European M&A was already showing signs of deal fatigue at the start of year. Then events in Ukraine forced the market to pause, and capital was sidelined.
This slowdown in deal activity has taken its toll on the region’s leveraged finance markets. Leveraged loan issuance for M&A (excluding buyouts) across Western and Southern Europe fell to US$5.3 billion in H1 2022—an 82% drop, year-on-year. High yield bond issuance earmarked for these purposes was similarly affected, dropping 76% year-on-year to US$2.2 billion during the same period.
Admittedly, 2021 was an outlier. Markets re-opened as the pandemic eased, releasing pent-up demand that sent deal activity skyrocketing. European M&A value hit highs not seen since 2007 and volumes far surpassed previous records. It was inevitable that activity would return to more sustainable historic levels, as it has done globally.
But 2022 is proving to be a bit of an outlier as well. Companies across Europe began the year facing rising inflation that turned out to be not as transitory as many had hoped. The initial shock of the situation in Ukraine was supplanted by a new wave of supply chain disruptions, sending the price of commodities surging, including crude oil, and driving inflation even higher.
While all of this has not prevented M&A activity, it has made for a more cautious 2022. Dealmakers are paying closer attention to the robustness of supply chain processes when building their investment theses and conducting due diligence. Market participants are treading more carefully and that is likely to remain the case for at least a few more months or until inflationary volatility is brought under control.
In July, the IMF downgraded its global growth forecast for 2022 to 3.2%—0.4 percentage points lower than its previous forecast published in April 2022, and down from 6.1% last year. The organization cited events in Ukraine, inflation, rising interest rates and post-pandemic supply chain disruption as causes for this slowing economic activity.
Some companies are already projecting lower EBITDA for 2023—due not to a lack of demand for their products, but to their inability to meet that demand. And all of this comes after the intense fluctuations in earnings experienced during the pandemic.
Ultimately, this uncertainty has made the life of dealmakers more challenging. And yet deals continue to be made, with lenders gravitating towards resilient, growing credits from in-demand sectors.
Pockets of resilience
There is no shortage of demand among lenders to finance the right credits and some sectors are still considered safe bets despite the volatility.
For example, supply chain resilience is driving deals. According to Mergermarket data, the largest deal of Q1 was Blackstone's €21 billion recapitalization of Mileway, described by the PE house as the “largest private real estate transaction ever.”
Blackstone was already invested in the company—the largest last-mile logistics portfolio in Europe—and demonstrated its commitment to the asset by passing it to a separate fund for a longer-term hold. Logistics-related businesses are highly sought after by PE as the supply chain crisis motivates companies to shift from “just in time” to “just in case” inventory management, and ecommerce takes a growing share of retail and consumption activity.
The ongoing energy transition is another strong M&A motivator. In March, the UK's National Grid sold 60% of its gas transmission business to a consortium led by infrastructure investor Macquarie for £9.6 billion; the deal included an option agreement for the possible sale of the remaining 40% to the consortium. The grid operator is moving toward becoming a pure-play electricity provider as the country and the rest of Europe look to wean themselves off fossil fuels.
Case in point: AXA IM Alts and Crédit Agricole Assurances paid Norwegian energy company Ørsted €3.6 billion for a 50% stake in its 1.3 GW Hornsea 2 offshore wind farm, located off the UK coast. Once constructed, it is expected to be the world's largest offshore wind farm.
The European Parliament’s decision to approve draft EU rules labeling investments in nuclear power plants “climate-friendly” has also sparked interest in this area. British nuclear technology company Newcleo recently secured a £300 million equity raise and has an IPO with a unicorn valuation in its sights, while NuScale, which is to supply Poland and Romania with advanced modular reactors, listed in New York following a special purpose acquisition company deal.
Large deals in other sectors have also progressed in H1 2022, with consolidation continuing to drive activity despite macro-economic headwinds.
In the fragrances and flavorings industry, Dutch ingredients and bioscience group DSM proceeded with a €19 billion merger with Swiss fragrance and flavor specialist Firmenich in Q2 2022. The deal forms a player of global scale that is ideally placed to tap into the consumer trends of healthier eating and sustainable and biodegradable ingredient use. The transaction follows a series of other mergers in the market as companies combine to extend their reach geographically and expand their capabilities.
Consolidation has also been a feature in the telecoms space, with Orange and MasMovil announcing a US$19 billion deal to combine their operations in Spain and build a market player with the size to challenge dominant market player Telefonica.
Deals such as these will continue to attract lenders looking for the right opportunities even as storms prompt others to batten down the hatches.
All eyes on ESG
Sustainability and broader issues around environmental, social and corporate governance (ESG) are also influencing credit analysis among lenders. Companies that are not considered ESG-friendly may find it increasingly difficult to attract financing for M&A deals and, when they do, it could be on more onerous terms.
Regulation may be playing a role here, particularly among direct lending funds. Last year, the EU’s Sustainable Finance Disclosure Regulation (SFDR) came into force, requiring fund managers to disclose the extent to which sustainability is integrated into their strategy and investment decisions. Private debt funds aiming to become Article 8 funds will need to find an ESG justification for most of their deals to comply with SFDR and, ultimately, attract investment into the fund.
Direct lenders are turning to sustainability-linked loans (SLLs), featuring an ESG-related margin ratchet, typically with key performance indicators (KPIs) discussed between the lenders, the sponsor and management on closing the deal. There is a focus now on ensuring that these are not merely token, pro forma KPIs but genuinely ambitious and achievable targets.
Given the nascent nature of this feature in Europe's leveraged finance market, some borrowers may look to refinance these SLLs early to circumvent interest rate step-ups should they fail to meet their KPIs. This is unprecedented—if SLLs can be refinanced in perpetuity, then loan documents will need to be adapted to protect lenders' interests. Companies should also be mindful of the reputational fallout that could come from trying to avoid their agreed ESG obligations.
A solid start
Headwinds in the form of high costs, slowing growth, the ongoing situation in Ukraine as well as rising interest rates and increasing ESG expectations are putting European credits under the spotlight.
While last year's financing frenzy began with a rash of refinancing activity and finished with a certified M&A boom supported by the economic restart, the ball has now moved back into the lenders' court.
Any deals that do not quite pass muster—whether because of the sector in which they operate, the limited progress made in establishing and achieving measurable ESG targets, or due to any other relevant point of relative weakness—will have to pay higher coupons and concede tighter terms as quality takes precedence. And that is likely to continue until the dust settles.