Lending activity has rebounded strongly following COVID disruption, with borrowers once again able to secure favourable pricing and attractive terms in a competitive market. In a recent roundtable hosted by Real Deals a panel of lenders and advisers discussed the drivers behind the recovery, how lenders are navigating competitive situations to find value and the outlook for debt markets over the next 12 to 18 months. 

Panellists:

Amany Attia, ThinCats

Tom Cox, FRP Advisory

Kirstie Hutchinson, Macfarlanes

Cécile Lévi, Tikehau Capital

Graham Neill, N4 Partners

Listen to the summary of the discussion here

What is the panel’s assessment of the current position of the market? After the initial period of pandemic uncertainty a year ago, how active has the market been this year and what are the characteristics of the deals that are getting done?

Kirstie Hutchinson: The market has undergone a quite radical transformation from where we were a year or so ago. In April 2020 there was a feeling of panic and confusion. People wanted to keep their heads above water and the focus was on liquidity and securing temporary waivers. Roll forward just a few months later to December 2020 and it became clear that Q4 2020 was one of the busiest quarters in recent years.

Inevitably much of that deal flow spilled into January ‘21 because deal participants couldn’t get everything away before the end of 2020. That supported a very solid start to Q1 and the momentum has carried forward into the rest of the year. We are seeing a wide range of transactions across sectors, including new money deals, and the market remains incredibly busy.

The high levels of deal activity are surprising when set against the worst-case scenarios predicted in Spring of 2020. Government support and insolvency moratoria have prevented a wave of distress, whilst lenders and borrowers have also been extremely pragmatic. Periods of uncertainty do not support sound valuations, so there is little point currently in pursuing enforcement and crystallising a loss at the bottom of the market.

Given these dynamics,  borrowers have been able to take advantage of considerable levels of liquidity to refinance and extend maturities. Even if you don’t need to refinance now, or want to exit, conditions are so favourable that sponsors have taken the opportunity to recap and refinance. 

M&A activity has also ramped up through the year. Sponsors are competing fiercely in auction processes and lenders are eager to finance those deals. Public-to-private activity has been especially active. The market is so buoyant that buyers are discounting the financing risk entirely, underwriting deals with equity and then running their debt and financing processes post-deal.

Tom Cox: We have had a very similar experience. If I look at what our practice has been busiest with over the last six to nine months, I would pick out M&A, recaps and refinancings. Sponsors are actively looking to use leverage to optimise returns and make acquisitions. Compared to where we were a year ago, the market is pretty aggressive.

That said, I have noted a bifurcation between COVID-resilient sectors like pharmaceuticals, healthcare and technology and heavily impacted consumer-facing industries that are still struggling and are finding it incredibly difficult to refinance. There is appetite for deals, but for deals in performing sectors.

One other observation is that lenders are increasingly selective about where they are going to spend their time in this hot market. Views are quite binary, with lenders either willing to run very hard at something or not even consider it at all.

Graham Neill: As a firm that deploys capital alongside our broader advisory work, we have also noted the difference between an appetite for sectors deemed COVID resilient and those that are not. Our existing investment fund, for example, is focused within the industrials space. In general, industrials have weathered pandemic volatility well, but industrial assets have had to demonstrate a clear differentiation to gain traction with lenders and sponsors alike. Strong M&A activity for industrial assets that have shown resilience has continued, as has corporate carve-out activity. Lenders and sponsors are focusing on those assets and situations where there is resilience or an opportunity to create value, so there is high selectivity.

Stepping back and looking at the market as a whole, terms could be considered towards the more aggressive end. I echo what Tom noted about selectivity. Lenders will choose where they focus and not enter processes unless they see a clear roadmap to being chosen to finance a transaction.

I wanted to turn to Cécile and Amany as lenders to understand how they have approached things. We hear that the market is very competitive, yet there is still a great deal of uncertainty and COVID risk is still very real. How have you gone about staying disciplined at the same time as maintaining deployment?

Cécile Lévi: It all comes down to having a clear strategy from the outset that specifies the deals you want to participate in, which builds in a natural selection. Even if you are a large established fund and have a large team, you can't address everything. You really have to direct your resources and bandwidth to the areas where you are strongest, and that means turning down opportunities on occasion and making trade-offs.

As a debt fund this can be something of a paradox, given that debt funds have established themselves by being flexible one-stop shops for a wide range of transactions. But there comes a point where you can’t cover the whole market. You must be disciplined, and in a market characterised by intense competition, if the leverage levels and pricing fall outside of your parameters, you have to be able to let transactions go.

We have focused on situations and industries where we have a strong track record, and we have also increased our focus on deals where we are already the incumbent lender or where we’re supporting buy-and-build strategies and growth financing requirements. As a lender you need to have your own area of expertise where you can bring value and contribute. 

