Banking & Finance 2024

Overview: Investor Demand Drives an Active Market

To date in 2024, global leveraged finance activity has increased significantly, primarily due to a significant upturn in refinancing and repricing activity resulting in the highest seasonal volumes seen to date which are dramatically above the levels seen during the second half of 2022 and 2023. Amid cooling inflation, stabilised benchmark interest rates and favourable monetary policy, loan investor demand has increased significantly in 2024. However, although central bank interest rates are expected to decrease in the latter part of 2024, they remained relatively high for a significant portion of the year, and, to a large extent, the macroeconomic and political uncertainties that dampened market activity during the second half of 2022 and 2023 have not abated. M&A activity and other drivers of new issuances of leveraged loans have also remained relatively muted. Borrowers have instead focused on opportunistic transactions, with most of the increased leveraged finance activity observed in 2024 consisting primarily of repricings, maturity-driven refinancings and “amend and extend” transactions, and also increasingly dividend recapitalisations. As a whole, however, the size of the US and global leveraged loan markets has not changed materially during the most recent twelve months, as the modest volume of new issuances is offset by repayments of existing leveraged financings as borrowers seek to reduce their cost of debt capital in a continued high interest rate environment.

As the worst fears of a “hard landing” and more widespread failures in the banking system following the failures or near failures of banks like Credit Suisse and Silicon Valley Bank in 2023, have subsided, debt financing options available to borrowers have started to rebalance with the return of the broadly syndicated market in 2024 following the significant slowdown it experienced in the second half of 2022 and 2023. As a result, borrowers have sought to capitalise on the competitive tension between the syndicated and private capital markets by opting to run several transactions on a dual-track basis with both syndicated and private credit options.

Despite the increase in overall market activity, the low new transaction supply in the US and EMEA primary markets from 2022 and 2023 continues to exist. Borrowing costs, although generally coming down in 2024, remain high, and there is still a valuation gap in the M&A market between the prices at which sellers are willing to part with their assets (often purchased at high multiples prior to the decline in the markets in 2022 and 2023) and the prices that purchasers are willing to take these assets off sellers’ hands. The scarce exit opportunities for private equity sponsors are apparent in statistics showing that portfolio companies are held on average longer than at any point in the last decade (LCD). Issuances of leveraged loans used for dividend recapitalisations are also at record levels in 2024 as private equity sponsors seek alternative ways of realising cash returns on their investments in existing portfolio companies.

Although the recovery of the M&A market has been slow to date from its low in 2023, the market outlook is generally positive, with existing money transaction activity expected to remain high in light of upcoming debt maturities in the coming years and interest rates expected to come down further, as well as promising signs from private equity sponsors of improved pipelines for M&A activity as they look to deploy resources of dry powder they have accumulated. The secondary loan market remains stable in 2024, supported by high loan investor demand.

Some of the predominant themes seen so far this year are set out in further detail below.

Trends in a Recovering Market

The first half of 2024 has seen a continuation of the 2023 trend of arrangers and issuers both in the private and syndicated markets opportunistically pursuing repricings, refinancings and “amend-and-extend” transactions, in light of a falling interest rate environment and high investor demand. New acquisition financings and other primary issuance continue to recover (albeit slowly) after having been brought to a virtual standstill in the latter half of 2022. Overall US leveraged loan primary activity reached a record total of USD736 billion during the first half of 2024, surpassing the prior peak for the first half of any year since the 2008 financial crisis in 2017 (LCD). However, new issuances made up only a small portion of this activity, accounting for 18% and 13% in the first and second quarters of 2024, respectively. Although in absolute numbers, new issuances are up from 2024, as a percentage of the leveraged loan primary activity as a whole, new issuances are down from an average of 25% in 2023 and an average of 52% in the five years before the interest rate hikes began in 2022 (LCD). The position is similar in EMEA, with year-to-date leveraged loan issuance reaching EUR71.22 billion, an increase of 177% against the EUR25.68 billion issued in 2023 (LCD). Although overall M&A-driven issuance in Europe has remained subdued, M&A loan volumes for 2024 currently stand at EUR21.79 billion, which is an increase of 131% compared to 2023 (LCD). From a global perspective, the first half of 2024 ranks as the fourth largest opening period for private equity backed M&A since records began in 1980 (LSEG).

As demand has continued to increase throughout 2024, supply has remained relatively stable. As a result, both the broadly syndicated and private credit markets have seen increasing downward pressure on leveraged loan interest rate margins and other pricing terms. Borrowers have been able to obtain favourable pricing and covenant terms in the broadly syndicated market, which in the first quarter of 2024 resulted in broadly syndicated loans being used to refinance a number of private credit facilities which were coming out of their non-call periods. This has put pressure on the private credit market to reduce margins. As a result, transactions that have reached the market in 2024 have generally seen looser covenants and tighter margins than during 2023, with terms on the broadly syndicated and the private credit sides converging. In the second quarter of 2024, the private credit market managed to reverse the trend from the first quarter of borrowers returning to the broadly syndicated market.

The prevalence of direct lending clubs, which was a feature of the market in 2023 and facilitated larger transactions when the broadly syndicated market was not open to many borrowers, has also continued in 2024.

In the USA, direct lending accounted for an estimated 56% of the volume of new issue loans financing LBOs in the second quarter of 2024, which is consistent with the previous quarter but a substantial decrease from the fourth quarter of 2023, when it reached 88% (LCD). In Europe, the private credit market accounted for 68% of all LBO funding in the second quarter of 2024 and although a slight decrease from the previous three quarters when it reached 77%, 73% and 74% respectively (Debtwire), it demonstrates the important role that private credit providers continue to play in the leveraged loan market. However, with pressure from the broadly syndicated market, the private credit market has explored alternative options to provide liquidity both in the USA and in Europe, and as a result we have increasingly seen holdco PIK financings included in capital structures.

