By Aymen Mahmoud, Samantha Koplik and Jun Won Kim.
Looking back on 2022 and beyond, hindsight gives greater visibility of the roots of the economic slowdown in the second half of 2022. But even those roots were insufficient on their own to precipitate that slowdown. For example, the delayed impacts of Covid-19 that were predicted by many did not singularly drive inflation rises. Interest rates, raw material costs arising out of conflict in Ukraine and broader geopolitical instability were meaningful contributors, as was the flux in UK politics and fiscal policy. Alongside these was the impact of a fatigued M&A market, where 2021 was so remarkable as to have, perhaps, overworked the M&A engine, with some refinements and repairs needing to be made. Together, these markers have brought about the economic indicators which signal stress and distress, and cause the kinds of financial markets where ‘special situations’ are prevalent and even performing credits see greater stress-testing among cautious participants: higher interest rates, greater consequential inflation, high raw material and energy prices, public market, and FX volatility all suggest a directional shift away from a prolonged period of cheap (and abundant) liquidity.
There may be some overstatement in the doom and gloom; looking to the past to inform current and future market behaviours where conventional wisdom has been modernized. While consumer discretionary spending is reduced as people tighten their belt, predicted slowdowns in other sectors do not seem to be taking hold – technology and SaaS businesses continue to drive activity alongside more defensive sectors such as healthcare. While exits and recapitalisations may have slowed temporarily, we appear to be more in a period of transactional reluctance than one of deep illiquidity. The European markets may see a slightly longer period of such reluctance on the whole, but we can likely expect the US markets to move out of a recessionary-styled position more quickly in 2023.
A key focus area between the buy-side and sell-side which has led to recent inactivity is the bid-ask misalignment of expected valuation multiples. As 2008 taught us, the relative absence of credit creates a more challenging private equity environment, but also causes lenders (and therefore borrowers) to closely examine the asset-class valuation multiples. That private market response is further driven by the impact in the equity markets, with widespread downward revaluation seen across numerous sectors in H2 2022. The sheer availability of dry powder within both equity and debt markets in recent times, alongside deployment incentives and a search for yield, created a thriving sell-side market. This, and the growth of competitive buyout markets, have continued to drive valuation multiples upwards, with buyers relying on exit valuations to create value as M&A volume reached all-time highs repeatedly in the 18 months following Covid-19.
Focus on valuations
The withdrawal of the credit markets and refocus on valuations will have multiple impacts, ranging from the NAV-based fund financings to new opportunities for this and other secondary type transactions to maximise value and returns. More generally the typical delay between buy-side and sell-side expectations converging should be short; with the huge amounts of committed, sophisticated and private capital available in the markets, which the money managers are paid to deploy, we can expect this realization period to be shorter in this part of the cycle than in previous years.
Within buyout documentation, transactions may be structured using increasingly back-ended economics, such as earn-outs to better align value with performance, or seller financing in the form of seller promissory notes. On the financing side, however, the key focus has been, and will continue to be, economics. There will be a very keen focus on ‘most favoured nation’ clauses in financing documents and in particular on the ability to subvert those provisions. Whilst European financings have always been more susceptible to workarounds for the most favoured nations compared to US markets, participants have typically respected the spirit of it. We may see more clubs of lenders and new lenders entering capital structures where an incumbent lender is more reluctant to deploy increased risk participation on a single credit; incumbents will be focused on any passive ability to reprice their facilities. This overall theme of bolstering economics helps lenders to adjust risk-pricing in a trickier environment and mitigate the impact of any blips in portfolios. For private credit, this continues to make their product offering attractive to investors who can already benefit from an inflation-adjusted asset class at a time where value may be harder to obtain. All-in yield will generally continue to remain higher than at more active periods, whether through fees, margin, call protection or some combination thereof.
There are various other M&A themes that we can expect to punctuate market behaviours in 2023, as participants seek to maximise value. One key theme, which will ultimately represent a continuation of the last few years, is buy-and-build. It has long been understood that adding appropriate synergistic businesses, either vertically or horizontally, tends to be more conservatively priced prior to acquisition than following integration into an existing business. Whilst this applies to the larger business transformative acquisitions which provide significant growth, a smaller add-on can yield a very significant return in relative terms and, if done systematically, in overall value. This investment thesis will likely be further supported through the ability of larger capital structures or more patient investor types being able to better withstand periods of economic stress than, for example, individual business owners or traditional banks, leading to an attractive arbitrage opportunity.
