Just over a year ago, TPG broke new ground with an AUD$1.5 billion (USD$1.1 billion) unitranche debt package, which was used to recapitalize Australian pet care company Greencross—the largest Australian-dollar denominated unitranche deal for an Australian borrower to date. At the time, it appeared to herald a new dawn for the financing of acquisitions of Australian businesses backed by large private equity sponsors with Australian-dollar denominated leveraged financing comparable to the scale and sophistication of the financing options available in the European and North American leveraged finance markets.
However, since that time, as a result of current macroeconomic events, M&A activity has been subdued in Australia and New Zealand, which is consistent with the global market activity, as the combination of geopolitical uncertainty, inflation and corresponding increases in base rates have made price discovery for both sellers and buyers challenging.
Consequently, after recording a slight uptick from Q4 2022 to Q1 2023, leveraged loan values in the Australasian market, which includes Australia, New Zealand, Fiji and Papua New Guinea, declined from US$1.52 billion to less than half that (US$640 million) in Q2, despite a marginal increase in deal volumes.
But, as expectations increase of a bounce back in M&A activity in Australia and New Zealand in the second half of 2023, what will the leveraged finance market landscape look like for sponsors?
Prior to the Greencross transaction, the Australian leveraged finance market had shown signs of evolving from its traditional bank dominated origins in terms of the available sources of capital.
Historically, unlike larger and more developed markets such as those in Europe and North America where the combination of insurance and pension funds, mutual funds, retail-focused business development companies and CLO vehicles provide liquidity to the syndicated loan market, Australia and the Asia-Pacific region (APAC) were constrained in providing liquidity due to the lack of a deep institutional investor base.
However, since around 2016, the arrival of international credit funds and the launch of local Australian credit funds changed that by providing much needed diversity (and liquidity) for borrowers in the leveraged finance sector in Australia—a sector which is often a lower priority for local banks compared to the numerous opportunities available for low levered, long tenor financing for repeat issuers in Australia’s large infrastructure and commodities-focused project finance sector.
Additionally, such credit funds have provided an alternative source of capital to the US-style term loan B (TLB) financings that had gained popularity in the past couple of years for funding large-cap M&A transactions in Australia.
This development is reflected in the leveraged finance transactions for Australian borrowers that closed between 2018 and 2022, which also saw the emergence of four financing options: (i) traditional “senior bank” financing (meaning Australian domestic banks and/or the Australian branches of international banks); (ii) unitranche financing (either led by a bank or private credit fund); (iii) US-style TLB financing; and (iv) “Aussie TLB” financing (less frequently seen and a subset of the TLB financing option).
The key indicative features of these options are:
Competition expands sponsor choice
While recent history suggests the above financing options represent the primary options available to sponsors, increased competition (and liquidity) in the Australian market may potentially change and perhaps reinvent the market by expanding the options available to sponsors.
This competition comes in several forms, including:
- New entrants: The increased presence of “new entrant” international private credit funds in Australia, matching (within a certain size bracket and requiring the presence of a leverage maintenance financial covenant) the oversupply of private credit liquidity seen in the European and North American mid-markets;
- Increased “dedicated” capital in Australia and APAC: Established private credit funds in the Australian market increasingly raising dedicated capital for deployment in Australia and APAC (helping, in the case of private credit funds otherwise operating a global fund, to alleviate “relative value” arguments in comparing Australian transactions to those in Europe or North America);
- Private credit competing with public credit: For those global private credit funds able to raise significant dedicated APAC investment capital, and which are comfortable with cov-lite deals, the opportunity to compete with investment banks in the cov-lite TLB/high yield space—replicating the “Private Credit 2.0” model seen in Europe and North America where private credit funds have been underwriting US$1-$2 billion-plus financings with increased regularity since 2019;
- Superannuation and pension funds investing in private credit: The developing interest of Australian superannuation and pension funds to diversify into private credit as direct holders of investments (as opposed to any previous “indirect” exposure to private credit as investors in private credit funds), which has increased the depth of the local syndication market (notwithstanding that their ticket sizes remain modest compared to those typically found in other markets);
- Australia emerging as an attractive investment option: Banks, funds and institutions within the wider APAC region “pivoting south” in search of investment opportunities due to geopolitical concerns, and viewing Australia as representing an attractive option given its well established and reliable legal system;
- Investment banks and private credit funds working in partnership: The willingness of investment banks to partner with (non-affiliated) private credit funds to help underwrite TLB products (as an “anchor investor”) to mitigate syndication risk (and hence the attractiveness of the “partnership” product from both a pricing and an execution certainty standpoint);
- Investment banks offering “private credit” option: Investment banks developing increased capacity to underwrite and hold loans using dedicated pools of their own capital to provide a competitive, “in-house” non-syndicated alternative to private credit funds in certain instances;
- Increase in junior capital: The re-emergence of liquidity within the junior debt space in Australia (to help round out a sponsor’s required leverage), as the private credit market provides dedicated junior capital and/or more private credit funds seek to find yield accretive investments to help balance out their overall performance. Within this space, participants can now offer in the Australian market the same flexibility in terms of products and structures seen globally, with second lien, mezzanine, holdco (payment-in-kind) loans and preferred equity options available.
