If we were to describe the standout features of the debt markets as we move through the second half of 2022, we might say the environment is turbulent and unpredictable. While lenders broadly remained active and stayed true to existing terms in the first half of the year, we now see significant shifts in the public markets taking place daily, particularly as it relates to the UK, which means that directionally it is hard to predict how the rest of the year will play out.
We were delighted to host a panel at our recent Healthcare Private Equity 2022 conference in London to discuss the impact of market uncertainty on borrowers, strategies and terms, and to consider what all of this means for healthcare deals in 2023.
The debt markets today
The capital markets remain broadly closed to borrowers and are much more restricted than they have been for a very long time, creating an opportunity for private funds to step in with credit solutions.
Ticket sizes have changed to the extent that even lenders capable of single-handedly deploying $1 billion-plus cheques are now showing less inclination to do so – even for the most compelling credits – as managers scale back on risk appetite. Those larger tickets are therefore being split among clubs of three or four (or more) players, and more broadly we see a much more conservative approach to underwriting market-wide.
The good news is that healthcare assets continue to look attractive to lenders in this kind of market thanks to their counter-cyclical nature and the industry’s long-term underlying growth trends and predictable revenue streams. While it is important to differentiate tech opportunities from healthcare as a matter of sector focus, with so much focus on digitisation to both enhance access and drive efficiency gains in the healthcare space, we see burgeoning investor appetite and thus a relatively strong pipeline of lending opportunities.
For the right borrower, the debt markets remain very much open but private credit is probably the only option, certainly in the mid- and upper mid-market. There is additional restraint on the part of lenders, which means that rather than pushing the envelope, borrowers will need to be more thoughtful on valuations for acquisitions. They will also likely need to accept either lower leverage multiples or higher pricing, while the likelihood of achieving dividend recapitalisations is limited without a very good credit story or strong residual skin in the game from the private equity investor.
With so much volatility around interest rates and currency risk, hedging arrangements should be front of mind for both new and existing debt, and those will bring an additional cost consideration as prices rise. In the lower mid-market, the clearing banks across Europe remain a feature of the market but there is now a question mark about their appetite to lend.
Overall, there is less competition among lenders in general terms but those that are still active are favouring non-cyclical credits in sectors such as healthcare. As long as the markets remain more expensive and challenging to access, borrowers are increasingly likely to delay tapping new debt unless there is a pressing need, given the likelihood of needing to accept tighter terms, or wider pricing if they do so.
Movements on terms
With lenders thinking much more carefully on downside protections, it is still possible for the highest quality credits to achieve strong borrower-friendly terms, but markets are certainly more thoughtful about these. We have not seen a complete reversal of the borrower-friendly terms evident in the market in recent years, but rather there has been a pause and perhaps more conservatism is creeping in.
Underwriting has certainly become even more credit-specific than usual as lenders dig into a company’s ability to withstand supply chain challenges or pass on inflationary pressures, but in more resilient regulated sectors like healthcare and financial services there is clearly a greater underlying confidence.
The real question as we head into 2023 is how long this period of volatility and uncertainty might last, there being plenty of potential for events that might stabilise markets very quickly, such as an end to the Ukraine war, a more accessible energy market and/or a resultant drop in inflation.
Similarly, private funds still have a lot of dry powder to put to work and will come under pressure from their LPs to drive returns, so it is hard to imagine sustained periods of limited capital deployment, particularly if inflation levels remain high.
A key takeaway from our discussions at HPE 2022 was therefore that healthcare borrowers remain better positioned than most to tap credit markets, but should expect some pullback on terms and pricing and to encounter more critical analysis of any lending opportunity.
At the same time, private credit funds face less competition for deals and are now highly sophisticated in their understanding of healthcare credits, so we can expect them to come forward with creative, flexible capital solutions to support borrowers in the face of difficult times.
Aymen Mahmoud is co-head of the London finance, restructuring and special situations group at law firm McDermott Will & Emery