Heading into 2023, European leveraged finance markets continue to deal with fierce headwinds, following 12 months of economic and geopolitical volatility that has prompted a general slowdown in issuance. What does this mean for the months ahead?
After the record-setting leveraged finance activity seen in 2021—as companies scrambled to refinance, M&A activity spiked and private equity (PE) went on a shopping spree—it was clear that pace was not likely to continue.
But in 2022, as the tail end of the pandemic worked its way through markets, companies were suddenly faced with a new reality. Conflict erupted in Ukraine, oil prices climbed and supply chains were disrupted. A decade of low inflation and interest rates came to an end across Europe. Financing began to tighten as debt became increasingly expensive.
By the end of 2022, while European leveraged loan and high yield bond markets began to see activity, it was well below normal levels and followed a prolonged period of lower issuances. Leveraged loan issuance in Western and Southern Europe was down 37 per cent year-on-year, while high yield bonds fell by 66 per cent during the same period. The third quarter of the year was one of the lowest quarterly totals for leveraged finance issuance in the region on Debtwire Par record.
In both cases, higher pricing was a major factor as it continued to climb throughout the year. On leveraged loans, almost 40 per cent of all deals saw original issue discounts (OIDs) of two or more points from par—by Q4, it was not unheard of for there to be OIDs in the low 90s on term loan B facilities. On the bond side, pricing seemed to finally peak by the end of the year, but only after six quarters of consistent rises.
At the same time, there were a few bright spots for leveraged finance markets throughout the year.
First and foremost, buyout activity remained active in the first half of 2022 before dropping off in the second half. Notable deals include KKR’s €3.4 billion-equivalent acquisition of independent beverage bottler Refresco and Bain’s purchase of human resource consultants House of HR, backed by a €1.145 billion term loan and a €415 million note.
Second, new money financing represented a significant proportion of total issuance early in the year, as issuers raised term loan facilities to partially refinance drawn revolvers and fund new acquisitions. As with everything else, however, headwinds meant that most of the new money facilities issued towards the end of the year were smaller add-ons.
Third, CLOs continued to perform consistently (though they were not immune to the general slowdown in the market). Overall, there was €26.1 billion in issuance in 2022—down 32 per cent year-on-year but, in November alone, there was almost €3 billion in new CLO issuance, well above historical monthly averages, according to Debtwire Par.
While there are still shadows on the horizon, the cyclical nature of leveraged finance means that there are always new opportunities. The key is to be prepared.
For example, inflation is starting to plateau in many jurisdictions, but interest rate rises may continue—in the UK, for example, in December, the Bank of England raised the benchmark to 3.5 per cent, up from 3 per cent. This was the ninth consecutive hike since December 2021, placing the rate at its highest level for 14 years. Companies will need to consider their options carefully to get their costs under control.
For those looking to pro-actively manage their debt, amend-and-extend facilities may be the best place to start. Small add-ons and maturity extensions will help many find their way through the forest until macro-economic conditions improve.
Those with the highest-quality credits will reap the benefits of the liquidity available in the market by upsizing as well as via likely tighter pricing during syndication (when compared to balance sheet lending). For example, Debtwire Par reports that French telephony firm Iliad and automotive supplier Valeo entered the market with €500 million notes, and both were upsized during syndication to €750 million.
While this points to a potentially bifurcated European market in the months ahead, where solid credits remain healthy and those already struggling may face an uphill battle, liquidity on the equity and debt ledgers remains strong, and leveraged finance activity is likely to pick up further to address their respective needs.
UK leveraged finance markets have come through a challenging period in 2022, with issuance across leveraged loan and high yield markets declining as rising interest rates, inflation and the conflict in Ukraine hit activity.
UK leveraged finance issuance in 2022 fell by just over 50 per cent year-on-year, tracking the drop off in issuance observed across the wider European market. Private debt lending has proven more resilient but has also felt the impact of rate hikes and geopolitical uncertainty, with fundraising markets and deal flow from M&A targets tightening through the course of the year.
The UK market faced a unique set of challenges. As a result, the Bank of England (BOE) hiked interest rates nine times through the course of 2022 to 3.5, the highest level observed since the 2008 financial crisis. The European Central Bank (ECB), meanwhile, upped rates four times in 2022, with its benchmark rate now sitting at 2.5 per cent to 1 per cent below the BOE level.
UK lenders and borrowers were already contending with political volatility, in the form of successive changes of prime minister and a catastrophic "mini-budget" in late September 2022. This catalysed a slew of collateral calls and forced sales of UK government bonds, requiring the BOE to step in and backstop bond markets to prevent the dislocation from spreading into other parts of the economy. Financing conditions are expected to remain calm in 2023 in the UK, with limited impetus to kickstart markets back into life.
But there are some early signs of green shoots. For example, after raising rates in December 2022, the BOE argued that inflation may have peaked, slowing from the four-decade highs recorded earlier in the year. Assuming inflation has topped out as predicted, there will be more scope for the UK central bank to halt or slow any further interest rate rises.
A change in the direction of travel on rates will provide issuers and investors with more certainty, help debt prices in secondary markets to recover and encourage primary issuers to come forward and test market appetite for new debt issuance.
