While 2020 has panned out very differently to what was expected at this time last year, some trends that were already developing in the lending world before the pandemic struck have in fact strengthened further. The rise of direct lending is one such example, as the prominence of these lenders amid such a torrid year indicates they will be a firm feature of the European mid-market in 2021.
The first half of 2020 saw financial markets, governments and individuals gripped with fear in the face of a global COVID-19 pandemic, which meant that previous concerns such as Brexit and the anxiously awaited downward cycle were sidelined accordingly.
But governments reacted swiftly to the pandemic, staving off an imminent economic catastrophe by providing furlough schemes and tax waivers. Banks, as lenders, have worked hand in hand with governments to supply state-loan aid in most jurisdictions, such as CBILS/CLBILS in the U.K. or PGE in France. Meanwhile, direct lenders provided covenant holidays and became more flexible.
After the first wave of panic — during which companies had to chase liquidity wherever they could and draw on their revolvers — private lenders (including direct lenders and private debt funds) bumped up their pricing and banks almost stopped origination, while from the summer onwards a relatively calmer atmosphere prevailed as market players were better-prepared to face the situation. By the fourth quarter, private lenders were providing 88% of funding for the capital raises LCD tracked in the European mid-market, which is higher than in the first quarter when they provided 70%. In both the second and third quarters, the percentage of funding provided by nonbank lenders fell to 64%.
As markets moved deeper into Q4'20 and began to look toward 2021, for lenders the backdrop mostly shifted back to one of business as usual. Pricing and leverage broadly moved back to pre-pandemic levels, and the desire to put cash to work is high, according to market participants.
For the year to Dec. 16, LCD tracked 125 direct lending deals in the European mid-market. Some 80% of these were for acquisition purposes, while 10% were for refinancings, 6% for general corporate purposes and 4% for capital spending. The most active countries by deal number were the U.K. (with a 26.4% share of deals), France (24%), and Germany (18.4%). Meanwhile, the most active sectors in Europe were Computers & Electronics (with a 22% share of the deals), Healthcare (14%), and Professional & Business services (12%).
Drivers to the upside:
Deals will be plentiful. Some of the deals that did not happen during the pandemic-impacted year of 2020 will likely come to fruition in 2021. According to the latest Deloitte Alternative Lender Deal Tracker, direct lending fell by 29% in Europe for the first half of 2020, compared to the year before. "Direct lenders hit the pause button during the second quarter of this year, however, they have become active again in the second half of the year as pressure on deployment catches up and M&A activity rises," Deloitte said.
Back to where we were. The first reaction that lenders had during the pandemic was to increase pricing and lower leverage, but now all the figures are back to pre-COVID-19 levels as if nothing happened. "At first we increased the pricings by an average of 100 basis points and we lowered the leverage by 0.5x," one U.K.-based lender said. "Now we are a back to a roughly 4.5x leverage and pricings around 650 bps," he added.
Dry powder. Another reason deals will be plentiful in 2021 is that there is a necessity to deploy a considerable amount of dry powder. Preqin data shows that over the past four years, 327 direct lending funds have deployed roughly $207 billion globally, while their dry powder stands at $112 billion. The situation is the same for private equity funds, which have raised so much money that they will need to deploy in order to start making returns for their limited partners, or LPs. In addition, private credit funds continue to be paid on deployed capital, adding to the continued desire to transact.
Bank lending retrenchment. Banks were largely focused on their existing portfolios in Q2'20, with lending teams working to process CBILS/CLBILS and PGE applications from their borrowers. This has meant a pullback from lending to new situations, a trend expected to intensify in the years ahead. In the U.S., the mid-market is dominated by direct lenders, sources explain. "We always look at the U.S. to know what it's going to be like in Europe down the road," a direct lender said. Consequently, it feels inevitable that the European market will take shape in a similar way to its U.S. counterpart. "Obviously some markets are more ready than others — the U.K. is definitely going down that road, France is more or less 50/50, and the Nordics are only just starting out in the direct lending world," one U.K.-based lender said. COVID-19 has added fuel to this trend, with bank-led liquidity reduced significantly during periods of macroeconomic uncertainty. "Banks do not like uncertainty and risks," a banker said. In addition, many banks throughout Europe were busy helping with the state-aid loans, and haven't had the manpower to chase both origination and help out with loans. Added to that is the very strong appetite of private equity funds to make deals and to go down the pre-emptive route (whereby such players snap up assets before auctions are complete) where direct lenders thrive, and it is likely that in 2021 and moving forward, the European mid-market will see the withdrawal of bank-club deals in favor of financings from direct lenders.
