This article is sponsored by Fidelity International.
With the M&A pipeline having slowed in the past year, where do you see opportunities and how quickly do you anticipate a rebound?
Marc Preiser: There has definitely been a slowdown across the past year, which has varied a bit across Europe but has touched all major markets. Deal activity is behind prior periods, partly due to a disconnect on enterprise values between PE buyers and sellers, and partly the consequence of the direct lending market resetting leverage ranges to more normalised levels.
Buyers are nervous about high short-term interest rates, sellers are nervous about getting the enterprise values they want, and both sides are a bit more conservative and risk-off. With many of our competitors also not knowing when their next fund will be raised, the investment pace looks slower and that probably will not change until the recalibration of enterprise values happens.
Sponsors eventually have to put money to work but there is a lot on hold; we continue to see refinancings and situations where sellers need capital, but there are not so many primary LBOs, and managers need to be selective in this environment.
We are all reluctant to refinance our competitors, so many of the deals in the market right now are bank replacements, where banks have maybe topped out or are more conservative so they are looking to alternative lenders to provide follow-on capital.
Geographically, there is caution around the UK due to high prices and wage inflation, while France is also quiet due to the equity valuation story. We are seeing quite a lot in Germany and Benelux, both of which continue to expand in terms of the adoption of direct lending.
Despite the current state of the market, it’s a good time to be deploying capital – we are underwriting deals at lower leverage levels with stronger terms at attractive spreads. And I think we will see the real increase in dealflow in the first half of 2024 as the revaluation cycle comes full circle and the gulf in multiple expectations between buyers and sellers narrows.
Mikko Iso-Kulmala: In terms of deal volumes, the core mid-market has experienced slightly less of a slowdown. It is taking a bit more effort to source the right deals, often with a broader range of sponsors, but when you get down and do the work, the slowdown is less pronounced there than it is in other parts of the market. Again, the experience, local knowledge and long-standing relationships really matter in this market.
In a highly competitive direct lending market, what impact is the higher rate environment having on existing deals?
MP: Part of the mystery that needs to be solved here relates to valuations. On existing deals, those valuations are based on outdated circumstances, so if you were to revisit them based on actual spreads and interest rates today, valuations would be lower.
LPs are starting to think harder about why their portfolios haven’t been revalued and why that wheel turning hasn’t yet gone all the way. Interest rates have only been high for the past year, so there is still a catch-up taking place, and at the same time we are seeing weakening cashflows and significantly tighter interest coverage ratios. LPs are starting to see signs of weakness across portfolios and private equity sponsors are recognising that some of their valuations may be a little high, all of which is causing people to be more cautious in their analysis.
Those themes have some positive impact on the market too, in that we don’t see the six and seven times leverage multiples any more, pricing is higher and spreads are better, while we are all being more cautious. So, the higher rate environment has changed the competitive landscape somewhat, with sponsors going back to focusing on deliverability and certainty of close versus financially engineering every last basis point out of a transaction.
MIK: In the past, the dynamics were often more about sponsors finding the right businesses and squeezing the economics out of deals as the zero base rate environment allowed market participants not to excessively worry about debt costs, and as a result, it was also easier to operate the underlying businesses with more leverage.
Today, there is a more balanced view of looking after and safeguarding the right businesses, with the focus on ongoing running costs. If you can get a structure right against the current market backdrop, it is much more likely it will work going forward and there will be more room for upside from an equity perspective while always focusing on capital preservation from a debt perspective.
Has there been a reset in relation to covenants and other deal terms?
MIK: Not so much a reset, but rather a renewed focus on the importance of deal documentation. Covenants in direct lending remain robust, but also the ability to negotiate deal documents with the right restrictions and deal terms remains extremely important. In return for speed, certainty and flexibility of execution, sponsors understand the need to partner on looking after the investments with a focus on a strong level of lender protections in the deal documentation while pricing the deals for the underlying risk. The current market environment provides increased opportunities to access deals with the right balance of risk vs reward for a potentially very attractive fund vintage.