The drop in corporate valuations and the weaker price of sterling relative to the US dollar and euro, meanwhile, could drive significant interest from overseas buyers on UK take-private deals in 2023.
Appetite for UK take-private deals has remained strong in 2022, despite macro-economic headwinds. According to Dealogic, UK companies valued at more than £40 billion were already taken off UK public markets in the first nine months of 2022. Public-to-private transactions are expected to continue providing a pipeline of M&A deals and financing opportunities in 2023.
Stalled issuance, growing concerns around rising costs, supply chain bottlenecks and the conflict in Ukraine—it's been a whirlwind of a year, with many remaining challenges for the year ahead
Stalled issuance, growing concerns around rising costs, supply chain bottlenecks and the conflict in Ukraine—it's been a whirlwind of a year, with many remaining challenges for the year ahead
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Typically, the pattern of peaks and valleys witnessed in leveraged finance since the start of the pandemic suggests we may be set for a rise in activity at some point in 2023—were it not for the various headwinds continuing to blow against potential progress.
What can markets expect to see in the year ahead?
In December 2022, the Bank of England Monetary Policy Committee, the European Central Bank (ECB) and the US Federal Reserve all decided to increase base rates yet again. President of the ECB, Christine Lagarde, warned of more rate increases in 2023, while US Fed official John Williams added fuel to the fire by warning that the Fed's policy rate may exceed the expected 5.1 per cent level.
While the public will be worrying about mortgage payments and the cost of living, this will concern any borrower hoping to secure new debt in 2023 without paying a premium. Average margins on first-lien institutional loans peaked at 5.39 per cent in Q3 2022, before cooling to 4.73 per cent in Q4—though still much higher than the 4.09 per cent seen at the start of the year.
It's been a similar story for European high yield bond borrowing costs—the weighted average yield to maturity for fixed rate bonds climbed from 5.39 per cent in Q1 2022 to 8.23 per cent at the end of the year.
€50
billion The value of high yield issuance in Western and Southern Europe in 2022
€183
billion The value of leveraged loan issuance in Western and Southern Europe in 2022
All these factors will challenge any highly leveraged borrower hoping to maintain their current standing in the market.
These pricing pressures paint a challenging picture for 2023. Fitch Ratings anticipates that ratings on high yield bond and leveraged loan issuers in Europe will deteriorate in the coming months. In addition, Fitch predicts that default rates could reach as high as 4 per cent in 2023 and 2024. By comparison, the institutional leveraged loan default rate finished 2021 at 0.6 per cent—the lowest rate in a decade.
Borrowers feeling the pinch will have fewer options to finance their way out of a rising debt load than they once did. Those facing maturities in the next two years are likely considering everything from amend-to-extend deals to improved covenant and/or security packages, equity injections or add-ons to push those maturity dates out further. As Debtwire Par reports, telecoms group Altice International based in Luxembourg, sports betting business Entain in the UK and French medical diagnostic firm Sebia all closed amend-and-extend deals late in 2022, targeting maturities between 2024 and 2026.
Credit quality will also be a factor for those chasing liquidity, with quality credits or those in “safe haven” sectors such as defence or infrastructure taking precedence—though that is not limited to the top end of the rating scale.
For example, per Debtwire Par, December transactions included UK nurseries operator Busy Bees (B-/B3 rating) which secured a fungible €105 million TLB add-on to repay revolver drawings, and French laboratory service provider Cerba Healthcare (B/B2), which secured a €220 million non-fungible add-on to its EURIBOR + 400 bps February 2029 TLC, priced at a margin of EURIBOR + 550 bps and a 96.5 OID. This demonstrates that transaction opportunities are not closed to mid-rated companies where supported by the market.
This flurry of activity inspires confidence at a time when investors do not know where things will land. Assets deemed safe and secure will continue to attract attention in the months ahead.
The fact remains that, at the start of 2023, the economic dust of the past 12 months has not yet settled. We may hope that the worst has passed, but as we have learned through recent events, stability and consistency are not guaranteed.
For those unable to pursue options like amend-and-extend deals or add-ons, private credit funds may also offer something of a lifeline. However, this may come with a hefty price tag. Decreased availability of bank debt means private credit margins have been climbing—Debtwire Par reports that they are up by at least 2 per cent on the start of the year.
Anyone hoping private debt will offer an escape from looming maturities may find themselves priced out in the coming months. Private investors may also worry about a company unable to secure an amend-and-extend deal, as this may flag a company in greater distress than is apparent.
The fact remains that, at the start of 2023, the economic dust of the past 12 months has not yet settled. We may hope that the worst has passed, but as we have learned through recent events, stability and consistency are not guaranteed.
When inflation began to climb, many argued that it was simply a market correction, likely due to the pandemic and rising oil prices. When the conflict began in Ukraine, many suggested that it would last a matter of weeks at most. As rates began to rise, many suggested it was only for the short term and central banks would settle down soon enough.
A year later and it's clear that factors such as these will continue to influence the market for some time to come, along with wider geopolitical and economic volatility.
One thing is clear: Choosing the right path in 2023 with be a challenge for everyone.
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This article is prepared for the general information of interested persons. It is not, and does not attempt to be, comprehensive in nature. Due to the general nature of its content, it should not be regarded as legal advice.
© 2023 White & Case LLP
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