Backstopping this increased optionality is the underlying flexibility of the participants in the Australian leveraged finance market. What the market lacks in liquidity depth compared to Europe and North America, it makes up for it with its sense of familiarity and shared purpose. Generally, participants are not constrained by labels. Banks will arrange and underwrite unitranche financings in which private credit funds participate and vice versa. Moreover, private credit funds will participate in TLB options underwritten by banks, but equally they can act as arrangers and underwriters—willing to work together to provide solutions for sponsor relationships and the sectors and businesses they support.
Outlook for H2 2023
The challenge for sponsors looking to optimize this increased competition will be getting the mix of leverage, pricing, covenants and execution certainty set to their preferred tolerance level.
Key considerations will be:
- Leverage: A unitranche or TLB option offers increased leverage, but the concern will be the price to be paid for the increased multiples. The option remains to combine a “cheaper” traditional “senior bank” financing with a junior debt tranche (for a lower overall blended cost compared to the unitranche/TLB options), but questions remain whether Australia’s conservative traditional “senior bank” market will engage proactively on comparable intercreditor arrangements to those benefitting the junior capital community in the European and North American loan markets;
- Pricing: In this respect, the traditional “senior bank” financing provides an attractive (if lower levered) option, even on a blended basis if an additional junior debt tranche is required to provide the sponsor with the necessary debt-to-equity mix. On the unitranche side, pricing in Australia for sponsor backed deals has in recent times operated within a relatively “static” range but, given the returns available in Europe and North America, private credit funds may revisit this local nuance. Within the TLB space, sponsors will be concerned to understand and control the exercise of yield flex rights and the underwriters’ syndication strategy—but this will be influenced by the targeted syndication market (i.e., APAC vs. Europe/US);
- Covenants: Recent global events have shown sponsors the value of cov-lite deals (and avoiding the requirement to meet a maintenance leverage covenant every financial quarter in an uncertain macro environment), but currently, the pursuit of the cov-lite option steers a sponsor toward a syndicated TLB product. On the lender side, the concern in Australia will be that the lack of a maintenance leverage financial covenant will reduce the size of the potential Australian/APAC syndication market–meaning that the deal requires the ability (for example, size, rating and sponsor) to switch to the European and/or North American market. Lenders may also be concerned that recent Australian TLB failures, like GenesisCare, evidence the perils of not having a mechanism to bring underperforming credits to the negotiating table in time to avoid a formal insolvency process. Despite the attractiveness of the pricing on offer, a traditional “senior bank” financing will require a second maintenance financial covenant (usually interest cover) and in the current environment of rising bank base rates, “future proofing” applicable financial covenant tests will be a focus for sponsors;
- Execution certainty: In evaluating any financing option, a sponsor will be focused on locking in execution certainty. A priority will be placed on obtaining a fully underwritten financing option with limited and specific conditionality to funding (and, if applicable, flex rights). This will require a proactive approach to creating the optimal competitive environment—traditional “bank/private credit” dual track commitment phase processes may require supplementing by way of hybrid and offshore options.
There are already signs that the market dynamics are changing in line with the above observations, with the lines between product and lender siloes blurring as banks and private credit funds compete for business. As market conditions start to improve and new processes kick off in the second half of 2023, competition among the various financing options and lender constituencies promises to intensify. The hope among sponsors will be that increased optionality will combine with the Australian market’s traditional flexibility to positively impact Australian dollar-denominated debt availability, pricing and terms.