Amany Attia: Our approach has evolved over the last 18 months and through this pandemic period we have worked hard to understand what new and existing borrowers require from us at particular times. In the spring and summer of last year, for example, working capital was the focus and making sure that viable companies that just needed working capital had the support they required. Then as we moved into the autumn, activity was centred around rebuilding and reopening, with funding required to bring in new equipment and replenish inventory. Moving into this year there has been a pivot towards a high volume of work with sponsors. 

So, if you saw our book last year versus this year, last year it was maybe 40 per cent to 60 per cent working capital and then inventory build-up, and now it's 60 per cent or more of M&A-related and sponsor-related activity. We are actively seeking and finding opportunities to fund deals for new clients as well as supporting M&A within the existing portfolio.

How have you gone about filtering the opportunities that come across your desk, given that this is a competitive market and lenders want to avoid a race to the bottom, and simply offering the cheapest debt on the softest terms?

Attia: Our approach has been to stick to a very finite set of credit criteria. What we really try and bring to the marketplace is an expertise in working with mid-sized SMEs, where we focus, and speed and assurance of delivery. We give an early yes or no to borrowers, and when we give an early yes, we deliver. Hopefully we have established a reputation for consistency. 

We also look at each transaction on its own merits, so we are not too rigid, and that has opened up opportunities in some sectors that are unloved right now, like leisure. We're not about to get rid of restaurants, we're not about to get rid of hospitality, but we're really looking at each individual case and asking whether the business is special enough to see this period out and has the backing to allow it to survive. Does it have a strong sponsor? Things of that nature.

On that point about the sponsor behind credit, how important has that become? Can the involvement of a sponsor be a deciding factor in whether a credit is funded?

Neill: Sponsor relationship, performance and track record is key. What has really become apparent during the last 12 to 18 months is how people and teams perform through times when conditions are far from optimal. What behaviours do they display and what actions do they take? The focus has sharpened on the quality of relationships and how lenders and borrowers have navigated the challenges that many businesses have faced at some point during the last year. The credit fundamentals obviously remain crucial, but relationships will be a key factor going forward, for current credits and new deals.

Cox: On the whole I think sponsor behaviour has been pretty good and pragmatic. Where appropriate there was a clear willingness to back businesses with more equity. If there was a joined up and grown-up discussion early on, there was probably a more meaningful conversation and agreement on any concessions. 

That said, we have seen some sponsors take very binary decisions. When GPs were not a position to turn to LPs to request more capital for an asset, they did wash their hands of those companies but this type of situation has been fairly rare. It has been case specific, but overall parties have been more transparent and open, with less gaming than seen previously.

You learn a lot about each other during a crisis. But it's difficult to generalise and because of government support, hard decisions haven’t necessarily had to be made yet. So, let's see.

If we shift the focus from the sponsor to the direct lender, how have direct lenders conducted themselves through this period? Debt funds have increased their market share since the global financial crisis, but haven’t had to work through a downcycle until now.

Hutchinson: Well, we haven’t yet experienced the deep downturn that was initially anticipated. We have had an artificial recession. Large sections of the economy were effectively shuttered and people were told to stay-at-home, but the technology was there to allow many businesses and their people to keep trading and working throughout.

At the outset everyone’s question was how lenders would behave.  What we have observed is that where sponsors stepped in to support their portfolio companies appropriately, direct lenders in particular were ready to do the same. When there was a proper, honest and open conversation, establishing trust and credibility around forecasting, neither the sponsor nor the lenders wanted to see fundamentally sound businesses fail by virtue of entirely external and extraneous circumstances.

I think there was a recognition on both the equity and the debt side that people’s behaviour through the crisis wouldl define reputations and relationships going forward and,  to their great credit, sought to behave accordingly. 

When you compare the banks to the direct lenders in the mid-market, I think it is fair to say that on balance the banks were very careful and didn’t pursue enforcement in situations where on paper at least they might have done previously, but were not as willing or indeed able to put their hands in their pockets to provide additional financing. The direct lenders were more able and possibly more willing to work together with sponsors to come up with solutions to help keep viable businesses going. 

Lévi: It is worth remembering the origins of direct lending in Europe. The asset class emerged following the financial crisis, and it formed the unitranche product which was designed to provide flexibility and freedom in terms of cash flow. Loans are bulleted and there is no principle amortisation, which has removed a lot of pressure on cash flows.

Flexibility has been an important factor in the stability of private debt portfolios. We haven’t yet seen private debt portfolios come under unmanageable strain and there haven’t been any major problems. There has been goodwill and supportive behaviour too, with direct lenders deferring things like cash interest and waiving covenants to give borrowers in their portfolios breathing room.

