Lincoln International's Aude Doyen recently participated in Real Deals' panel to discuss the state of the lending market.

This has been a volatile year for debt markets. Interest rates have continued to rise, we saw Silicon Valley Bank fail in the US, and leveraged finance and private debt market activity in Europe has suffered double-digit declines. What is the outlook for GPs and lenders in these choppy markets?

Thomas Stromstedt: The outlook is unclear and keeps shifting, but in the US there are signs that inflation has peaked and is starting to come down. That could be a trend in Europe too, with the UK a bit of an exception. The market consensus is that US rates could start coming down next year as inflation cools. European rates, however, are still on the rise and it is less obvious when those rates will stabilize and come down.

From our perspective at Investindustrial, we have always been focused on conservative leverage across the portfolio, which – together with hedges implemented – has limited the impact of rate rises. That isn’t going to change. We continue to focus on conservative leverage and implementing hedging strategies as appropriate.

Neil Price: At Mayfair, we first look at inflation and interest rates from the actual investment perspective, and then work backwards to consider how the debt should actually be structured. We don’t want to be running our investments thinking about the banks or the debt funds. Therefore, we take a more conservative approach and review the business’s performance, looking to bring in more leverage later on if appropriate. We always look to find solutions that are most applicable and beneficial to the management teams with whom we partner. Across our portfolio, leverage is quite low and, even in 2021, we didn’t take on significant leverage.

Rebecca Sinclair: We take a similar view and have always been cautious when it comes to leverage. For a few years already, part of our investment process has involved sensitivity analysis of base rates in the 6% to 8% range, which has really helped because it has given us the confidence to know that a business can withstand the level of debt even if the base rate goes up to 8%.

That has been important for us, as well as just making sure that we’re not overstretching any of our businesses. We have only refinanced when required (to finance a buy-and-build, for example) as opposed to putting in as much leverage as possible. We do a number of primary buyouts, so having the breathing space to invest without daily concerns about debt serviceability is important.

Ivan Greenwood: I would echo those comments. I don’t think our approach has changed much from any other point in the cycle. We do naturally keep an eye on terms, pricing and debt availability, but the focus is on building in some downside protection and hedging appropriately. We want to avoid situations where management teams have to focus on debt repayments instead of growing their companies.

Jordan Kay: We are also generally quite conservative, so our appetite has not really changed. We are looking to raise additional debt for one asset to fund a US expansion, but with debt costs where they are at present, we can use our own capital as there isn’t much difference in the spread between our own loan notes versus what is available in the debt market for shorter-term finance.

One interesting observation is that we’ve had a couple of fixed-rate offers. That makes decisions more challenging because you are trying to figure out where the base rate will land and whether it is worth taking up the option to fix.

How do you view fixed rate versus variable rate at the moment?

Kay: It does depend on the specific case and what the other terms are. You could get quite a good fixed rate, but the lenders may want an amortizing facility and restrictions on your yield being paid, which you won’t be keen on. It is a case-by-case assessment.

Sinclair: We’ve fixed rates in some of our businesses, but as you outline, that can come with less flexibility. That is the trade-off everyone is having to consider. You can lock in the fixed rate, but the structure will be less flexible than the structure for debt that isn’t fixed. It depends on the business and the level of leverage and what you are looking to do really.

Doug Wilson: It goes back to that certainty point… whether it works or not depends on what happens with rates, and right now nobody can be 100% sure where they’re going to go.

Dave Sherrington: We are seeing the yields on fixed-rate debt increasing to 10-11% in the current market.

The cost differential between margin plus and a fixed rate is 100 basis points, maybe 150 basis points. It comes back to the point on whether you want to hedge your bets. Do you want to fix your rates for five to six years, hedge the structure for a period, and then come out when base rates hopefully settle?

Price: We look to take a balanced approach between reviewing market forecasts and running portfolio companies as best we can. People thought rates would top out in 2022, but we’re in 2023 and it’s a very different picture to the one many people predicted.

Aude Doyen: The big challenge for all stakeholders is visibility. It has been very difficult to establish when interest rates are going to peak, especially in the UK. Even if the rate settles at the higher end, dealmaking will pick up as long as there is stability and visibility. At the moment, we are not there yet.

How are the lenders at the table navigating the higher rate environment and wider macro volatility?

