Direct Lenders Set To Capture More Of The Multi Billion Leveraged Buyout Markets From Banks

Walgreens Boots Alliance’s recent shelving of plans to sell its UK high street pharmacy chain as private equity bidders were unable to raise the associated syndicated bank finance given market instability severely impacting funding?availability serves to underscore the major structural changes accelerating in the European leveraged buyout (‘LBO’) markets?in 2022. Investors are increasingly turning to alternative private institutional credit funds to secure funding for multi billion € mega LBO deals.?

Since the financial crisis of 2007/08, so called institutional ‘Direct Lending’ private credit funds have operated in the European mid-market replicating their success in the USA. But, until recently, only a few Direct Lenders have been able to commit to the size of loans required to finance?multi billion?€ LBO deals. However, over the last 2 years, record levels of funds have been raised by European Direct Lenders as investors have been attracted to the superior returns available in private markets. European direct lending fund raising in 2021 was a record US$44.2 bn according to Preqin.?Additionally, the rapid?convergence?of terms between Direct Lending facilities and public high yield bonds and LBO loans?underwitten?by banks and then sold or ‘syndicated’ to?institutional?investors in the liquid collateralised loan obligation ('CLO’) markets has accelerated these market developments.

As a result, post 2020, increasing numbers of European Direct Lenders have been able to participate in much larger €1 billion+ deals, previously the preserve of the bank led CLO or high yield bond markets. In June this year, U.K. payroll and software company?Access Group, announced it had secured new investment from its private equity owners alongside a reported landmark €2.3bn?unitranche?loan provided by Direct Lenders, the largest ever deal of its type completed in Europe. By comparison, geo political tensions and macro economic concerns have left the public debt markets dealing with strong headwinds in the first half of 2022; data from?Pitchbook LCD reports the new issuance of European leveraged?bank loans being just €28.1bn down sharply from €82bn last year. As a result, Direct Lenders are more frequently stepping in to fill this void and private equity funds are increasingly seeing Direct Lenders as a viable alternative to the high yield and bank syndicated CLO markets in the largest?transactions.?Indeed, we anticipate that Direct Lenders may pivot over the summer months to look at the pipeline of stalled deals in the underwritten public LBO markets, albeit on different pricing.

Direct Lenders point to their loans’ structural advantages in an environment where broader market uncertainty is on the up and likely to remain high in the second half of 2022. Typically, banks underwriting leveraged?loans?prior to their ‘syndication’ to?non-bank?investors have looked for the ability to change the interest rate on a loan to the extent that this is required to sell the facilities to investors. Conversely, Direct?Lenders?are able to make commitments to borrowers without these?‘market flex’ provisions thereby providing greater certainty of funding to buyers and sellers. Additionally, because their facilities are not syndicated and are held to maturity, typically Direct Lenders’ public information disclosure requirements are less and the timescales within which facilities can be arranged may be short.

Certainty comes at a price, Direct Lenders have historically required a premium to public markets where single-B rated?LBO credits were pricing in Q1 this year,?prior to public markets becoming challenging, at c.3.75% to 4.0% p.a over cost of funds; broadly,?1.5 to 2.0% p.a. lower than the Direct Lending markets. Today, recent commentary from PitchBook reports all in rates in Direct Lending at between 6% to 7% over the cost of funds ('SOFR') rate which is 1.5% p.a. We anticipate these rates may rise through the Autumn as lenders respond to ongoing macro volatility and our recent market experience suggests that rates are on the increase in certain sectors. In the ‘super heated’ buyout markets of recent years, bank syndicated facilities have increasingly had limited financial covenants and so called ‘cov-lite’ facilities have been the norm, mirroring the lack of covenants in the high yield markets. But, by the end of 2021,?competitive pressures have led to a convergence of terms between the Direct Lending and syndicated markets. Today, larger direct lending deals are similarly ‘cov lite.'?

What about the future in 2022 and beyond? In the short term, for a range of reasons, we see some Direct Lenders and investors pausing primary deal activity and deciding to take a break on new deals over the Summer after the frenetic pace of activity over the last 18 months. Public debt markets are likely to remain challenging and deals in sectors with the greatest exposures to macro economic uncertainty will face a much higher bar from lenders. But, beyond the Summer, with present uncertainty being the new norm, we see Direct Lenders increasingly being the default funding option in many areas of the LBO markets. More broadly, despite headwinds, we continue to anticipate 2022 being a very strong year for M&A driven by companies’ imperatives to acquire new technologies and talent, environmental, social and governance priorities,?supply chain optimisation, portfolio transactions and ongoing very strong overseas buyer interest in UK PLC.?