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Taking the temperature on debt

Talya Misiri 12 August 2021

Similar to PE, private debt has been able to weather the COVID-19 storm and has not been as affected as public markets. When it comes to financing during unexpected events such as the pandemic, a mixture of support from equity, banks, management teams, suppliers and other shareholders has enabled businesses to pull through. Indeed, banks and debt funds provided financial support where they were able to. While debt funds continued to support businesses and their sponsors, albeit cautiously, through the pandemic, banks providing debt retrenched on long-term financing and instead provided government-backed support loans.

Now, as the market continues to rebound post COVID, Real Deals takes a look at the response of banks and debt funds, valuations and pricing, ESG and the potential consolidation in a segment of the market.

Banks vs funds

Time and again, large scale events such as the pandemic divide the winners from the losers in all areas of the economy. And, in private debt, the response of the banks has once again been positioned in comparison to private debt funds.

Assessing both parties’ response to the pandemic, there has been a clear difference in behaviour. After the initial slowdown in March last year, the banks largely retrenched from providing long-term capital and debt and instead worked to dispatch government-backed loans.

“In most European countries, banks have been counterparty to executing government-backed loans, so some have experienced resourcing and bandwidth issues in other parts of the lending business,” Lincoln International managing director Aude Doyen says. In comparison, it seemed to be business as usual for the majority of debt funds in the lower-to-mid market.

“At the beginning of the pandemic, we saw the direct lending market take a bit of a pause, temporarily with new activity...But that pause came to an end pretty quickly,” Lincoln International managing director Xenia Sarri says. “The funds never really stopped lending.”

Valuations & pricing

Valuations and pricing in the debt market were also largely unaffected by the pandemic. Sarri says: “Regarding terms, there was a bit of widening around pricing for a while, but we came back to pre-pandemic terms very quickly. I would say by October of last year, pricing had tightened back to what it was before the beginning of the pandemic. When you look at leverage and the economics, it’s as competitive as it’s ever been.”

Considering competitive pricing, Eurazeo managing partner and head of private debt François Lacoste, says that there has been more competition in the mid-market in comparison to the lower-mid market. He notes that Eurazeo’s debt arm has “remained very cautious regarding structures, leverage, covenants and pricing, and have not aimed to be too aggressive on these. However, certain transactions including some in IT and healthcare have been very aggressive in terms of valuations and pricing during big auctions.”

Indeed, the sectors in which businesses operate have been a determining factor for valuations. CVC Credit partner Neale Broadhead says: “I think valuations have certainly gone up for those businesses that are deemed to be COVID-resistant or shown themselves to be resilient. I’d say that’s in the healthcare, education, software, and connectivity space, those ones are certainly getting healthy multiples… and I think this is likely continue through the year.”

Private debt funds’ appetite to service assets in resilient sectors is certainly the case at present. Sarri adds: “One thing we’ve seen is a bit of bifurcation around the sectors lenders are focusing on. There’s certainly been a preference for healthcare and tech deals.”

Considering assets that faced a tougher time during the pandemic, Beechbrook Capital co-founder Paul Shea says that with little information about the future value of businesses, certain sectors such as hospitality and dining proved trickier to value. He explains: “While it’s hard to put a valuation on it, we worked closely with the IPEV valuation methodology, discounted cash flow, and tried to present different methods of assessing valuations in line with industry standards.”

Nonetheless, “as stock markets and pricing recovered and buyout multiples recovered, we’ve seen a rebound to pre-pandemic levels,” Shea adds.

ESG incentives

Similar to private equity, ESG has been rising up the agenda in the private debt market. In particular, a recent development in the space has been the accelerated use of ESG margin ratchets.

ESG ratchet provisions in loans are being utilised across the lower and mid-market as a means to incentivise borrowers to improve their ESG performance. More specifically, incentives come in the form of pricing, whereby a borrower’s performance will result in either a reduction, or an increase to the margin depending on how well it meets the agreed criteria.

Lacoste comments: “It is now becoming market practice to include an ESG ratchet clause. Even firms that were less advanced around ESG are now trying to implement this.”

Similarly, Broadhead highlights that CVC Credit is actively encouraging the use of this ratchet provision with sponsors. “One thing that we’ve been very supportive of and have been pushing is ESG margin ratchets in order to really promote and help encourage our borrowers to have good ESG governance and credentials… We’re looking at it, not only from an environmental perspective, but from labor, human rights, ethical standards, sustainable procurement, etc.” he says.

“We think that by offering a monetary incentive to improve year-on-year for various different metrics via a margin link ratchet, it will get done, as opposed to people just saying, ‘Yes, I’m doing it’. If you define the targets, then people will work towards these to get the reward.”

Mid-market consolidation

Looking at the private debt market more broadly, supply may be outweighing demand in the mid market. Talk among the industry suggests that there may be a consolidation of mid market debt players in the near future as the market matures.

Beechbrook’s Shea says: “There seems to be a lot of managers focused on the €1bn plus size range; there’s probably about 60 of them.” He notes that while funds of this size will be beneficial to the long-term success of the private debt market, “in the short term, there’s possibly a bit of an oversupply of capital in the mid market”.

Increased talk of consolidation has been highlighted by LPs too. Eurazeo’s Lacoste says: “The pressure for this [consolidation of mid market debt] is coming from investors who want to concentrate their portfolios around several managers they trust and of a certain size in order to limit their control ratio.” He adds that offering a diversified portfolio will be difficult for smaller and local mid market debt houses. “They won’t have the same abilities and potential for global investment, or to do add-on acquisitions, it is quite difficult for a local and smaller player, and more regional firms, where investors want more pan-European capabilities.”

In contrast, Lacoste notes that in the lower mid market, firms need to be local and supply seems to be meeting demand. He says: “You need to be on the ground to understand the market and to be very local. You also need to have a direct contact with the management and with the PE sponsor and to understand their mindset.” 

Categories: Insights Expert Commentaries Funds Mid [€200M - €1B] Small [€200M or less]

TAGS: Cvc Capital Partners Cvc Credit Partners Debt Esg Europe Mid-market Pricing Private Debt Private Equity Uk Valuations

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