Corporate Lending and Leveraged Finance outlook – succeeding in a “permacrisis”

• United Kingdom

• Banking and finance
• Corporate finance

11-01-2023

What a difference a year makes. As we exited 2021, most economies were returning to pre-pandemic levels and borrowers were predicting an expansive 2022, with lenders keen to deploy funds to help them. This was all assisted by lending terms and conditions which had begun to normalise to pre-COVID levels.

Fast forward 12 months and the Collins dictionary has now named “permacrisis” as their word of the year; describing it as an extended period of instability and insecurity, in which the UK and beyond continues to face ongoing crisis, such as pandemics, political instability, war, inflation and climate change.

So, in a period of such volatility and uncertainty, it’s worth taking a moment to reflect and assess where we are, and where we might be headed in 2023. Ian Tetsill, Head of Debt Finance Strategy, recently took the opportunity to catch up with colleagues Jason Wurzal and Hannah McAdam in our Corporate Banking & Finance team and Chris Hastings and Lisa Boyle in our Leveraged Finance team, to get their thoughts.

Corporate Lending market

Ian – firstly Jason, how has activity been for corporate borrowers in the past 12 months?

Jason - as you say Ian, we started the year with a degree of optimism and M&A was certainly an agenda item for a number of our clients who were expecting the V shaped post-COVID recovery to continue. Pricing was returning to pre-COVID levels and tenors were pushing out again to 5 years. This was encouraging some borrowers to consider full refinancings, rather than undertaking short term extensions which were a feature of 2020 and 2021.

Clearly the events in Ukraine changed the landscape considerably, as the effects of sanctions, the impact of supply chain disruption and the volatility in financial markets, was fully digested. As the year progressed and central banks increased interest rates to curb rising inflation, many borrowers put M&A on the back burner and delayed their refinancing plans, while this new norm was digested by them and the banks.

That said, towards the end of the year, we saw borrowers returning to the market, looking to lock down their medium term liquidity by undertaking full refinancings.

Ian – Hannah, what have you seen as the implication on terms and for lender appetite generally as a result of the above?

Hannah - banks are generally well capitalised and open for business, but we have seen that the bar is rising and, given the prevailing uncertainty caused by the cost of living crisis, we are seeing increasing selectivity from some lenders and certainly more rigour from credit committees. Some sectors, particularly those engaged in discretionary spending consumer activities or those unable to pass on price increases, are finding it increasingly difficult to access capital on previously available terms and may have to settle for shorter tenors and/or increased pricing to get their deal away.

Borrowers with robust business models who have been open with their relationship lenders and kept them fully appraised of the impact of changing scenarios on their business models, are generally able to attract better terms.

We are also seeing an increase in the number of conversations around interest rate hedging as clients seek to understand and, in a number of cases lock down, an added level of uncertainty which they have not had to consider for many years. A number of lenders are also insisting on hedging for the same reasons, which is a requirement we have not seen for some time.

Ian – Jason, what does the landscape for Corporate Loans look like for borrowers in 2023?

Jason - I expect much of the caution we have seen to continue, but unlike the bond markets which have been very volatile over the past year, I expect the bank lending market to continue to remain relatively stable with relationships between borrowers and lenders being key. Because of the difficulties in the capital markets, banks are certainly seeing more demand on their balance sheets currently.

It seems inevitable, with increasing risk in the economy being felt by businesses and, with the underlying cost of capital increasing, that terms may tighten. We are suggesting to clients that they refinance as soon as they can, rather than when they have to, in order to keep ahead of this curve.

In a few isolated cases, we have seen clients drawing down some or all of their RCFs and/or tapping their accordion facilities to ensure they have ready liquidity to hand. We are also hearing talk about forward start facilities returning to the market. These can help to eliminate future refinancing risk in a volatile pricing environment by locking in future commitments from certain lenders at a known price. For context, we are not seeing any real evidence of liquidity concerns being an issue for lenders or borrowers at this point, but on a case-by-case basis, some of these measures may be worth considering.

I expect sustainable finance to remain a key topic in 2023, particularly for the banks, and it will increasingly become a mainstream item for all refinancings. It continues to be advisable for finance teams to stay abreast of and consider how their wider group’s ESG strategies can fit into their financing plans and discuss this with their lenders. It is certainly true that given the clamour amongst lenders to enhance the ESG aspects of their loan portfolios, a compelling ESG strategy can help generate significant interest when putting together a lender group for a financing.