Wilson: We are deal-by-deal lenders and everything we do is fixed rate, structured as either mezzanine or senior debt, so we have been insulated from rising rates to a degree.

That said, where we sit as mezzanine, obviously it’s important for us to be close to what is happening at the senior lending level, and the big question for our borrowers is: what parameters should be built into their forecasts with respect to senior debt? That is going to be very important for our portfolio.

For ourselves, the environment puts us under some pressure to push up our fixed rates to make sure that we continue to deliver the returns our investors are looking for. There are some pretty secure low-risk products in the market that are delivering improved returns because of higher rates. That is pushing up pricing for lending across the capital structure.

Sherrington: As a leveraged cashflow lender, we are razor focused on cashflow and affordability of debt. We don’t over-lever businesses. We are funding sponsor-backed growth companies, so we are not in the high leverage territory of 4x to 5x Ebitda. In our part of the market, there is headroom and some resilience.

There is no doubt that there has been a lot of stress on businesses over the past 18 months with inflation and energy costs, but our credits have traded strongly. We are monitoring base rate increases closely, scenario planning for a 6-7% base rate and analyzing how the cashflows will react to that.

In a more challenging market, where are borrowers turning to source capital, and are lenders still open for doing new business?

Doyen: One interesting development is the widening delta between SONIA and Euribor rates, which effectively means that the cost of borrowing in sterling is greater than it is for borrowing in euros, given margin does not compensate for this. That is actually something our clients are thinking about when investing and financing deals. We definitely see more interest from borrowers with UK assets trying to lower overall financing costs by borrowing more in euros if they operate with a mix of currencies.

Historically, SONIA rates have been more expensive than Euribor, but that gap has widened even further. Euribor base is about 1.5% cheaper at present, expected to get to 2% cheaper when rates peak. When you look at debt funds, there is more capital in euro-denominated funds than in sterling funds, and when UK deals are funded from these euro funds, the hedging and foreign exchange costs are pushing up the price of sterling debt even higher.

Most of the deals we work on will have a cross-border element and involve multiple currencies – some of it is natural hedging, but we have seen UK companies raising euro tranches of debt more than they used to, to help bring down overall financing costs.

Sinclair: We have explored using debt denominated in different currencies to create a natural hedge, which we have never done before. We are focused on investing in UK-headquartered companies, but where we do have revenues and costs in other currencies, denominating some of the debt in a different currency is a way to hedge against interest rate risk.

Does that add complexity to a debt structure? Is it worth the trouble?

Stromstedt: It depends on each company, but yes, it is worth looking into. If I look at our portfolio, Italy and Spain are the historic core markets for the firm, but we are also now active in the US, the UK and on a pan-European basis.

We cover a range of lower mid-market, core mid-market and large deals. For a local business in Spain, we can do a club deal with Spanish banks and that will be in euros. It is the same in Italy. It’s only in the larger deals that have a cross-border element that we explore currency splits for acquisition term debt, whereas revolvers and similar facilities typically are multi-currency.

Most of our mid-market deals with multiple currency acquisition debt have been done with the direct lenders. Most of the bank-financed deals we have done have been in one currency (except revolvers).

I just want to circle back to the wider point on whether the lender universe has evolved as the macro backdrop has deteriorated – are there still as many providers active in the market?

Doyen: Banks and funds are open for lending. Nobody is saying that they don’t want to lend, but what is changing is the scrutiny of credit quality, leverage and pricing.

What is interesting is that there are more bank club deals. When you back solve on how much debt you can afford in this higher rate environment, the higher margins charged by the credit funds mean debt quanta cap out a bit sooner compared to what we were seeing in 2021. The delta in terms of the leverage that you can get from a bank or bank club and funds has reduced as a result.

If you price the extra incremental leverage that you’re getting from a fund, the marginal cost sometimes is very close to equity. The banks are thus providing a solution that will not really impact sponsors’ returns and is lower risk.

There is a conversation to be had on documentation and flexibility, but the banks are a lot more flexible than they were 10 years ago, and a GP can secure a package that is flexible enough from the banks. In 2020 and 2021, sponsors would pretty much default to the direct lenders because they offered higher leverage, but in the current market that is not always the case.

From a sector perspective, areas like consumer are difficult for lenders, although there are different solutions in these sectors, with ABL an option for retail borrowers in particular.

We also see a bit more layering in capital structures, with flexible capital providers filling in the gaps between senior debt and equity.