Focusing on being the sole or lead lender is also important today, as it allows you to negotiate those documents in a way that best protects lender and investor interests. Information flow and maintaining a really close relationship with the borrower and sponsor is also key. That gives lenders the ability to stay on track with what is going on with an underlying business, so that any sign of deviation from the underlying business plan can be picked up as soon as possible.
MP: Compared with what we were seeing in more robust times, we are definitely able to ask for more specific terms in quite a lot of transaction documentation. The power shift is interesting, and we see more of a spirit of co-operation, with sponsors looking for partners and more willing to have a dialogue around the business model, the business plan and how they will continue to grow the company. We can then work with them to set reasonable parameters.
How are general partners preserving value in portfolios during the current economic challenges?
MIK: Direct lending has been growing towards being one of the main sources of debt finance today and for the future. Driven by the appeal of certainty of financing, speed of execution and customised financing solutions, borrowers are increasingly opting for direct lenders over other alternatives.
The main risk currently relates to the costs of servicing debt and, specifically, interest coverage ratios. With underlying base rates having increased, investors are picking up very attractive yields, but on the other side of the table, borrowers need to ensure incoming cashflow is sufficiently robust to deal with the cost of debt. If not properly managed, those costs of debt could become a strain.
General partners can preserve value by managing a wide subset of deals overlaid with strong credit management analysis, but also by stress-testing deals and stringent negotiation of deal documentation. It is not just about picking the right business today but also structuring the right protections for lenders and investors.
On top of that, you really need to ensure that every deal you do correctly reflects the realities of the environment we are operating in today. Conservative leverage is therefore important, as decent companies that have piled on too much leverage could easily end up being punished in this market. If you get the underwriting and structuring right on these deals, you can really futureproof your portfolio.
Finally, it comes back to maintaining a close relationship with the underlying borrower and sponsor, solid ongoing information flows and having open and honest conversations about everything, good or bad.
MP: We tell the team all the time – price the risk. Build a portfolio that provides diversification, but the important thing is bottom-up analysis, asset by asset, to make sure that all risk is priced appropriately. We see a lot of opportunities, but if it’s a risk we don’t want, we have to take a pass.
Are investors getting the information they need from their managers in the face of uncertainty? How can lines of communication be improved?
MIK: There is always room for improvement in communication with LPs, in private credit just as in every other asset class. Increasingly, institutional LPs have their own reporting and regulatory requirements, so being able to understand and incorporate those needs is critical.
With more insurance capital coming in, for example, and the regulatory requirements constantly evolving in areas like ESG and sustainability, keeping on top of those investor needs is really valuable for LPs. The enhanced transparency allows all parties to constantly improve the visibility of their portfolios and thus also ensure that the portfolio is delivering what it is meant to deliver.
MP: As the industry grows and direct lending become a more standard solution for institutional investors, there are more players and a growing demand for transparency and consistency. We currently have quite a lot of differences between managers around reporting so LPs have a lot of choice, and we certainly see them showing greater interest in the data and in the level of detail behind that.
How are market conditions impacting different parts of the senior lending market, from the lower mid-market up to the mega-deals?
MP: The core mid-market remains our focus and is largely stable because it is driven by primary leveraged buyouts, refinancings or expansions by companies that will be consistently transacting. On the larger side, there is ebb and flow, with more competition at the top end. The volume there is driven to an extent by conditions in the syndicated lending market, so demand for direct lending does come and go.
For us, the best risk-adjusted returns are in the core mid-market where there is more activity, fewer alternative lending sources and we are looking at companies that have been around for years, with long-term founder teams or committed equity sponsors, which allows us to build long-term relationships and undertake bottom-up analysis as we build our portfolio. This contributes to a lack of volatility across this segment of the market.
MIK: We have seen the direct lending market in Europe gradually become mainstream and more desirable as a source of financing. In the core mid-market, the strength of relationships is more important than ever. Building really strong local relationships allows managers like us to source the right deals efficiently and make sure they are the right companies for us and our investors, mitigating the impact of volatility and the deal market slowdown.
Marc Preiser is portfolio manager, direct lending, and Mikko Iso-Kulmala is head of private credit solutions, at Fidelity International