Debt trends

Volumes

As a result of increasing syndication risk for large cap deals and with approximately €70bn of currently unsyndicated deals sitting on their balance sheets at the end of 2022, the appetite of bank underwriters waned considerably last year and volumes of leveraged loan and high yield bond issuance saw a dramatic decline in 2022, recording falls of 65% and 82% respectively. Total European transaction volumes fell 60% year-on-year to €38bn from €96bn in 2022 and sponsor-backed loan volumes fell-off 66% in 2023 to hit a meagre €36bn.

The level of attrition for mid-cap deals was less marked due to the lack of syndication issues, but the mid-market was not entirely immune to the wider political and macro-economic pressures that persisted throughout last year and have carried over into 2023.

Whilst the shutters largely went up on the broadly syndicated market, the increasing size and inherent flexibility of debt funds saw them remain more open for business and eager to deploy given their finite investment periods. This was perhaps best evidenced by a club of direct lenders backing the largest ever European unitranche in support of the £3.5bn financing for the Access Group.

In the absence of significant M&A activity levels, the focus for the start of 2023 is very much on refinancing existing assets and amend and extend processes, particularly where there is pressure on financial covenant headroom.

2023 outlook

With the various macro-challenges set to remain for the coming months we expect that the availability of financing for new money M&A transactions will remain tight, particularly in the large-cap syndicated and high yield markets. That said, we are a long way from the liquidity crisis experienced in 2008 and 2009 and with strong fundamentals continuing to underpin the asset class, interest costs and inflation arguably having peaked and the ramping-up of pressure to deploy what remain record levels of capital amongst PE houses and private credit funds, we expect that H2 of 2023 will start to see that pressure translate into the mid-market in particular moving back towards more typical levels of liquidity and functionality.

In the meantime, as sponsors shift their focus to portfolio management in the absence of new M&A, the wheels will continue to turn on bolt-on transactions with related incremental facility add-ons driving new money deployment across the market.

Portfolio management

Given the contraction in the M&A market and the strong headwinds being faced across numerous sectors, sponsors have been fully focused on reviewing their portfolios, either in terms of taking remedial action due to deteriorating financial condition or with a view to preparing businesses for future exit once the M&A markets recover.

The key contributors to the former are the dual pressures of rising inflation and interest rates. Whilst margins for new money deals and add-on incremental facilities have tightened slightly by comparison, the unprecedented jump in the floating rate element of interest costs for existing facilities has eroded free cashflow and liquidity reserves of operating businesses. Coupled with a reduction in core EBITDA due to inflation and supply chain issues, pressure is being put on financial covenant headroom, particularly cashflow and debt service cover tests but also incurrence or event-based tests, for example leverage tests for establishing and drawing new debt to fund acquisitions or pay dividends. This has led sponsors and their portfolio treasury teams, together with their legal advisers, to closely examine the terms of their finance documents to explore mitigatory actions, including broadening interpretations around EBITDA add-backs, increasing headroom by applying of cash overfunding for certain prescribed uses (for example acquisitions and capital expenditure) and extending interest periods to their maximum tenor.

In terms of interest cost and liquidity issues, certain levers are available for sponsors and borrowers to pull within the framework of existing documents to help ease immediate pressures. These include extending existing interest periods, toggling cash pay interest to PIK (or introducing new PIK tranches through existing incremental facilities, hollow tranches or structural adjustments provisions) and, as widely seen during the pandemic, drawing committed revolving facilities in full and parking cash.

Holdco PIK, back-leverage and ARR financing

Whilst there has been a fall-off in new M&A activity over the last 12 months, the popularity of Holdco PIK and back-leverage instruments on those sponsor-backed deals that have completed does not appear to be waning.

That is no surprise in view of the wider market conditions, as introducing PIK instruments into the wider capital structure enables sponsors to maximise their ability to target the most attractive assets. Although more expensive than cash-pay debt and attracting margins north of 10%, these instruments sit outside the main "senior" banking group and often do not themselves contain maintenance financial covenants and so their use should not impose any new financial covenant pressures.

Given the current state of the market, many PE houses are now looking to take minority stakes with a view to upscaling to a majority interest and refinancing as and when the costs of borrowing have returned closer to historic levels. Back-leverage instruments are typically used on such minority investments to leverage the sponsor's acquisition of the shares in the top company of the main newco stack and will, given their deep subordination, be structured as non-cash pay PIK, but will often contain a maintenance financial covenant that looks at the overall leverage of the back-leverage borrower and its subsidiary group, including the main operating group in which the senior debt is borrowed.

