HEADLINES

• Direct lenders were able to take on large-cap financings in 2022 as loan and bond markets pulled back
• Nimble managers are taking out hung bridges and buying up debt in non-conventional syndication processes
• Direct lending moves into 2023 in good shape, but pressures on portfolios and tighter fundraising markets could slow deployment

Inertia across European leveraged loan and high yield bond markets in 2022 opened a window of opportunity for direct lenders to fund larger credits and strengthen their core mid-market franchises.

Despite the challenges posed by rising inflation and interest rates, as well as supply chain bottlenecks and the fallout from the Ukraine conflict, direct lending activity sustained high levels of deal flow.

According to Debtwire Par, European direct lending issuance came in at €51.6 billion in the first nine months of 2022, well ahead of the €38.8 billion posted in 2021. Deal count of 705 transactions for the period, while down from the 899 deals in 2021, also held up well ahead of pre-pandemic levels.

These levels of direct lending activity—particularly in the first half of the year—stood in contrast to the double-digit declines observed in syndicated loan and high yield bond markets, where issuance has slumped in the face of macro-economic headwinds and investors have preferred buying up discounted credits in the secondary market to new deals.

Filling the gap

The slowdown across capital markets has given direct lenders an opportunity to fund larger credits that would normally have been funded with loans and bonds.

Replete with dry powder following a strong run of fundraising in the past 24 months, direct lenders have routinely stepped in to take on credits that shelved or shunned public bond and leverage loan plans and opted for private debt solutions instead.

Advent International, for example, initially lined up a €430 million floating rate note to partially finance its acquisition of Italian ingredients manufacturer IRCA, but switched to a senior acquisition finance package provided by CVC Credit Partners as public credit markets turned.

Other examples of deals switching to direct lenders include France-based buyout firm Astorg's acquisition of drug development company CordenPharma, where banks were initially expected to provide financing. Instead, Astorg went with a €1.5 billion financing from a club of four private debt providers.

Direct lending clubs, like the one that funded the CordenPharma, have become increasingly common, as direct lenders band together to diversify risk and combine their financial firepower to take down jumbo credits. The £3 billion refinancing of software company Access and the debt provided for Clayton, Dubilier & Rice’s acquisition of the UK, Ireland and Asia operations of French services business Atalian have both been financed by clubs of direct lenders.

Direct lenders have also taken advantage of the flexibility and nimbleness of the private debt model to provide banks and borrowers with variations on classic syndicated deals.

In the acquisition of Danish pharmaceutical company Norgine, by the private equity arm of Goldman Sachs, for example, the financing was underwritten by Jefferies, KKR Capital Markets and Goldman Sachs with a plan to syndicate directly to private credit firms rather than institutional investors, according to Bloomberg.

Private debt funds have also stepped in to provide liquidity for underwriting banks stuck with debt that they have not been able to syndicate. At the end of 2022, US and European banks were sitting on approximately US$42 billion of buyout debt stuck in syndication because of the more risk-averse market, according to Bloomberg.

Direct lenders have seen an opportunity to buy up this paper and help banks clear their books. Specialist debt fund manager Pimco, for example, bought more than €1 billion of loans from banks that underwrote the buyout of French payments business Worldline as well as €500 million of debt used to back the buyout of UK supermarket chain Morrisons.

In addition to the opportunities presented at the large-cap end, the mid-market—a core market for direct lenders—has continued to tick over. Mid-market M&A involving companies valued at less than €1 billion has proven more resilient to the deteriorating economic backdrop than mega-deal activity, ensuring a steady flow of transactions to finance for direct lenders.

Maintaining momentum

With syndicated loan and high yield bond markets expected to remain relatively moribund into 2023, direct lenders are well positioned to continue winning market share in the large-cap market, strengthening their position as the go-to option for mid-market deals.

The next 12 months, however, will not be without their challenges.

There are signs that direct lender bandwidth will be shifted from new deals to portfolio management. According to Debtwire Par, there are hints that borrowers across European direct lending portfolios are already bracing for squeezes on profitability that could see credits push up against covenants.

Amend-and-extend and refinancing deals may stave off some covenant breaches, and direct lender credits are also parsing through their accounts to identify EBITDA add-backs and so-called "exceptional items" that could help them squeeze through covenant tests.

Nevertheless, in a mid-market lender survey conducted by Debtwire Par, 15 per cent of respondents say they expect between a fifth and half of their portfolios to be vulnerable. More than 40 per cent expect covenant waivers to be the main restructuring mitigation strategy in the next three to six months.

Anecdotal reports are also emerging that direct lenders are starting to tap the brake on the pace of deployment more generally after a frenetic period of activity through both 2022 and 2021.

Fundraising across all private markets has slowed in 2022, with increasingly risk-averse investors scaling back their exposure to alternative assets. As most direct lenders are well ahead of deployment schedules, there is no rush to fully deploy existing vehicles and face a choppier fundraising market earlier than necessary, according to Deloitte.

Direct lenders are still open for business but can afford to be choosier about the credits they back.