Expert analysis by Nicholas Williams, Reed Smith
Christine Lagarde recently signalled that the European Central Bank will likely end negative interest rates within months, forecasting that borrowing costs could hit zero by the end of September. This follows the recent decision by the Bank of England to raise interest rates to their highest level for 13 years, with a 0.25 percentage point increase to 1 percent.
With rates rising across the UK and the Eurozone, what does this mean for European credit funds?
It appears the consensus among most credit funds is that, in the short term at least, inflation is a far bigger concern than rising interest rates. This is both in terms of the potential impact on the performance of portfolio companies and on the economy more widely. Inflation soared to a eurozone record of 7.4 percent in April and in the UK it is forecast to be 10 percent by the end of the year.
Whether one views the current period of inflation as transitory or more permanent, few would argue against the need for policy makers to attempt to counter the supply-side shocks caused by the conflict in Ukraine, the ongoing Chinese coronavirus lockdowns and the hangover of supply-chain and logistics bottlenecks.
In addition to helping in slowing inflation, the rise in interest rates may also finally start to cool valuations. This is likely to be welcomed by debt and equity investors alike, although leveraged buyout activity is expected to remain strong in 2022, with private equity firms still sitting on so much dry powder that needs to be deployed.
In an environment of uncertainty, the ability of credit funds to execute processes quickly, combined with the incremental covenant headroom they can typically offer borrowers, may also position them to increase market share over traditional bank lenders as private equity sponsors look to minimise execution risk and obtain the most flexible deal terms.
For the time being, it is unlikely that the rise in interest rates will reduce returns for credit funds. In the European mid-market, most loans deployed by credit funds are structured with a leverage-linked margin that floats above EURIBOR or compounded SONIA (following the abolition of LIBOR).
In line with the rise in the central bank rate, SONIA has gradually increased over the past six months (even allowing for the LIBOR transition), with EURIBOR also starting to follow suit.
Margins on existing floating-rate deals will be unaffected by this rise in underlying rates and, with real rates still relatively low and forecast to only rise gradually, one would expect pricing on new loans to hold up in the short term. If inflation does not prove to be transitory and rates continue to increase into 2023, or move upwards more steeply than forecast, then we may see margins start to adjust.
As a side note, it will be interesting to see how management teams adapt to the rise in borrowing costs.
While borrowers of leveraged loans were traditionally required to hedge up to two-thirds of the principal amount of loans, after a sustained period of low interest rates, mandatory interest rate hedging on deals has become a thing of the past, with responsibility for hedging instead left to the discretion of management teams.
However, with many deals no longer including an interest cover covenant, combined with a rise in flexible interest terms such as payment-in-kind toggles, there may be a delay before the rise in borrowing costs has any impact on loan covenants.
In summary, while we could start to see some effects of rising interest rates on the private credit market in the next year or so, in the immediate term activity is likely to remain high as PE sponsors seek to deploy accumulated capital and more bypass banks and turn to private credit funds to obtain the best financing terms for deals.
Nicholas Williams is a partner in the London office of law firm Reed Smith