To what extent has the health of a direct lender’s existing portfolio predicted the capacity of a manager to lay on additional capital for incumbent credits and continue deployment into new transactions?

Attia: We have a distinctive set up and group our people into teams of hunters and gatherers, if you will. There are those dedicated to looking at new transactions and putting those transactions in the books. Then once the transactions are in the books, we turn it over to a group that manages the portfolio on an ongoing basis. They make sure covenants are met and that assets are performing in line with projections.

With this structure we have been able to bring on new business at the same time as giving our existing book the attention that it needs and deserves. The two teams work very closely together.

Economies are reopening and government support is tapering off. What happens in this next phase, especially when considering that many companies will be carrying more debt coming out of the COVID period than going into it?

Neill: I am optimistic. There will be companies in certain sectors that have had to take on extra debt to see out lockdowns, but debt markets are open and well-placed to support these businesses.

There will inevitably be some bumps in the road, but I’m not expecting anyone coming in with sharp elbows. As the other panellists have mentioned, parties on all sides have been collaborative throughout this pandemic so far and I’m certain that will continue.

Cox: I also expect to see lenders and borrowers take a pragmatic approach. In sectors that are still on the backfoot, valuations simply don’t justify crystallizing a loss at this point. Where there is still pressure on balance sheets, borrowers will continue to recut, refi, amend and extend for the time being until we have a more stable platform. Until we have more clarity, forbearance is still the only way to go.

It sounds like the consensus is that there isn't this crunch point or maturity wall on the horizon. It seems that there are options to either amend, extend or negotiate forbearance, or even refinance out of any pending maturity walls?

Hutchinson: There are some businesses that were already struggling pre-pandemic and the COVID situation has been an accelerant to that decline. Those businesses are likely to run out of road and need ro be restructured, but for other borrowers with sound businesses the markets are currently so deep that there will always be somebody who will want to provide a capital solution at an appropriate risk adjusted price point. 

Private debt managers have seen this opportunity and are launching an array of new strategies and funds to cover a variety of liquidity and credit situations. Managers are evolving their offerings to provide private capital of all descriptions. Some are taking equity positions. Others are branching out into structured finance. Fund finance is growing. There is significant inventiveness and creativity in the market.

With so many funding options available, I don't see a cliff edge. I also can't see governments or global monetary institutions acting politically or economically in a way that could jeopardise recovery or even precipitate an even greater crisis by ripping off the plaster of support. 

Politically, governments need to be seen to be doing everything they reasonably can to make sure that economies get through this. Equally, there is a lot of private capital that is well-positioned to address distressed or unusual situations.

To close could I ask each panellist to outline the priority for their business for the rest of this year and going into 2022. What are you anticipating and what are you keeping your eye on?

Attia: We have a few government programs that we are still delivering, so we are really focused on completing those programs and making sure that borrowers  get to take advantage of those programs. 

Then, we are really starting to build for next year because we do think the government will end up withdrawing its support. We are seeing the banks continue to withdraw from the marketplace. So, we really are looking to take advantage of that for next year. We also think M&A activity will be around for a while, or at least for most of this year, and we will continue to see a lot go into that space.

Lévi: In terms of private debt, we have a private debt secondaries vehicle, and our plan is to develop new strategies. Private debt is becoming more mature, and we see opportunities to invest and trade LP private debt positions.

We have also launched an impact lending fund and we are introducing ESG ratchet terms into our unitranche documentation. Following the pandemic, and as governments focus on energy transition and achieving net zero carbon emissions, impact and ESG will be key themes for businesses.

Finally, we want the team to grow, expand across different countries, and as always, do more transactions

Neill: From an N4 perspective, we will be focused on maximising value for our current investors and portfolio, which has proven to be resilient throughout the pandemic. We will be focused on harvesting that value and subsequently expanding our platform, across both our investment and advisory practices. As a recently formed firm, expanding our team has been key as we use our knowledge and experience to unlock potential through partnerships; we are certainly looking forward to seeing what opportunities develop in the next 12 months.

Cox: Some of our advisory work is starting to pivot towards more special situations and refinancing capital structures that aren’t going to be fit for purpose going forward. We want to engage with those borrowers relatively early and avoid getting to the point where it is too late to restructure. We are anticipating more volume in that space as 2022 opens up. 

Hutchinson: Staying close to our clients. The crisis kicked off with a period when all ongoing transactional activity effectively stopped, and instead we were on calls with clients seven days a week. There's no better way to demonstrate what you can do for clients than by being there with them in difficult circumstances. We did that and it has deepened relationships. If you are there to help clients through the difficult periods you will benefit from building that trust when new opportunities arise.