The economic fallout from the global pandemic has dramatically changed the focus and behaviour of private market lenders and investors.
The European Commission’s most recent projection of “a deep and uneven recession” was based on a forecast of the eurozone economy contracting by 7.5 percent in 2020. The Bank of England’s prediction of “a very sharp fall” in GDP was coupled with a forecast of a 14 percent contraction in the UK economy in 2020. These forecasts have driven a flurry of state aid initiatives across Europe, making it tricky to understand the short- and longer-term outlook for mid-market private debt.
UK government initiatives
Recognising the economic impact that covid-19 was likely to have on British businesses, the UK government launched a host of support measures.Businesses with a turnover below
£45 million ($54.8 million; €50.8 million) can apply for loans under the Coronavirus Business Interruption Loan Scheme.
Under CBILS, 80 percent of the future losses an accredited lender may incur are guaranteed, subject to certain conditions. At the time of the announcement, many details around how the scheme would operate were uncertain, particularly how lenders’ credit policies would tie in with the overall initiative. Other details, such as a requirement for personal guarantees and aggregation of revenues at a portfolio level for PE-owned companies, also caused complications.
Refinements to the scheme were made and money is flowing. Data from trade association UK Finance as of 6 May showed that more than 62,000 applications had been made, of which more than 33,000 had been processed successfully, representing circa £5.5 billion lent so far. The scheme left a major gap for larger mid-market companies and this gap was addressed by the subsequent announcement of the Coronavirus Large Business Interruption Loan Scheme. UK businesses with a turnover of more than £45 million can apply for a loan of up to £25 million, and those with revenues of more than £250 million can apply for up to £50 million.
Larger companies applying for loans under CLBILS may also need to prepare for inter-creditor negotiations. Although many CBILS applications are made with a company’s existing sole lender, many CLBILS applicants may have more than one lender. Incumbent lenders may prefer to provide the new funding themselves rather than it coming in under CLBILS on a senior basis.
Notably, the schemes have presented challenges for PE-owned companies. Banks may no longer be aggregating revenues across the portfolio of PE-owned businesses (some confusion seems to persist). However, tests related to EU state aid rules are still causing many applications to fail. These rules, designed to stop member states from propping up failing businesses, require companies to pass certain financial tests. Many PE-backed companies are failing these tests, due to the use of shareholder debt in their capital structure.
This and other features of the schemes – such as requirements for borrowing companies’ directors to personally guarantee 20 percent of potential losses – are seen as major roadblocks, and lobbying is ongoing for changes in the schemes and state aid regulations. The ramifications for the private debt landscape will be substantial. Significant amounts of new debt are being incurred at a time of reduced profitability. The servicing and repayment of this new debt (within three years for CLBILS) will rely on a steep post-pandemic recovery in trading that may not be the case for many businesses. Furthermore, there will be a need for working capital financing as businesses seek to grow.
Banks fighting fires
Companies looking for liquidity caused by the immediate fall in revenues have turned to their existing lenders for support. UK banks have been overwhelmed by liquidity and debt service deferral requests. Those companies with undrawn revolving credit facilities have been drawing down heavily, with many using nearly all of their pre-arranged facilities.
Although banks may expect to see a rise in lending during such difficult circumstances, the activity this time around has been compounded by government lending schemes. Bank lenders appear to be supportive of existing clients, but there have been many instances where stakeholders, including sponsors, have been asked to share some of the burden. Looking at the longer-term availability of debt from UK banks, many are likely to remain focused on serving their existing clients and will have a reduced appetite for new relationships.
Overall, we saw deal volumes slow considerably in March with the pause button hit on many M&A and debt-raising processes. At the same time, we are starting to see signs of green shoots, and deals being completed in the healthcare, professional services, technology and telecoms sectors.
Funds with special situations strategies were sitting on large amounts of dry powder leading up to the pandemic, and market conditions have opened up many opportunities for them. Most are now busy and we have seen several examples of rescue financings in both the public and private markets. However, such financings come at a huge premium in terms of cost and are therefore not always attractive to borrowers.
Elsewhere, PE funds will be re-evaluating, and some may be increasingly looking at rescue financing and switching their strategies to have a focus on debt. Finally, we expect to see subsequent waves of companies facing liquidity issues. The overall result will be a high level of corporate leverage, which will require a steep recovery of trading conditions that may not materialise. Relationships between banks, credit funds and sponsors will be tested.
We expect lenders to maintain caution for at least the medium term. However, pockets of liquidity remain in mid-market debt, which has seen an explosive increase in the number of lenders since the last financial crisis.
Jacco Brouwer is managing director and head of European debt advisory at financial consultancy firm Duff & Phelps
Credit funds: all eyes on portfolio?
Market participants will be keen to see how debt funds respond to the first major downturn since the boom of the European private debt markets.
Although private debt is largely a mid-market debt product, many credit funds also invest in syndicated loans. As the fallout from the pandemic started to filter through, the syndicated loan markets slowed to a near standstill. Secondary loan bid prices fell to around 80 percent of their pre-covid-19 value, with individual names trading below that.
While not as severe as in the last financial crisis, many alternative lenders shifted their focus to the better-yielding secondaries market and would require mid-market financing opportunities to be priced comparably on a relative value basis.
European-focused, mid-market credit funds can be broadly divided into four categories:
1. Those which have essentially been ‘closed for business’ and focusing almost solely on portfolio issues.
2. Funds which are selectively open for business, but with an eye on yields in the secondaries market with the bar for new deals set very high and terms, including leverage, adjusted to reflect higher perceived risk.
3. Funds that are open for business, seeking opportunities with defensive companies, or those which may benefit from the current crisis, without necessarily seeking higher yields. This is particularly the case for some of the funds operating in the lower mid-market.
4. Funds with a special situations strategy or focus, whose ‘time to shine’ has come after a long wait during the bull market.