The popularity of financing deals structured on the basis of annual recurring revenue ("ARR") rather than more traditional EBITDA as a reporting measure has also become entrenched for certain sectors. We increasingly see these structures being used by PE houses to leverage nascent tech businesses where the first few years of operation may see the generation of little or no profit, but the reliability of what is often a subscription-based revenue model is used as the base reporting metric. Financial covenants in the first two to three years will typically test debt:ARR after which such tests will "flip" into a more traditional debt:EBITDA covenant. Interest will also typically be structured on a non-cash pay PIK basis for the ramp-up period given the lack of cashflow available to service debt in the early stages.

Hedging

The dramatic movements in base rates during 2022 brought into stark focus the need for businesses to proactively manage their exposures and protect themselves from such rises in order to preserve underlying cashflows and liquidity.

Businesses that had failed to properly hedge themselves by the end of H1 last year suffered the dual impact of both rising rates coupled with an uptick in higher hedging costs. The volatility in FX rates, in particular a much weakened sterling in the immediate aftermath of last Autumn's ill-received mini-budget, saw a number of business suffering both increased core supply chain costs and effective increased dollar borrowing costs where underlying cashflows were booked in sterling.

The importance of creating either a natural hedge against movements in FX rates, often by redenominating drawn debt into the currency of underlying cashflow, or taking out a FX hedge product, remains a top priority for sponsors and borrowers.

Whilst hedging cap products have become increasingly prevalent over recent years, they are typically much more expensive than rate swaps and require the payment of an upfront premium. With a focus on preserving cashflow and liquidity, many businesses have therefore been turning back to swaps as their hedging product of choice.

In terms of lender requirements, we have not yet seen any noticeable return to the inclusion of mandatory hedging provisions in finance documents, however it may be that they start to appear again in term sheet negotiations as we go through the next cycle.

ESG and sustainability-linked loans

ESG considerations have achieved elevated status for the majority of businesses over the last couple of years and will only continue to increase in importance given the ongoing evolution of the underlying regulatory frameworks.

In respect of the impact on debt markets, the main areas of focus in recent times have been on ESG-linked margin ratchets and related key performance indicators that underpin those ratchets. At an earlier stage of the evolution of such so called "sustainability-linked loans" the relevant provisions were created on a fairly rudimentary ad hoc, deal-by-deal basis and in many cases amounted to little more than an agreement to agree the relevant metrics with only very limited reductions in margin being achieved on satisfaction with what were very often surprisingly loose, easy to satisfy KPI's. In the face of perhaps predictable criticisms of "greenwashing", the treatment of ESG in the debt markets has now reached a new level of maturity as evidenced by the recent publication by both the Loan Market Association and the US Loan Syndications and Trading Association of defined principles that, as from 9 March 2023, require to be satisfied in order for a new loan to be classified as a green, social or sustainability-linked loan.

Growth

With the current slowdown in fresh M&A affecting the entire market and available leverage and documentation terms tightening, there have been no significant borrower-side improvements to finance documents over the last 12 months. Indeed, anecdotal evidence suggests that lenders are beginning to push back on high yield bond style covenant-lite loans (i.e. those with no maintenance financial covenants) even in the large-cap space. It has therefore generally been a case of ensuring that the borrower-friendly flexibilities and protections that have been hard won over recent years are not eroded. Given that platform assets underpin the investment cases of most PE houses and with bolt-on acquisitions accounting for a record 65% of all mid-market deals last year, the various tools under the finance documents that are required to support such inorganic growth remain in sharp focus. These include:

• permissions to make acquisitions (with related incurrence tests being calculated on a pro forma basis and no hard-wired cap on quantum).
• securing committed or incremental add-on facilities to fund acquisitions including the ability to re-lever back to opening leverage.
• financial covenant adjustments catering for acquisition synergies and ability to re-set covenant levels post-acquisition.

LIBOR discontinuation

The last 12 months have, thankfully, now seen full transition from LIBOR-linked facilities for sterling and dollar tranches to the new "risk-free" SONIA and SOFR rates respectively. All of our new money deals including sterling and dollar tranches have been papered using these replaced rates, with any remaining historic facilities also successfully transitioned from LIBOR to the new reference rates during the course of the last year.