Image: Getty Images
The outlook for leveraged finance in the short term seems bleak, though there are reasons to be hopeful looking further ahead. By Edward Holmes and Rob Davidson of law firm Paul Hastings.
While numerous indicators suggest an imminent economic downturn and the resulting market implications, there are reasons for cautious optimism. Cheap and plentiful debt has been the oxygen of the high-yield (HY) bond and leveraged loan markets over the past decade, underpinning a benign environment for merger and acquisition (M&A) and buyout activity.
Since February 2022, galloping inflation, rapidly rising interest rates and the threat of recession have combined to reverse these favourable dynamics, with equity markets in freefall and bond yields rising steeply.
Leveraged debt markets have followed suit, generating sharp falls in primary market activity. As of late November, European HY primary issuance volume fell to €22bn, compared with €146bn in the same period in 2021, a decline of 85%. In the European leveraged loan market, issuance reached €33bn, versus €111bn, equating to a 70% decline.
The secondary market performance of leveraged assets has suffered commensurately. Fixed-rate HY bond prices are down about 10% in 2022, while floating-rate leveraged loans have been more resilient but have still dipped by about 4%.
As prices have fallen, yields have soared. The JPMorgan HY index was up 436 basis points (bps) by November 25 to 7.60%, while spreads over the interest rate curve rose from around 300bps in January to 550bps by late November. After almost a decade of expansion, European HY funds have started to shrink, with roughly €13bn of net outflows in the year to date.
Margins and spreads have also risen in the leveraged loan market. Meanwhile, activity in the collateralised loan obligation (CLO) space, which represents roughly half of the global leveraged loan market, has eased. European CLO new issuances are down about 35% in the year to date.
In the past few weeks, as recession fears have receeded slightly, the leveraged finance market has seen a modest improvement with an uplift in secondary prices and a few more deals coming to market. However, the technical picture remains unpredictable and yields remain high compared with historical averages.
Private equity funds are keeping their powder dry for now, but we may see a flood of M&A activity eventually burst through
Despite all this, there are a number of reasons to be hopeful. Private equity funds are keeping their substantial stores of powder dry for now, but we may yet see an explosion of M&A activity. In fact, the growing backlog of uncompleted M&A deals and refinancings could provide the basis for a new dawn.
Depressed M&A volumes
The end of the era of easy money has led to a dramatic downturn in private equity M&A dealmaking, which has been a key driver of leveraged finance activity in recent years. After a poor first half of the year, European M&A activity suffered a 42% contraction in the third quarter, a trend which is widely expected to continue into early 2023.
The depressed environment in the M&A market has left many of the leading underwriters in the sector nursing severe losses. One recent example is the $700m losses reportedly sustained by the banks underwriting the $16.5bn leveraged buyout (LBO) of business software company Citrix Systems by Vista.
Although the syndication of the debt for this deal was completed, in order to offload the bonds and loans from its books, the underwriters had to distribute both the bonds and loans at large original issue discounts. With losses mounting and risk appetite declining, investment banks are pulling back from underwriting large M&A financings.
Underwriting losses incurred on the Citrix Systems buyout were reportedly limited thanks to the support of one of the firm’s acquirers, Elliott Management, which bought $1bn-worth of bonds. This reflects a broader trend across the M&A market which has seen private credit funds deploying their capital by stepping in to provide the debt needed to finance buyouts.
Credit funds have even been able to support financings that were underwritten as syndicated facilities, with investment banks opting to place debt privately with these funds rather than wait for an improvement in the syndicated loan market. But in this environment, and as their capital dries up, credit funds have become more selective. They are taking smaller chunks of deals and managing to negotiate more favourable terms with less leverage, higher yields and more lender protections.
Reasons to be positive?
Leveraged finance primary markets on either side of the Atlantic have reopened since the summer break. Nevertheless, the short-term outlook remains clouded by a macroeconomic environment shaped by the expectation of sustained high inflation, accelerated monetary policy tightening and the increased likelihood of prolonged recessions in the US, Europe and the UK.
Against this backdrop, there is an increasing risk of issuers defaulting and credit ratings being vulnerable to downgrades. Fitch Ratings forecasts that default rates among issuers in the HY market will rise from 0.6% in 2022 to between 1.25% and 4.0% in 2023. In the leveraged loan space, the rate is projected to increase from 1.3% in 2022 to between 4.5% and 6.0% in 2023.
Superficially, these indicators suggest unpromising prospects for leveraged finance. The outlook need not, however, be universally bleak for several reasons. Foremost among these is that in Europe alone, private equity funds are estimated to control $430bn of dry powder which they will want to deploy sooner rather than later.
This suggests that when the market picks up, the backlog of M&A deals and refinancings in the pipeline will lead to a rapid revival in primary market activity, albeit with potentially lower leverage multiples – not necessarily a bad thing for global stability, moving forward.
This suggests that the backlog of M&A deals and refinancings in the pipeline will lead to a rapid revival in primary market activity
Heavy primary issuance will also be needed to absorb early maturities. Although relatively few companies have debt set to mature in 2023, there is an estimated €65bn of European leveraged debt due to mature in 2024 and a whopping €117bn in 2025. These figures auger well for the medium-term prospects of the leveraged finance market.
Private credit funds, meanwhile, now have some $1.2tn of assets under management which need to be deployed. These funds have been taking market share from investment banks for the past decade, becoming more involved in higher value and more complex transactions (such as European public-to-private acquisitions) that would typically be underwritten by investment banks.
Because they usually demand high rates of return, credit funds have traditionally operated in the mid-market space and as providers of the mezzanine piece of debt for larger LBOs. It will be instructive to see how much of the market share they retain when the public markets reopen. Given the expectation that rates will remain higher for longer, the shift towards private credit funds becoming anchor providers of debt for the largest LBOs may become a more permanent feature of the market.
More broadly, an important source of support for a revival in M&A volumes and buyout activity in 2023 may be bargain hunting among private equity buyers. Reduced multiples in equity markets, coupled with dislocations in currency markets which have sharply reduced the value of the euro and sterling, are making public companies look increasingly attractive, especially to opportunistic US sponsors.
Many of these may look to capitalise on the perceived overvaluation of the US dollar to make acquisitions in Europe and the UK, revivifying the M&A market.
Edward Holmes and Rob Davidson are partners in the global finance practice of international law firm Paul Hastings.