Challenges in equity markets also create arbitrage opportunities for private equity funds with available dry powder. As macroeconomic factors continue to put downward pressure on public markets as a whole, sometimes affecting public companies irrespective of their underlying value, private equity funds may face increased opportunities to acquire public targets at a discount. Accordingly, we would expect the take-private market to continue to remain globally relevant in 2023. Additional arbitrage opportunities may be available for US Dollar investors, even though Sterling rates have bounced back. It was less than ten years ago where £1 would cost you $1.65, so the relative pricing opportunity for US investors into European structures is still strong, even with Sterling priced around $1.20.
One interesting development that may continue to feature in 2023 is that of smaller private credit funds looking to help with the buy-and-build capital structures by providing liquidity at a lower pricing threshold than some of their more established competitors, in order to pick up market share. Effectively deploying funds during a period of reduced activity may well help to propel future fundraising rounds and stimulate LP interest, boosting those smaller funds in the same way as it did for today’s larger credit funds in previous years during periods of capital market inactivity.
To combat certain market risks, we have seen emergent trends appear: the well-heeled amend-and-extend or A&E and the return to focus of hedging exposures. For the latter, this touches on operational hedging, but more so relates to indebtedness – on both a floating-rate interest basis and a volatility of FX basis. Whilst not being required by lenders mandatorily en masse just yet, it remains a key focus area including for borrowers as they look to ensure that they are properly defending their capital investments within in an expensive market for derivative products. On the former issue, there have been a large number of borrowers opting to try to extend their maturities for 12 or 18 months in the belief that a more accessible lending market will be available in that extended period, versus seeking refinancing in the current environment. In a market where private credit has such a heavy participation, the benefits of ‘patient’ and less aggressively regulated capital can be seen with real clarity. Direct lenders don’t need to move precipitously during a period of underperformance in the same way that a more traditional lending bank would; they can instead work with companies to provide time and flexibility at an appropriate risk-adjusted cost where all stakeholders are likely to benefit.
That risk-adjusted economics here are a double-edged sword. For some credits, particularly though with publicly traded debt, there may be an arbitrage opportunity even for the borrowers. Being able to buy par debt back at a 20% or 30% discount may represent a sound economic investment in the secondary markets. We have seen this tactic deployed in the past, particularly in high-yield capital structures and, although the window for secondary trades in the immediate aftermath of Covid-19 was short, the current economic landscape may make these trades a far more interesting proposition.
An interesting counterpoint in light of the earlier discussions in this paper is that the jumbo deal being risk-on for a single credit institution is unlikely to be a feature of the near-term markets. As we can see from recent jumbo transactions, a number of lenders are needed to underwrite the credit. This means that there are a greater number of ‘take-and-hold’ participants, particularly in the private credit space, which also makes it potentially more difficult to obtain an amend and extend on an existing credit, or a covenant reset. That difficulty may only be logistical in substance, but it does mean that a hold-out lender becomes far more meaningful in an A&E situation.
What, then, of 2023 in real terms? Transactions may be slower, outside of trade buyer acquisitions. The increased focus on diligence and the care taken to ensure that eventualities have been carefully considered will show LPs that their asset managers have been vigilant in their investment analysis. This generally helps to ensure that a transactor does not feel that they have been first to act for fear of being shown-up by other market participants – there is always a feeling in the leveraged finance markets that one would not want to go first and look bad. This is also supported by the fact that lenders (particularly in the US) are once more focused on base rates even though initial indications from economists are that we won’t expect low interest rate floors in the near or even medium-term. That being said, a few deals opening up the markets and setting new market standards will likely also pave the way for a glut of transactions and activity across the private equity and financing gamut.
We can certainly expect more special situations financings in the next 12 months: those businesses that can be supported by patient capital, will be – at an appropriate price. For businesses where things have simply gone too far or where there is an unseen factor which precipitates a speedy decline, debtors can look to more modernized restructuring regimes across Europe, bringing them closer to the US systems to protect going concern viability. We can expect this to align well with public policy across Europe and the US, where governments will be keen to avoid increased rates of unemployment, particularly in the mid-market. It will be interesting to see what route is adopted by start-up or scale up businesses, which have been unable to weather more difficult conditions owing to their small size. Of course, there is the opportunistic M&A route above where a larger buyout house can pick up these types of company relatively cheaply, but we may instead see more creativity around these businesses merging with other business lines to consolidate and defend a strong underlying asset which faces only temporary difficulties. The scale-up and start-up communities are known both for their creativity and their willingness to help one another gratis. In any event, history has shown on many occasions that periods of stress or distress also create significant opportunity and the most creative actors are often those best-rewarded.
Aymen Mahmoud, Samantha Koplik and Jun Won Kim are partners at McDermott Will & Emery.