European leveraged finance enters new era

High interest rates weighed down on deals, precipitating a drop in leveraged loan issuance in 2023. However, there are reasons to be optimistic that deal activity will pick up in 2024

As our latest leveraged finance report reveals, in 2023, financial sponsors grappled with one of the toughest deal financing environments since the global financial crisis, feeling the burden of severe monetary tightening and rapidly evolving market dynamics.

Steps taken by monetary policymakers at the European Central Bank (ECB) and Bank of England (BoE) to curtail inflation significantly impacted, and continue to impact, leveraged buyout deal structures in Europe.

Leveraged loan issuance was most noticeably affected, with 386 deals announced in Western and Southern Europe in 2023, down 6.8% compared to 2022 and the lowest total of the past eight years. The aggregate value of those transactions recorded a somewhat steeper year-on-year decline of 10.2%, from US$193.9 billion in 2022 to US$174.1 billion in 2023, again the lowest total since 2016, according to Debtwire Par.

However, the circumstances for European high yield bond issuance have been better. In 2023, Debtwire logged 196 such deals in Western and Southern Europe, up 43.1% from the previous year’s 137. In aggregate value terms, those bond issuances were worth a combined US$79.4 billion in 2023, up 47.3% year-on-year from US$53.9 billion.

Although fixed-rate, high yield bonds offered greater certainty on pricing in 2023’s high interest rate environment, their strong year-on-year performance must be considered in context, given that 2022 saw markedly low levels of high yield issuance. While 2023’s total of US$79.4 billion represented a welcome reprieve from the lowest point of 2022, that annual sum is nonetheless the second lowest of the past eight years.

Anticipated rate cuts

Elevated interest rates—which reached a 15-year high in the UK and their highest levels in the European Union since the launch of the euro in 1999—precipitated increased borrowing costs in 2023, making it challenging for sponsors to transact at desired valuations.

Despite these challenges, dealmakers are optimistic as interest rates stabilize, suggesting potential improvements in deal financing conditions as 2024 progresses. Signs suggest that central banks have come to the end of the recent cycle of rate hikes, with the US Federal Reserve, ECB and BoE holding rates steady at their end-of-January meetings.

With inflation trending down consistently during the past several months, arguments in favor of sooner-than-expected rate cuts, perhaps within just a few months, are beginning to gather support. For its part, the Federal Reserve has hinted that it will make three quarter-point rate cuts in 2024, though monetary policymakers around the world continue to manage expectations carefully.

Nonetheless, even if rate cuts materialize only in the latter half of 2024 in Europe, it is clear that rates have at least peaked. That now offers financial sponsors greater certainty when pricing deals and modeling appropriate leverage levels. This, in turn, could bring buyer and seller valuation expectations back in sync, revitalizing deal activity.

Refinancing familiar credits

Refinancing existing debt facilities emerged as a dominant trend in leveraged finance in 2023, with sponsors exploring opportunities for assets that require novel capital structures.

Refinancing markets have remained open to companies operating in popular sectors that have traded well over the past couple of years, as was the case in deals such as those struck by Zentiva Group and Pure Gym, which enjoyed robust investor support.

Debt costs have risen over the past year, but have remained within manageable limits, encouraging investment banks to organize refinancings for established borrowers who have a strong history of borrowing money through a best-efforts approach. Arranging banks have found it simpler to facilitate refinancings on this basis rather than providing the underwritten commitments that new deals demand. Even with interest rate cuts expected later this year, banks are cautious regarding syndication risk, stemming from previous instances where banks faced challenges syndicating debts, resulting in prolonged exposure.

Uninvested capital and exit potential

Another prospective driver of deal activity in 2024 is the growing sense of restlessness among investors. The private equity industry is under pressure to put to work its vast stores of capital—approximately US$2.6 trillion as of December 2023, up 8% from the prior year due to the slowdown in private equity dealmaking, according to S&P.

Moreover, on the sell-side, there is a sense of urgency for sponsors to deliver exits. According to Bain & Co, buyout funds are sitting on US$2.8 trillion in unexited assets, more than four times the level recorded during the global financial crisis and the highest level on record.

Given the incredible sums of uninvested capital and the need to distribute returns to their investors, sponsors will be under acute pressure to reengage with M&A markets following their 2023 hiatus.

Collectively, with an improving interest rate outlook, there is hope that this environment will soon become a much more conducive environment to dealmaking.

Private debt’s golden moment

Over the past 12 months within the private markets arena, private debt has been perhaps the hottest and most resilient asset class, with investor demand for these strategies proving to be very robust.

Amid rising interest rates, private debt showcased a strong portfolio performance and excellent returns. It has emerged as a primary source of finance, even for large-cap deals that used to be outside of private debt’s range. Today, sponsors can raise larger sums among private debt providers, with the latter also more frequently collaborating on transactions.

A valuable point of distinction in the private debt model’s favor is that the loans that lenders have on their books are typically held by a single lender or a small club, generally enabling swifter decision-making without having to navigate multiple layers of approvals. As such, larger financial institutions, including leading investment banks, are setting up their own private debt desks, adding another option to the funding mix. The market has also witnessed the emergence of private debt “CLOs”, offering distributable debt products and expanding the market reach of private debt lenders.

Signs of revival

Besides the successes of private debt lenders, there are signs of a revival of high yield and syndicated loan markets, illustrated by the US$8.65 billion bond and loan package that Chicago-based private equity firm GTCR was able to secure from a group of banks, including JP Morgan Chase, Goldman Sachs and Citi, for its carve-out of payments company Worldpay.

Should the loan and bond markets continue their recovery, offering sponsors reduced capital costs, a shift back to these traditional funding sources for deals may occur. This could prompt private debt funds to adjust pricing to maintain their market share gained over the past two years, introducing a new competitive dynamic in the financing landscape. Following a challenging period and with the expectation of lower interest rates, sponsors may soon find deal activity and financing alternatives opening up once more.

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