The market for lower rated borrowers is also returning as net demand is driving increased risk tolerance. In the second quarter of 2024, borrowers with a B- rating or lower from at least one credit rating agency accounted for 51% of the refinancing volume (up from 35% in the first quarter and 23% in 2023) (LCD). That risk tolerance is returning to the market is also seen in the second lien market where, after seeing almost no activity at all in 2023, second lien leveraged loans have started being issued in the US market in 2024, with USD3.61 billion issued in the second quarter (LFI). Another feature of the market in 2024 has been the inclusion of syndicated delayed draw term loans (DDTLs) on transactions funded in the broadly syndicated market. DDTLs can be attractive to private equity sponsors, particularly if they plan to pursue buy-and-build strategies. They are a feature of many private capital transactions, but historically, when seen in syndicated transactions, they were provided by club banks and no syndication was contemplated.

Although overshadowed in volume by repricing transactions, in response to improving borrowing terms, high investor demand and few exit opportunities, dividend recapitalisation activity reached USD35.3 billion in the US market through 11 June 2024, a figure comparable with the record years 2013 and 2021 for the same period (LCD). The volume of dividends taken out of businesses by private equity sponsors has also risen in EMEA, with EUR3.9 billion of total loan issuance supporting dividend recaps in the second quarter of 2024, which is the highest level since the first quarter of 2021 (LCD). For so long as the foregoing favourable market conditions remain, this trend is likely to continue. Further, as private equity sponsors seek alternative exit strategies, particularly where their investment time frame is coming to an end, portability features (ie, where a change of control will not trigger an event of default or mandatory prepayment subject to certain conditions) have increasingly made their way into credit documentation.

Covenant terms have generally remained borrower friendly in the first half of 2024 as demand has outweighed supply (CreditSights). As riskier borrowers have returned to the market, the average leverage ratio for speculative rating borrowers in 2024 is 4.7x, up slightly from 2023 but still below the levels seen in each of the years 2017-2022 (LCD). Even though interest spreads have been coming down so far in 2024, the continued high benchmark rates have led to the average interest coverage ratio at issuance coming down to 3.1x, which is the lowest level since 2007 (LCD).

As certain borrowers have continued to struggle with upcoming debt maturities and high borrowing costs, liability management transaction (LMT) activity and innovation have continued to gain speed in the first half of 2024, though new developments in case law may slow the momentum. The US bankruptcy court’s June 2023 ruling in the Serta Chapter 11 litigation, which upheld a contested up-tiering financing and focused on loose contractual provisions, is currently in the midst of appeal. Additionally, two recent lender favourable decisions came out of the Texas bankruptcy courts (Wesco/Incora and Robertshaw), which both stand in contrast to Serta and may represent a scaling back of LMT efficacy going forward. The rate at which new up-tiering transactions will be seen will depend on the results of these cases, and whether market stresses continue. Although there are some examples of LMT’s being executed in Europe, they remain relatively rare. However, given the general loosening of terms and covenant packages, borrowers continue to push for the inclusion of protections in documents to mitigate against these risks. Another development in response to the increased LMT activity is that the market is beginning to see lenders entering into co-operation agreements with respect to various types of restrictions on voting and trading of loans to seek to minimise the risk of LMTs to the parties’ detriment (Reorg).

Following significant activity in 2023 associated with the cessation of LIBOR and the transition to SOFR, 2024 is the first full year in which the market has entirely moved away from LIBOR. In the USA, the leveraged loan market has consolidated towards using Term SOFR as the main benchmark over other benchmark alternatives, with daily simple SOFR often seen as the primary backup option. In light of the fact that primary market activity in the USA is now primarily based on SOFR, and the advantageous pricing environment for borrowers in 2024, so-called credit spread adjustments for SOFR facilities are trending towards being reduced or removed, although spreads of 10/15/25 basis points or the ARCC-recommended spreads are still sometimes seen.

Sustainability-linked leveraged loans, which typically tie the interest margin charged to compliance with certain key performance indicators (KPIs), continued to grow in 2024 not only in EMEA (where they have traditionally been more commonly seen) but also in the USA. Accordingly, Q1 2024 saw the highest global Q1 volume of sustainability-linked loans since the inception of the market. Standard practices emerging include independent third-party verification of compliance with KPIs and fixed timeframes for KPI implementation when flexible ESG amendment features are included (where KPIs are set at a later date following closing). Pricing structures tied to KPIs allow for both margin increase and decrease. Advisory bodies such as the LMA and LSTA have also helped guide developments in standard provisions with updates to their sustainability principles and guidelines.

Conclusion

The past twelve months have seen a dramatic increase in leveraged loan market activity compared to 2022 and 2023, driven by increasing loan investor demand and stabilised central bank interest rate and inflation environments. However, the recovery of the new issuance activity remains slow against the backdrop of continued relatively high borrowing costs, scarce exit opportunities for sellers in the M&A market and macroeconomic uncertainty. Despite the slow M&A recovery, recent market developments, including ample loan investor demand, favourable borrower terms for the transactions that reach the market and improved M&A pipelines of private equity sponsors, give cause for optimism. As the coming twelve months unfold, if macroeconomic conditions continue to be stable and interest rates continue to decrease, there is cause for optimism that M&A activity will accelerate and the valuation gap between buyers and sellers will decrease, which would propel new money primary market activity. For borrowers continuing to struggle with borrowing costs, which remain high, the trend of increased liability management transactions activity is likely to continue.