Covid-19 has turned the dynamics in acquisition finance markets upside down. In a recent Real Deals roundtable discussion, a group of GPs, lenders, and advisers dialed in to discuss the changes in the market and how lenders and borrowers are reacting.

Speakers: 

Daniel Sinclair, partner, Ares Management

Peter Brown, head of private debt, Luxembourg, Aztec Group

Adriana Oller Astort, partner and founder, Resilience Partners

Tom Cox, partner, FRP Advisory Miles Otway, partner, Connection Capital

Paul Shea, partner, Beechbrook Capital

Click here to listen to the key discussion points

How many opportunities have there been for lenders to fund new deals? Is it unrealistic to expect much deal activity against the current backdrop, or is there an opportunity to win business and market share for lenders who can keep deploying?

Daniel Sinclair: We strongly believe that times of volatility often result in bank retrenchment and the closing of the liquid markets. When that does happen, we see direct lenders like ourselves, who are well-capitalised and well-positioned, able to step up and fill those gaps in the market. That theme has played out since the start of the Covid-19 pandemic across Europe, so we are actually seeing additional opportunities.

One thing that is really important is flexible capital, and being able to look at a wide range of financing structures across different parts of the capital structure for businesses that are at different stages of their development.

Tom Cox: While deal volumes have started to pick up in more defensive sectors, classic performing midmarket deal opportunities have, perhaps unsurprisingly, been relatively sparse since the start of the crisis. Daniel, can I ask whether the opportunities you are looking at have been mainly at the upper end of the mid-market, or have deals been coming through from across the market?

DS: It has been interesting to observe where deals have come from. We have funded deals in the larger cap space, like Ardonagh, which is the largest ever unitranche deal. So, the larger deals do come through, but the core of what we do, and the Ebitda profiles of the companies we back, has remained consistent over the last five years.

Over the last couple of months, the market has seen relatively few new deals launched. Processes that were in chain paused, and then the high-quality transactions in stable sectors picked back up and completed. 

Does that chime with what the other investors and lenders on the panel have observed? Have you been able to do any new deals since lockdown, or has there just not been enough M&A activity in the first place?

Adriana Oller Astort: I would echo what Daniel said. Deals went on hold because of uncertainty around current trading and valuations, but deals involving companies that continued to trade well through lockdowns have moved forward. We have done one new deal through this period and are close to securing another one, although both these processes had started pre-COVID. We haven’t closed a deal that has been originated post-COVID yet.

Although the themes have been broadly the same, however, there are some specificities in different markets. In Spain, for example, a lot of COVID rescue money has basically been channeled almost exclusively through the banks, which means that banks have been focused on distributing this capital at the expense of other lines of business.

Companies that haven’t required rescue funding haven’t had many options for lending. They are performing well and need financing, so that has opened up opportunities for us.

Paul Shea: I’d agree with a lot of what’s been said. March and April were very quiet. But since then, deal flow has picked up materially. Private equity firms still have dry powder and limited fund lives, so they have to do deals. Sponsorless SMEs have got taxes and rents to pay, which were only postponed, not canceled, and some businesses are not just resilient but have actually performed extremely well. They’re looking for money to grow and take market share. There are a lot of opportunities.

Some countries are a bit more active than others. Germany’s active, Ireland’s active, and the UK is increasing. We’re mandated on around three transactions at the moment, and hopefully a fourth fairly soon. Things are definitely picking up, and many of the credits look attractive.

It is good to hear that the market is starting to show signs of life, but with personal contact still restricted, how difficult is it to get behind a deal when there hasn’t been an opportunity to eyeball the management team?

Miles Otway: I think that is more of a challenge for private equity investors. It is less of an issue on the debt side. For private equity, the relationship with management is so important, and that is built up through a process where you can get close to a team, understand their drivers, and where you can add value that the next sponsor can’t.

It is on the relationship, not the pricing, that you win a deal, and that is the bit that is probably harder for private equity when you can’t meet people in person. On the debt side it is still an issue, but less of an issue, because if you are backing assets or a cashflow, you can take more of a view. It is also important to remember that there are other dynamics at play than just the impact of Covid-19.

In the UK, for example, we have had an unconvincing denial from the Treasury that capital gains tax (CGT) is going to rise. That is just one of many factors that will drive deals. I wouldn’t be surprised at all if you have a series of cashout deals that have elements of a debt structure and elements of an equity structure to them, in order to appropriately balance the risk of a CGT rise.

