The past year has proved to be a game of two halves for European mid-market debt. After a strong start to 2020, deal volume fell considerably during the second and third quarters as covid-19 struck and banks and debt funds prioritised existing clients and portfolio companies.
However, the sight of markets recovering from the initial shock and news of a global vaccine rollout sparked optimism, which resulted in activity rebounding strongly in the fourth quarter, and momentum continuing into 2021.
There are reasons to be cautious, with economic activity this year expected to remain below pre-pandemic levels and considerable uncertainty over the long-term impacts of covid. However, the positive developments seen in recent months suggests that debt activity levels will remain robust throughout 2021.
Liquidity aided market rebound
In the first half of 2020 lender risk appetite in mid-market debt reduced drastically, a trend compounded by the strain placed on banks as they were tasked with implementing various government loan schemes. A number of the banks that handled these covid relief programmes were forced to further limit their bandwidth to take on new clients.
This reduction in funding, alongside increased risk premiums, caused yields to spike. In addition, a significant amount of M&A processes were either withdrawn or paused as deal stakeholders navigated uncharted territory. The deal count in the UK asset-backed loans market was also subdued, although less volatile compared with the leveraged loans space, with lenders heavily focused on the smaller end of the market and existing commitments and clients.
As lenders and investors adapted to the new normal, market sentiment began to improve over the summer of 2020, giving rise to greater activity in the leveraged loans sector. By the fourth quarter, a combination of pent-up private equity demand and high levels of debt fund dry powder resulted in a strong rebound in the market, with 172 deals reported, compared with a low of 89 in Q3.
At the close of 2020, private debt fund dry powder levels across all European lending strategies hit $105 billion – the second-highest level since the end of 2018. The considerable amount of capital – compounded by the need to put cash to work, particularly among private equity and debt funds under pressure to make returns for limited partners – should provide borrowers with confidence that liquidity in the market remains strong.
Flight to safety
Widespread uncertainty in the financial markets at the beginning of the pandemic also prompted lenders and investors to shift their focus to so-called defensive sectors, including tech/software, business services and healthcare. This quickly resulted in more competitive bid processes in these sectors, with debt prices and terms returning to pre-pandemic levels.
In contrast, sectors that have been more severely impacted by the pandemic, such as travel and aerospace, have struggled to attract loans from mainstream lenders and have relied more on support from governments and existing stakeholders.
In total, more than two-thirds (69 percent) of debt transactions during the second half of 2020 were in defensive sectors.
Lender appetite for more cyclical sectors is expected to return as economies across Europe emerge from lockdown, but lenders are likely to continue to show a preference for defensive credits and those embracing new technologies and innovation.
Accelerated fund market share
Although the events of the last 12 months have been unpredictable and unprecedented, they have also accelerated trends that had begun to develop before the pandemic hit, including the rise of debt fund market share. In the UK, this market share was as high as 77 percent in the second half of 2020, compared with historical levels of approximately 60 percent.
Banks remained cautious on ‘new-to-bank’ lending despite the rebound that started in the second half of 2020. They have shown less appetite for super senior revolving credit facilities, as the risk-adjusted returns increasingly do not stack up for them, especially when taking into account European Central Bank guidance on total gross leverage caps.
“Banks remained cautious on ‘new-to-bank’ lending despite the rebound that started in the second half of 2020. They have shown less appetite for super senior revolving credit facilities”
As a result, debt funds have increasingly stepped in to bridge these facilities at closing.
Although first-out, last-out structures have historically been pegged as a popular middle ground, debt funds and banks are increasingly pushing back on these types of deals. Whether asset-backed lending will step into the gap left by reduced clearing bank appetite for SSRCFs remains to be seen. Many companies in defensive sectors simply will not have the asset base to allow for an ABL solution, and negotiating intercreditor terms for combined ABL plus unitranche structures remains a cause of concern for many market participants.
Meanwhile, deals above €300 million, which are typically funded by the syndicated loan market, are also attracting funding from debt vehicles at an increasing pace.
This suggests the transition towards greater debt fund market share is likely to continue.
Growth of ESG
Environmental, social and governance considerations are attracting growing attention from private equity funds and private debt vehicles. Where once ESG was simply seen as a ‘nice to have’, it has now become a key consideration for lenders when assessing an opportunity. There has been a rise in the number of lenders offering margin ratchets linked to ESG targets – a trend that is expected to continue.
As such, companies that fail to keep pace with changing regulation and ESG criteria may find themselves in a less favourable position with lenders. In turn, this potential funding gap may need to be plugged by asset-backed loans or more expensive pools of special situations capital, or it could result in higher levels of restructuring.
After what has undeniably been a challenging year for Europe, it is perhaps unsurprising that economic recovery is not expected to reach pre-pandemic levels before 2022. Recovery is also predicted to be uneven across different countries.
In the UK, the effects of Brexit are still yet to take full effect, with the advent of covid-19 and high levels of government support perhaps masking or delaying the impact.
It is likely that many companies will need to refinance and restructure short-term debt products as we come out of the pandemic, particularly as the extraordinary levels of government lending that have been put in place begin to unwind, along with other government support schemes and temporary support from incumbent lenders. Many businesses will also need funds to finance post-pandemic business growth and working capital.
However, there remain reasons to be optimistic about transaction activity. The deal pipeline within the leveraged loans market is expected to remain robust in 2021, as paused M&A activity has started to come to fruition and corporate divestitures increase to raise money for core activities.
At the same time, the market will be bolstered by high levels of dry powder and an eagerness to deploy capital to resilient sectors and businesses, which should mean strong transaction activity continues throughout 2021.
Jacco Brouwer is managing director and head of European debt advisory and Greg Forde is director – European debt advisory at Duff & Phelps, a Kroll business