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Coronavirus - Private equity and the pandemic: The future of debt funding - Global

  • Global
  • Banking and finance
  • Coronavirus
  • Distressed - Stressed financing and special situations

25-08-2020

Being asked to write an article on the future of the debt markets is something of a poisoned chalice, but I’ve checked my horoscope with Mystic Meg who at the time of writing promises that my “zone of opening opportunities and new horizons takes on mind-master magic”. I’ll take that as an indication that all of the following predictions will be profound and accurate. As always, I would be very keen to discuss any alternative insights, whether you can claim to have achieved “mind-mastery” or not.

The good news, as discussed in my colleagues’ recent articles on M&A trends, is that things seem to be changing for the better. This seems an odd opening statement given the current economic climate here in the UK in beyond. But there is definitely an increasing sense of optimism that the private equity / M&A markets are reopening, and with it a call for debt financing. Whereas the focus of my article in June was on finding short-term liquidity and plugging the holes created by the pandemic, our latest rounds of calls with lenders, investors and advisors have had a very different tone. Applications for CBILS and CLBILS (which never gained much traction in the PE market) appear to be significantly down in numbers compared to June and July, and the number of waivers and amendments to existing financing packages are also steadying. All market participants are looking forward to getting back to ‘business as usual’ investments. But the key question is whether business as usual will mean a return to pre-Covid-19 standards, or a ‘new normal’.

In addition to funding for buyout and bolt-on acquisitions, refinancing and recapitalistations are likely to be high on the agenda once confidence in the market improves. Stating the obvious, the Government’s financial rescue schemes here in the UK will result in more debt in the market, which will also require refinancing in due course. As a result, there is potential for Q4 of this year and early 2021 to be busy with a healthy menu of M&A activity, opportunistic investments, further amendments and waivers, and restructurings.

Once the taps are opened, some businesses will naturally be more appealing to lenders than others. Traditional bank lenders, in particular, will be more focussed than ever on their exposure to different market sectors, Covid-immune businesses, and the availability of diligence material and financial information to inform credit decisions. Equally some lenders will be viewed as more approachable and appealing as a counterparty for sponsors and borrowers – reputationally many lenders have handled the pandemic well and demonstrated flexibility and support for their clients that will help their market profile when the next wave of deals come to market.

A tale of two (or three…) markets

Given the economic environment that we will all be navigating for the next few months and beyond, it seems likely that the variety of debt products on offer, and providers of such options, is likely to be more diverse than pre-pandemic, and the needs of financial sponsors and their portfolio companies is also going to be highly varied.

A contact suggested on a recent call that we are likely to see a tale of two markets. At one end of the spectrum will be portfolio companies and potential targets which are highly appealing to the lending community. These will be the businesses which have remained strong, or even prospered, through the last few months. These borrowers are therefore likely to be able to dictate terms of any financing packages, and will provide solid, but unspectacular, returns for lenders.

On the other hand will be those businesses badly hit by Covid-19 and/or wider macro-economic issues. Some such companies will be natural targets for takeover, but others will need to go it alone and they will either be in a position of testing the risk appetite of their existing funders, or, sadly, requiring the services of insolvency specialists. Within this category there will be opportunities for distressed investors. Sponsors and their advisors have become increasingly savvy to the tactics of special situations funds; many deals now include restrictions on lenders transferring commitments to ‘distressed funds’ (however defined). However, these restrictions often cease to apply whilst defaults are outstanding. Deals will be done in the distressed space; debt and equity will be heavily traded.

But what of the middle-ground? Surely there will be a large number of private equity- held companies who don’t fit the buckets above. Time will tell whether these businesses will appeal to lenders who could otherwise back the companies in growth mode at the strong end of the market, or are struggling enough to need a turnaround or loan-to-own investor of the kind that will be seeking the high returns at the distressed end of the spectrum. One way or another there will be a debt requirement in this middle portion of the market.

Competitive tensions – the M&A market

As Ceri-Ann and Paul suggested in their great article on the future of M&A a couple of weeks ago, buyers are likely to be under pressure to demonstrate their ability to complete on an accelerated basis, whether competing in an auction for a distressed asset or a strong business. In what is likely to be a highly competitive private equity market, certainty of execution, and therefore deliverability of any related debt financing packages, is going to be critical.

My colleagues have also highlighted the difference in the identity of investors in the market when looking at distressed assets and opportunistic buyouts or bolt-ons. Logically the same can be said for the identity of providers of funding – i.e. distressed buyouts are likely to be a stretch for the risk appetite of more traditional banks, but are likely to be fertile ground for investment from special situations and distressed debt funds. The size and flexibility of the private credit market is going to be critical here – this market has been expanding at great speed over the last few years. There is absolutely no shortage of capital or willingness to make up for lost time in deploying it.

This all sounds very familiar. Pre-pandemic we were regularly facing highly compressed timetables and asked to provide certain-funds style financing packages for private transactions. Given the availability of investor capital in sponsors’ war chests and fact that the bank debt market is returning from a hiatus (rather than having ever been truly closed for business), stiff competition for deals is almost guaranteed.

What’s market?

Robust businesses are likely to be able to play the field of lenders just as they did in late 2019/early 2020. There is no apparent reason why terms should be any less favourable for borrowers than they were pre-lockdown – the same factors that applied then will apply once the market fully re-opens. Competition will help to keep pricing down. Interestingly in June/July there was a sense that we might see lenders increase margins by as much as 1-2%, but that idea seems to have been short-lived, and deals are already in the market at or around pre-pandemic pricing.

More generally there is a sense that strong sponsors investing in tried and tested businesses will almost certainly be able to keep terms consistent with those seen late last year and in Q1 2020. In all likelihood this means many deals with a single (leverage) covenant, favourable carve-outs and baskets in relation to restrictive covenants, and flexibility for acquisitions and distributions. This is unlikely to come as a surprise to sponsors, who have simply come to expect these sorts of terms, but lenders might have hoped that the pandemic would have provided opportunity to reign in some of the borrower-friendly terms that sponsors and debt advisors have been peddling for the last couple of years.

Obviously the distressed market is likely to be far more varied. In this space lenders will need to remain competitive, but sponsors and portfolio companies in distress are more likely to have to live with board oversight, minimum liquidity tests, and enhanced reporting. At least in the short-term.

In next week’s article Danny Blum gets stuck into tax snakes and ladders, speculates on tax rates and will discuss whether the market’s approach to management incentivisation arrangements is likely to have been impacted by the pandemic and market slow-down, or if this too will bounce-back to pre-Covid standards.