HEADLINES

• Private equity (PE) deal value in Europe dropped from US$599.2 billion in 2021 to US$369 billion in 2022
• Private debt fund structures in the region will ensure that buyouts and deal financings continue despite a tough market
• Debt funds have appetite to fund large-cap as well as mid-market transactions
• Club deals are becoming commonplace, as direct lenders take on bigger deal financings and diversify risk in their mid-market portfolios

European PE dealmaking declined in 2022—down 38 per cent year-on-year, according to Mergermarket—as macro-economic uncertainty intensified, valuations became increasingly volatile, and financing tightened.

Under the circumstances, the outlook for 2023 is uncertain. To what extent will structural incentives encourage sponsors and lenders to continue doing deals? How will an expanded universe of debt providers be able to overcome the obviously difficult macro-economic conditions?

Financial sponsors will not be sitting on their hands in the months ahead, even with a possible recession on the horizon.

Sponsors need to continue investing their limited partnership (LP) commitments through the cycle to deliver the expected returns. A downturn can also open new opportunities—dollar and euro-denominated funds will see potential value in chasing UK assets due to weaker sterling, while that same phenomenon, coupled with depressed values of some listed companies, may encourage more take-private deals.

The fact that financing is more expensive and difficult to secure could make dealmaking more challenging, but not enough to override the existential requirement for financial sponsors to sustain activity. As firms look ahead to the new year, here is a five-point checklist on what to expect from deal financing in 2023:

1. PE funds will keep deploying capital (and so will debt funds)

Regardless of whether syndicated loan and high yield bond markets reopen for buyout financings or not, in the months ahead, private debt funds will continue to serve as a steady source of acquisition financing. According to Deloitte, European private debt assets under management have increased five-fold in the past decade. With debt funds adopting similar fund structures used in the buyout space and sharing some of the same types of institutional investors, private debt fund managers should be similarly compelled to keep deploying their large capital pools across the cycle.

For most of 2022, private debt has been the best option available to sponsors, including for large-cap transactions that would usually be financed with syndicated loans and bonds.

According to Debtwire Par, more than ten transactions earmarked for potential syndication in 2022 were bankrolled by direct lenders, either in full or in part. So long as investors in the syndicated loan and high yield markets remain cautious, sponsors should be ready for direct lenders to take a firmer stance on pricing and terms—many direct lenders may become more selective before underwriting new deals in 2023.

With debt funds being the go-to option for sponsors in recent months, a key question for financial sponsors will be at what point high yield and loan markets come back into the frame, issuing new debt at a margin that is competitive with the offering of debt funds.

2. More sponsors are joining the club

Historically, direct lenders have preferred to do deals by themselves, but with new opportunities emerging to take on bigger deals, direct lenders have joined forces and undertaken club deals in increasing numbers.

A club of direct lenders, for example, funded a more than £3 billion refinancing for Hg and TA Associates-backed software company Access. The direct lending arm of The Carlyle Group and HPS financed Clayton, Dubilier & Rice's acquisition of the UK, Ireland and Asia operations of French services business Atalian.

One of the more recent examples is EQT Infrastructure's efforts to acquire Trescal, specialists in calibration services based in France. The sponsor reportedly secured more than €600 million in commitments from a private credit club that includes Apollo, CVC Credit, Goldman Sachs, KKR Credit and Park Square-SMBC. The deal was also dual-tracked—Marlborough Partners was mandated to arrange bank-supplied staple financing, with direct lenders standing by. In the end, however, EQT Infrastructure opted for private credit providers, a noteworthy break from its historic reliance on bank-led financing.

For sponsors, the emergence of direct lender clubs marks a "back to the future" moment, as putting a direct lending club together is akin to marshalling old-fashioned bank lending clubs.

Direct lender internal processes are typically faster and nimbler than those of banks, so getting direct lenders to move in the same direction should be more straightforward than the more challenging bank club processes of earlier years. Nevertheless, bank club deal experience will prove valuable as sponsors focus on how to corral lenders in anticipation of more of these transactions in 2023.

3. Debt-raising dynamics will have to change

As direct lending club deals become more commonplace, the dynamics of intermediated acquisition finance raising processes will have to change.

In the more benign liquid markets of the past ten years, sponsors have set up financing processes as auctions. They have specified their terms and lenders have competed to get in on deals. With a surfeit of lenders ready to fund deals in 2022, sponsors have been able to pit them against each other to land the best financing package.

This competitive structure has worked well when a single lender underwrites a deal, but when deal sizes increase and more lenders are required, it becomes increasingly difficult to herd lenders through a process.

In borrower-friendly markets, sponsors can (within reason) limit the time available to direct lenders, as well as their scope to comment on terms. When markets are tighter and lenders can be more selective, however, it will be increasingly challenging for sponsors to let direct lenders fall by the wayside if they want more time or have more complex documentation requirements. On larger credits, even a lender that will only hold the sort of minority stake that would not ordinarily afford it much influence may have to be accommodated.

Sponsors may have to relinquish some control over the process timetables if they hope to keep all lenders onboard.

4. Speed will be of the essence

While syndicated loan and bond markets have been choppy and may remain so in the near term, financing windows will still open—albeit intermittently—and sponsors should be prepared to move quickly.

Windows for issuance opened in 2022 when the outlook on inflation and interest rates improved and issuers, including Hunkemoeller, Fedrigoni, EnQuest and Cirsa, managed to navigate the market turbulence to secure high yield financings.

Although there is limited activity at present, European high yield bond and leveraged loan markets have become far more efficient in recent years. For example, if issuers are well prepared and have updated their disclosure, they could be prepared to launch a high yield bond offering in a matter of weeks and not months. Such windows will continue to open in 2023, providing financing opportunities for nimble sponsors.

5. Be ready to refinance when the time comes

Should inflation and interest rates top out, as trends late in 2022 suggested, secondary pricing in loan and bond markets is likely to recover, and markets for primary issuance will revive. As soon as they do, sponsors that agreed to tighter covenants, higher pricing and lower leverage multiples to finance deals in the past 12 months should lay the groundwork to refinance.

Given the higher proportion of deal financings done by direct lenders in 2022, sponsors looking to refinance when market conditions improve should be particularly mindful of deal terms. Direct lenders putting their money to work over a set period and planning to hold debt to maturity will typically include pre-payment fees and non-call provisions in documents. Sponsors should be very clear about what is required to refinance or reprice, and not assume that they will be able to roll into another structure whenever they choose without some financial pain.