Wilson: The shift in the market has actually helped us because we’re pretty flexible in what we can structure. Cash is the big issue for everyone, and if there’s something that we can structure that can help with that, we are happy to look at it.

We are putting on our thinking caps and exploring different options. We can do preferred equity carrying a preferred return rather than loan notes with a paid coupon, for example. We are also seeing a higher volume of secured opportunities.

It is about solving a problem and we have the flexibility to do that. That is a good attribute in this kind of market.

Sherrington: Our focus is very much on the lower mid-market. During the last decade, the banks have largely come out of that market – and that’s still the case. Some debt funds also came into the lower end of the market before moving back up. Overall, the competition has cooled in our space and we’ve actually had the best half year that we’ve ever had, so we are still growing market share. We’re not putting tons of leverage into deals and stressing them, and we are providing flexibility and deliverability. Sponsors and management teams value that approach.

Stromstedt: It seems as if everyone has gone back to ‘Leveraged Finance 101’ and refocused on the basics like interest rate cover and debt service coverage ratios. In the bull market, everybody was just looking at leverage multiples and loan-to-value ratios.

If I look across our operations around the world, in Italy banks are open and we have done some lower mid-market club deals. In Spain there is also bank appetite and we have had good dialogue with the main banks, which are definitely open for business – for conservative deals.

In the US, many smaller and midsized banks are under pressure, especially after the Silicon Valley Bank situation and subsequent regional banking crisis. The direct lenders have really taken over in the US mid-market. Direct lenders have also stayed active in Europe, although they have become much pickier. They deployed significant amounts of capital in the early stages of the market dislocation, so have had space to step back and pause for breath.

If you then look at the upper end of the market, the high yield bond and institutional leveraged loan markets have experienced significant dislocation, but are hopefully starting to come back into shape.

Overall, it has been a bit of a mixed bag, but the banks and funds are still there and open for business when the right opportunities present themselves.

Kay: For smaller assets with Ebitda in the £2m range, we have found the high street bank space to be quite challenging, but for bigger assets with Ebitda of £10m or more, appetite from the high street has been very strong.

What we have also observed is a significant rise in equity rollovers. We will be the only loan noteholder in a structure, but in return we’ll get a small stake of the equity. We almost play like a mezzanine lender in these situations. We’ve seen a lot more deals like that.

Greenwood: It’s important to remember the backdrop of the last few years. We’ve had the pandemic, global supply chain shocks, the situation in Ukraine, as well as inflation and raising interest rates. As a lender you are going to be a lot more focused on the types of businesses that you are looking at, and the end markets that they’re exposed to.

We have seen less impact on healthcare businesses, for example, where there is a more sustainable need.

Price: We focus on relationships across our portfolio and our lender base. I think relationships are essential to success but massively undervalued. We’ve worked hard to build strong lender relationships and these are quite concentrated across our portfolio.

The banks have definitely come back in and that’s probably not what people expected. On the fund side, people are cautiously open for business. A year to 18 months ago, a fund would do a £100m package at the drop of a hat, but now they’ll only do £50m and they’ll want someone else in there with them. They just want a bit more comfort before taking deals to investment committees.

What has the investment committee experience been like for the lenders at the table?

Wilson: Sectors like consumer are difficult, but what has been interesting across our portfolio is that consumer company revenues have been really strong, although the cost base has increased.

Greenwood: Consumer is a broad sector and there’s nuance within that sector. Some consumer businesses will be very strongly positioned for the next few years.

Sherrington: We’re not a thematic investor and we do have some consumer exposure. The macro headwinds have hit the market, but consumer sentiment has proven resilient. We see good management teams with good products and good brands performing very well. Sponsor-backed consumer businesses doubled down through the pandemic period, increased liquidity reserves and have big cash buffers, so are actually very, very stable.

Thematic investing has its benefits, but when funds and banks pull back from a certain sector, you can take the time to look at individual assets and find some fantastic credits.

Greenwood: Neil’s comment about relationships is really important because that is what facilitates the dialogue on the detail and brings these opportunities to life.

Sherrington: We brought on a number of mid-market sponsors that didn’t get much support from other lenders through the lockdown period, and we have seen those positions grow from £5m to £30m. We have now established relationships with good mid-market sponsors that ordinarily we wouldn’t have worked with. That opens all kinds of doors for us.