The direct lenders' upper hand. Some private credit funds have diversified and raised special opportunities funds, through which they can deploy capital in cases where there is more risk. With European corporate default rates expected to tick up, and greater financial stress likely to emerge on balance sheets — especially as unemployment picks up in 2021 — this dynamic will create an opportunity for these types of funds.
The rise of ESG. Strongly led by LPs, environmental, social and governance criteria have become prominent not only for private equity funds but also for private debt funds. ESG is no longer just a vague philosophical notion to aspire to, but rather it has become a concrete tool, which took some important steps forward in 2020. In October, Eurazeo announced it had used the first-ever unitranche (a single facility that combines different types of secured and unsecured debt in a single loan with a blended interest rate) linked to ESG, which came from direct lender Barings to support the acquisition of Utac-Ceram, a French automotive testing specialist. This initiative came from the private equity sponsor, which as a listed company was keen to show its commitment to ESG issues. The financing put together with Barings features a margin step-down mechanism designed to encourage the borrower to meet ESG criteria. In doing so, it cuts its cost of capital, and the more criteria it meets, the larger the reduction. Because these are annually tested criteria, the company will need to remain committed to meet them. Though such criteria have yet to be standardized, since they can change from one situation to another, the market has clearly taken its first step toward directly linking the cost of capital to ESG criteria, and this is expected to be seen more frequently in 2021.
Jumbo unitranches. Another dent to bank lending and its market share could be made by the capacity for European direct lenders to provide large unitranches, even of up to €1 billion or higher. Despite the COVID-19-induced uncertainty, London-based insurance firm The Ardonagh Group Ltd. agreed the largest unitranche yet seen globally in 2020, through a roughly £1.5 billion deal to refinance debt. The deal was provided through a club made up of ARES, CDPQ, HPS, and KKR. Certainly, the direct lenders that supported Ardonagh were not new to jumbo unitranches. Indeed, Ares in early 2019 provided what is thought to be the previous largest unitranche in Europe, to Daisy Group, in a refinancing deal totaling £1 billion. Meanwhile, KKR sold the biggest Italian unitranche in 2019 via to support Advent's acquisition of chemicals company Industria Chimica Emiliana S.r.l (ICE). And in April, it emerged that HPS had provided a €325 million unitranche to support EQT's purchase of Schülke & Mayr GmbH. Then in December, the broadly syndicated market refinanced with euro and dollar term loans a roughly $950 million-equivalent unitranche loan provided by Blackstone as part of a $1 billion debt and equity financing to support Capvest's buyout of Datasite Global Corp. Unlike these financings, however — which were generally provided on a bilateral basis — Ardonagh is the first deal of this size in Europe to feature several lenders. "There are private lender club deals in the U.S., and it is possible that we will start to see some of those in Europe too," a U.K.-based lender said.
Drivers to the downside:
Aggressiveness. COVID-19 has hit some sectors hard that were already struggling, such as retail, automotive and leisure, and has propelled sectors such as tech and healthcare even more into the must-have camp for investors. This will translate into an unbalanced supply and demand dynamic. Inevitably, lenders and sponsors alike will be funneled into the same deals, leading to more aggressive terms with looser documentations and lower margins.
Adjustments. As the pandemic wreaked havoc with the EBITDA of most businesses, more creative EBITDA adjustments to compensate for patchy trading are likely to emerge. With competition to win deals high, the appetite to push back on adjusted EBITDA numbers is consequently reduced, leading potentially to companies taking on more leverage than their business model can sustain.
The forgotten issues. Many of the headwinds facing the market and economies before the pandemic struck have continued to blow, but are no longer center stage. For example, the British government and Brussels had yet to reach a Brexit trade agreement by the time of writing (Dec. 18), and there is still no visibility on fishing and competition issues. This adds a layer of uncertainty to the market, and could have a detrimental effect on the European economy as a whole, as well as mid-market deals.
The lag time. How long the pandemic has to run, and when and where the major scars will be felt most, is still uncertain. The start of 2021 will likely be full of optimism due to vaccine rollouts, but it is likely that some dents in the market may emerge later in the year. Firstly, it has been more difficult for auditors to do their jobs as they could not go on site, so it takes longer to provide proper audits. Secondly, Government schemes have put many companies on life support, and have potentially masked underlying issues. "At some point all this cheap money that governments have provided will need to get repaid," a direct lender said. To pay off additional debt and deferred payments, operating cash flows need to ramp-up quickly. This is going to be challenging for many borrowers, particularly as furloughing ends and deferred taxes become due.
Consolidation. It is possible that the strain the pandemic has put on the market overall will result in a disappearance of some funds. "I feel sorry for any fund that wants to enter the market now," says a lender. "First-time funds will not be able to fundraise at all for the next year, and therefore consolidations can happen — didn’t we see Bridgepoint acquiring EQT Credit this year, for example?"