There is continuing interest in sustainable finance. Whilst implementation and, most importantly, impact might not always be keeping pace with this interest, there are nonetheless some evolving trends to observe as the market contends with the environmental, social and governance (ESG) aspects of the loan product and the businesses of borrowers and lenders.

It is sustainability-linked loans (SLLs) that follow the LMA’s (and others’) Sustainability Linked Loan Principles (SLLPs) which are most in view as a “product” for acquisition finance. This is unsurprising when you compare their characteristics – which link pricing to the borrower’s achievement of sustainability performance objectives – with those of the alternative (or additional) green and social loans – which focus on the borrower’s use of loan proceeds. Financing an acquisition on the basis of the cash-generating potential of an operating target business provides a prime opportunity to support (or prompt) a borrower group in improving its sustainability credentials. This is an opportunity which lenders and borrowers appear keen to grasp – recognising that SLLs could help individual businesses and the wider economy transition to net-zero.

It seems the distinction drawn above between SLLs and loans which might be termed “ESG-linked” but which do not meet all of the components of the (voluntary) SLLPs will continue to generate debate, especially if the SLLPs and guidance surrounding them continue to be incrementally tightened to protect the integrity of SLLs and ward off allegations of “greenwashing”. Actually, these allegations may be more likely in respect of (i) the lack of materiality of the key performance indicators (KPIs) and ambition of the sustainability performance targets (SPTs) selected and calibrated by a borrower than (ii) dubious evidence of the borrower’s performance against those SPTs. However, it is the latter and not the former which is subject to mandatory independent and external review under the SLLPs. The high cost of this relative to the modest benefit of a reduction in margin has caused some borrowers to opt out of full compliance with the SLLPs. Whether, in time, “official” SLLs will become the only show in town for borrowers seeking loan pricing benefits for improving their sustainability performance is being closely watched.

In this regard, regulatory “nudges” provided publicly by the Financial Conduct Authority (FCA) in a letter to lenders active in this area have been well noted for the suggestion that the FCA is willing to introduce “further measures” to ensure the robustness of SLLs as an impactful part of the “transition finance ecosystem” (despite acknowledging it does not directly regulate the market in SLLs). This intervention may well have had a dampening effect on SLL volumes, though, timed with a decrease in acquisition finance volumes generally, it has probably given both lenders and borrowers a useful opportunity for reassessment of the materiality and ambition of what they have been seeking to achieve in sustainability terms.

Another challenge to implementing the SLL framework in acquisition finance facilities is the compressed timetables to which these transactions often have to run if funding is to be certain by the point at which the acquisition is to complete. This has led to the conclusion of what some call “sleeping” or “springing” SLLs, whereby the mechanics of an SLL are documented but the KPIs and SPTs are not included at the outset. As well as being attractive from a timing perspective, this approach has its merits (perhaps necessity) in allowing a purchaser to sufficiently understand the sustainability credentials and feasible trajectory of a business it acquires before it contractually commits to SPTs. However, there is significant potential for greenwashing. Guidance surrounding the SLLPs condones the approach in only exceptional circumstances and where properly scrutinised KPIs and SPTs are inserted within 12 months. Until that point, the arrangements must not be promoted as an SLL.

Since the 2023 publication of the LMA’s model provisions for SLLs, there have been fewer transactions on which they might conceivably be employed (as noted above), but their introduction – linking the SLLPs to LMA framework facility documentation – has rightly been viewed positively: helping to build deal-specific consensus, and a wider understanding, on how to document SLLs. They will help build momentum should SLLs again take off, permitting greater focus on what is most important for impact: the materiality of KPIs and ambition of SPTs.

SLL or not, it seems that lenders increasingly consider that the sustainability profile of a borrower is, to a noteworthy degree, a proxy for its resiliency – not least because, if a well future-proofed business is in present financial difficulties, its sponsor/shareholders may be more likely to support it.