Sinclair: That is something we see too. The lending universe for smaller investments is completely different for the larger deals. You almost have to have different sets of relationships for the different-sized deal categories.

Sherrington: You may come on to this but some of our peers and ourselves have hit caps on the amount of debt we can hold, and we see syndication becoming much more common in lower mid-market debt funds to manage that. Historically, any lower mid-market deal has always been a bilateral lend, but we are partnering with some of our competitors and starting to syndicate deals.

How does that work in practice? Are you selling down an entire position once you’ve hit a certain cap, or will you stay in the deal?

Sherrington: It’s quite nascent at the moment and only a couple of these deals have been done. You grow with the asset and when it reaches a certain size you sell down. That is a sort of stepping stone into syndication, but we are not at that stage yet.

Wilson: We’re definitely seeing an uptick in co-investment type opportunities, but these are deals where we will go in together with other lenders, who will take up different slices of the capital structure. That helps us to push the numbers and get involved in some larger deals.

Any perspectives from the GP side on private debt clubs? Are you comfortable when positions are sold down to other lenders?

Sinclair: Our interest will be around controls and who we have to deal with. If ultimately the position ends up the same, we’re still dealing with one party and the dialogue is straightforward, then I think we would be relatively comfortable. The concern is where you have two or three lenders and it starts to hold things up because you have to educate more lenders and get them up the curve.

Doyen: If you do a club deal with two credit funds, or do the same deal with only one of them, you’ll typically get a better deal if you do it with one of them. As soon as you start clubbing, terms can take a hit – one fund can accept the other as lead lender but that’s not always the case.

Stromstedt: We have done some club deals on the bank side and the private debt side. There is usually a lead lender that drives the terms, and I don’t think our terms are worse in deals where we have more than one lender, because the lead lender is often able to do the deal alone anyway, so the others fall in behind that lender.

On a related point, in the US where we have done a few direct lending deals recently, we went very wide to make sure we had financing cover.

In one situation we were oversubscribed, but we went with only one lender because they were standing out as the best option. In another oversubscribed situation we went with a club deal that included quite a few lenders. In the US you generally have different voting rights, where you need more than 50% to have a blocking position (versus more than a third in Europe), so it is easier to avoid holdup situations when there’s a clear lead lender that is driving the deal.

Finally, I wanted to ask the panel for views on refinancing risk. We keep hearing about looming maturity walls, but I have seen statistics suggesting that 80% of leverage loans only mature in 2025 or later. Is refinancing risk a concern right now?

Kay: We keep an eye on things but overall the portfolio has a long runway before facilities mature, so we have done our refinancing business and are generally OK on that front.

Doyen: There are fewer vanilla, like-for-like refinancings in the market. If a maturity is approaching you do have to look at the capital structure, assess the debt servicing costs and think about whether you have to bring in more lenders or different debt tranches or instruments.

Price: I think you just need to think about it slightly earlier than you might have done in the past. In particular, you have to look at the state of the credit. If it is massively leveraged and trading is flat, it’s going to be tough to refinance and options will be limited.

Stromstedt: There is this current wave of amend-and-extend (A&E) transactions, especially in the syndicated markets. Not all lenders will be able to extend, so there is also a new-money element to these deals.

For mid-market transactions and club deals, banks have generally been willing to discuss A&E options too. It buys all parties a bit more time to figure out if markets are going to normalise, instead of doing a long-term refinancing when there is a lot of uncertainty and financing conditions are worse. Then an A&E can be a good interim option for everyone.

How comfortable are lenders with amend-and-extend deals?

Sherrington: We would definitely look at them, but we would tread carefully. You have to think about the share of risk. We are not going to pay down a load of loan notes and just transfer risk to a senior debt position. That said, we are a growth investor and the companies we lend to might outgrow the facilities we put in first up. We are very happy to put in larger facilities in these circumstances.

Wilson: Just to come back to the broader refinancing point, we have actually seen plenty of opportunities come our way when borrowers have to refinance. Liquidity is tighter so borrowers have to look at alternative structures – something that potentially rolls a coupon, for example. That’s what we are looking at. We’re trying to focus more on rolling coupons and maybe moving a little bit more into equity, which is a common theme in everything that we do. Every time we look at either amending and extending a facility or refinancing, that is a quid pro quo. There is so much more appetite for this kind of solution.

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