Ian - so given the above backdrop Jason and Hannah, what is your key advice to clients approaching the lending market in 2023?

Hannah - be fully prepared and ensure you have contingency plans.

Jason - expect lenders to ask more questions and require more information to make their lending assessments and ensure that you have the best debt and legal advisers to help you navigate the challenges.

Leveraged Finance market

Ian - so Chris and Lisa, turning to your area, what are your reflections on 2022 in terms of activity and trends across the leveraged finance market?

Lisa - M&A and leveraged buyout deal volumes clearly took a hit in 2022 due to the underlying uncertainty across the economy. Whilst some sectors have been resilient, market participants have generally had to pause and reflect in order to consider the effects of lower demand and increased costs that are affecting many businesses and how this will flow through to valuations.

However, the market remained active and whilst PE house funding activity slowed, it remained broadly in line with historical averages. Therefore, whilst PE may have had to consider holding and consolidating certain investments whilst seeking the right exit opportunities, the uncertain market and drop in valuations of certain assets has provided opportunities for refinancings, bolt-on acquisitions or secondary buy-outs.

Despite a somewhat turbulent period as noted above, there is no shortage of capital, with a plethora of banks and funds willing to lend into the market. This bodes well for an active market in 2023, particularly if volatility continues to subside and an element of confidence starts to return.

Ian - turning to 2023, how do you see the market playing out?

Chris - generally, 2023 could be a somewhat fractured market with a considerable divide between investors and businesses at either end of the performance spectrum. I think there are a few really interesting dynamics to consider and I would categorise them as follows.

Banks - the pressure on cashflows caused by rising interest rates should inevitably mean that leverage levels will decrease, which could mean that more deals could favour bank lenders where the all-in cost of capital is cheaper. We may also see more minority equity deals, with lower leverage favouring the bank market, as owners de-risk some of their investments at a time when valuations may be suppressed and IPOs or alternative strategic options may not be possible. A number of active PE houses have established minority-investment focussed strategies over recent years and so we would expect this to be an active part of the market.

Debt Funds – I have no doubt funds will very quickly find a way to remain a compelling solution for PE. They have for some time had the advantage of being able to provide more flexibility in terms, hold levels, structuring and speed of delivery. That said, I suspect the ability of funds to be creative with their returns and possibly provide more hybrid pricing solutions, potentially using pay-if-you-can, PIK and equity instruments, may be a necessary feature of their offering, in order to compete with the lower margins on offer from bank lenders. With some banks having entered the already highly competitive private credit space, funds will need to continue adapting and seeking avenues that will differentiate them from the pack.

Fund raising - whilst the fund raising environment may prove difficult for some private fund lenders, for others it may be an opportunity. Given recent currency movements against Sterling, the UK may appear to offer value for overseas players and for those raising debut funds, it may provide an opportune moment to enter the market. We have been seeing a number of new market entrants on the lender-side who have been very busy fund raising and establishing a UK presence. The bottom line is private credit remains a very attractive asset class for investors and we expect them to continue to invest through the cycle.

Terms - recent interest rate increases have clearly put more pressure on highly leveraged companies. We expect more lenders to try and introduce additional covenant protections such as debt service cover, minimum EBITDA or cash requirements , or as a minimum, insist that a base case forecast should provide a minimum level of debt service cover for the proposition to be viable.

Lisa - I agree with all of the above and in summary, I think it’s going to be a really interesting year where we can anticipate deals of all shapes and sizes given the various macroeconomic factors at play. I think we will see a combination of traditional buy outs, bolt on acquisitions and refinancings, but also more opportunistic and special situation style financings. We may also see an uptick in ABL (asset based lending) financing, particularly if cashflows are constrained and there is an opportunity to be creative with balance sheet assets to maximise the overall package. Overall I expect good deal appetite among market participants as they adapt quickly to the evolving environment.

Ian - thanks both. I think one thing that is certain is that 2023 is going to provide some new and interesting challenges and communication between participants will be key. As legal advisors operating right across the market, advising both borrowers and lenders, and with commercial debt finance insight in the team, we are ideally placed to help our clients navigate through the months ahead.