Peter, we have heard from the direct lenders and sponsors, and there is clearly the appetite and capability to put money to work despite the challenges posed by Covid-19. How are the banks reacting and how are they positioned?

Peter Brown: The banks are in a somewhat unusual position. On the one hand, they are much more resilient than before the financial crisis of 2008. Tier one capital levels were down in the single digits then. Now they are in the mid-teens, so the banks are holding much more capital and are much stronger.

However, they are under significant pressure to deliver government-backed loan schemes and support the wider economy and jobs. This has led to a focus on supporting their existing clients and made new deals more challenging.

But it is expensive to hold assets on the balance sheet, and corporate loan losses are likely to increase considerably as government support measures fall away and the true economic impact is felt. As credit quality deteriorates, then the capital cost increases which also poses some interesting challenges on returns and the economics of holding onto assets.

From a leveraged finance perspective, what this all means is that the banks have been more conservative because it’s more expensive to put higher-risk debt out. It absorbs more capital, so they’re generally playing at the super-senior and senior part of the capital structure and working alongside private debt players and other credit investors.

I see the trend of the last ten years, where private debt has taken a larger and larger share of the leveraged finance market, continuing as the banks deal with deteriorating credit quality, absorb capital, and see returns fall further.

MO: One thing to add is that there is a growing acceptance of cost for flexibility and headroom. Different direct lenders who have different ways of looking at an opportunity will come to the fore. When the economy is stable and everything is growing at two percent to three percent, entrepreneurs want the cheapest debt option and lean towards the banks, but when there is a period of uncertainty borrowers value a more flexible structure – whether that is a bullet or something with a cash sweep. Businesses are willing to pay a little more for a structure that takes off some of the pressure.

TC: We have certainly seen a shift to that kind of more flexible product, especially in the sponsorless market. Management teams are realising that the old relationship with the bank isn’t going to work anymore. They are now much more willing to investigate the options with the institutional market.

This is tracking the massive shift on the sponsor side over the last five to six years. Any statistic you read will say that between half to two-thirds of the sponsor-backed market is now supported by private credit.

PS: The interesting thing, and this has always been a question borrowers have asked, is how the institutional market will behave? The infrastructure of direct lenders is going to be a key factor. There are different infrastructure models across the market, and it is going to be interesting to see how the response of the different funds to lockdowns plays out.

What does that mean for what the market looks like in five to six years’ time? My perspective has always been that there’s likely to be a period of adjustment in the mainstream market, with niche lenders playing into specialist areas. I think that to a certain degree, the level of infrastructure around funds is going to be a driver of that going forward.

That leads nicely onto a question I was really interested in hearing the panel’s thoughts on. The number of new lenders has proliferated, and deployment has been crucial for new entrants who have to deploy to secure fee income. What happens when red lights start flashing and credits come under pressure? Do infrastructure and scale become more important, and does that suggest a consolidation of the lender universe?

TC: I don’t know if there will necessarily be consolidation, but I do think there will be a different structure to the institutional market. The managers with infrastructure will without a doubt be better positioned. It is worth remembering that in the mid-market, the reality is that there isn’t actually that much experience in restructuring because a lot of people have been deploying into a bull market for 10 years. It is going to be quite interesting to see how people cope when everything potentially does start lighting up red.

AOA: The question of consolidation does depend on which region you are operating in. Direct lending in Spain, for example, is still behind markets like the UK and the Nordics. There are fewer funds in our market for starters.

What we have seen is that the London-based, pan-European funds that came out once a month to do sponsor-backed deals with €30m Ebitda have found it difficult to deploy in the current environment without being local. Then, we have seen the local managers who raised second funds and have moved up the market and want to do bigger deals. They have had to start looking at other markets like France.

There aren’t many local midmarket funds around. It can actually be a lonely market, but that works for us because there are lots of deals to look at and not that many players to fund those deals.

PS: I am not sure if we are going to see consolidation anytime soon either, but I would say that if you are in the middle of the pack and you are only paid fees on invested capital and don’t have a scale, that can lead to challenges. Where you are in the market and your fee structure is important. We sit down and discuss budgets with our investors, and how we’re going to manage their fund, and we have a rational discussion about what’s needed, and they support us. We do receive fees on committed capital, so we are not under pressure to deploy. That makes a big difference.

MO: My sense is that you’re not going to have an immediate turnaround where a whole bunch of people exits the market overnight, but what you may have is managers slipping away over an extended period of time as those businesses see whether they can work those funds out.