Loan Note: European deals in the doldrums; weak covenants could impact recoveries

Europe deal market slowed in H1

Europe’s private debt deal market continued to decline in the second quarter of this year, down 23.4 percent on the previous quarter and 47.9 percent down on the same quarter of last year, according to the latest Deloitte Private Debt Deal Tracker.

The first half of the year saw 256 deals completed, down 36.2 percent on the first half of last year. Dealflow from the M&A market continued to be sluggish and there also continued to be a wide difference in price expectations between buyers and sellers. But while financings have become more conservative, Deloitte reports that appetite to put capital to work remains strong.

The UK market saw drops of 26.1 percent compared with the second half of last year and 41.4 percent compared with the first half of 2022. UK leveraged buyouts saw a particularly notable decline, with only 18 completed – the lowest number in the equivalent period since 2016. As a proportion of total European deals, the UK’s share has dropped from 34.8 percent to 26.2 percent between 2021 and 2023-to-date. Over the same period, Benelux has risen from 10.1 percent to 14.1 percent.

One clear trend that has emerged is a decrease in the amount of leverage supporting deals. The four most popular sectors – business/infrastructure/professional services, TMT, financial services, and healthcare/life sciences – saw the proportion of deals with 4x leverage or more fall from 71 percent to 61 percent between Q2 2022 and Q2 2023. Over the same period, leverage below 3x increased from 14 percent to 19 percent.

Paper highlights covenant weaknesses

One of the characteristics of a more challenging financing environment has been borrowers reportedly forced to make more concessions to lenders in their contractual negotiations. However, it appears to be the case that these concessions are only around the margins and don’t make up for the big swing in favour of borrowers in recent years.

Indeed, new analysis by Fox Legal Training – a covenant training programme headed by European Leveraged Finance Association chief executive officer Sabrina Fox – indicates just how much lenders have conceded over the last decade. “Provisions… originally engineered to protect lenders have since become tailor-made to afford borrowers increased flexibility,” says a press release from Fox Legal Training.

Features of the leveraged finance market highlighted by the analysis included:

• Seventy percent of collateral packages immediately post-GFC included real assets and structural collateral, while in the modern vintage only 20 percent include hard collateral;
• The capacity to incur debt that would dilute lenders’ collateral (as a proportion of EBITDA) increased from 25 percent post-GFC to 44 percent in the modern vintage;
• Over the same period, the capacity to incur certain priming debt doubled from 17 percent to 34 percent.

Fox notes that changes such as these could result in lower recovery rates, “particularly given the steep refinancing wall coming up in 2025 and 2026”. A recent report from JPMorgan indicates that this is already happening. Recoveries for high-yield bonds and leveraged loans over the last 12 months were 19.6 percent and 39.7 percent respectively, down on the 25- and 24-year averages of 40.2 percent and 64.3 percent respectively.

Index-linked income target for pensions

Long-dated index-linked income and real estate are allocation priorities for European pension funds, according to the European Fund Survey from real assets manager AlphaReal.

The survey of European pension fund professionals, representing €324 billion in assets, found that more than half expect to increase their allocations to long-dated index-linked income, and a quarter expect to increase those allocations dramatically.

Three-quarters of investors expect a yield of 2.5 to 3.0 percent from long-lease index-linked real estate assets, while a further 20 percent expect yields of 3.0 percent to 3.5 percent. Secure income real assets such as commercial ground rents were cited as an attractive option for European pension funds.

The same survey found that 46 percent of European pensions say their main strategic allocation priority is to increase diversification in the portfolio, while 28 percent say it’s to increase expected returns and 18 percent cite increased portfolio income.

The main risk management priorities are to reduce the absolute volatility of the portfolio, cut volatility versus liabilities (liability matching) and meet liability cashflows as they fall due.

The funds said they allocated to illiquid assets to earn a premium above more liquid assets. Nearly all (98 percent) said they had an allocation to illiquids, with nearly half of pensions allocating more than 10 percent of their portfolios.

A call to LPs

Our LP Perspectives 2024 Survey is now live, and we would greatly appreciate your participation as we seek to understand investor sentiment in the private markets today. Here’s the survey link.

Some pointers on this year’s survey:

LP Perspectives is PEI Group’s annual study of institutional investors’ approach to private market asset classes over the coming year. The survey gathers insight on investors’ asset allocations, propensity to invest, performance predictions and views on the wider market.

The results will be published across all our titles.

Respondents will receive the results of the asset class of their choice as a thank you for completing the survey. PEI Group will also donate $5 to UNICEF for each completed response.

The survey takes no longer than 10 minutes to complete, and all submissions will remain anonymous.

The deadline for submissions is Friday 6 October.

Essentials