Sponsor-lender relationship faces stiff Covid-19 test

Debt funds have increased their market share of leveraged buyout deals in Europe prior to and during the coronavirus crisis, with sponsors often favouring their flexibility over bank financing. In Germany, for example, bank financing accounted for 29% of LBOs recorded in the period, while debt funds made up the remaining 71%, according to GCA Altium's Mid-Cap Monitor.

This shows a marked increase from H1 2020, when debt fund financing accounted for 52% of leveraged deals. However, the crisis has been a test for sponsor-lender relationships for both groups of lenders, with GPs particularly keen to see how the behaviour of debt funds could develop when times get tough.

Once the initial liquidity needs of their portfolios had been addressed, be it via additional liquidity injections or applications for state-backed financial support, the risk of covenant breaches was at the forefront of the minds of many lenders and sponsors.

EBITDA adjustments were also a key topic, with debates over which exceptional items could be counted, given the unexpected impact of the pandemic and state-enforced lockdowns on many companies. "Of course covenants need to be reset, but banks are acting sensibly," one sponsor tells Unquote. "They are fed up with dealing with credit committees and are happy to waive covenants, as long as they do not expect to lose their money."

Overload
However, when the support packages were introduced, some banks were initially overwhelmed by the need to distribute state-backed loans. While PE-backed companies were excluded from many such programmes, either when the schemes were introduced or at a later date, the situations in which banks found themselves had other effects on sponsors. Another sponsor tells Unquote: "We have some portfolio companies using several instruments – where banks were quick, forthcoming and proactive was with KfW funding. But when looking for standard products, not crisis financing, they were overwhelmed with KfW applications. We could not even get our banker on the phone – we did not expect it to be so damaging."

"The banks have a much bigger portfolio than most of the debt funds, so they had many more workout deals in Q2, and they had the KfW programme on the table as well," says Norbert Schmitz, managing director at GCA Altium, by way of an explanation. "A debt fund with five assets, for example, would not have such a difficult time." However, other sponsors tell Unquote that this was not an issue that they experienced.

New business was hard to come by for lenders during the first few months of the crisis, given that many deals came to a halt amid uncertain financials in the wake of the pandemic. GCA Altium's Mid-Cap Monitor attests to this fact: the survey found that 59% of the deals that took place in the German market were for add-ons and refinancings, compared with 44% in H1 2019. "We have seen add-ons and refinancings increasing, since lenders feel more comfortable if they know the asset, even if it is trading with some difficulty," GCA's Schmitz told Unquote when the survey was published in August 2020.

While banks took longer to open up following the initial crisis phase, market participants now attest to the fact that both banks and debt funds are open for business, albeit with certain caveats and accounting for a substantial market bifurcation.

In my view, lenders are not very strict at the moment: people know this crisis is temporary" – PE sponsor

Two-speed market
The division of the buyout market is also reflected in the tone of the talks that sponsors will have had with lenders during the pandemic, one sponsor says: "This depends on the asset: if the relationship was delicate because the asset was in distress pre-crisis, then the relationship has not improved. But there have usually been constructive talks if the asset was not distressed. In my view, lenders are not very strict at the moment: people know this crisis is temporary."

"There is a big difference between industries that were distressed before and those in trouble now," says one lawyer. "For the latter, there were holidays of 9-18 months to renegotiate business plans. There were minimum liquidity covenants and EBITDA, but they rarely demanded fees. The relationships are important, and all parties hope for a recovery."

Nevertheless, the general consensus from market participants is that lenders have been understanding in negotiating covenant holidays where necessary. Earlier this year, a sponsor reported: "Direct lenders have been supportive so far, giving us covenant holidays, allowing us to draw on RCF and, in one instance, a delayed-draw capex facility for additional liquidity."

The market participants with whom Unquote spoke said they do not expect banks to take the keys in the manner that was more common during the global financial crisis (GFC). One sponsor says: "This is not a credit crunch like in 2008, so there is no need for the banks to be so aggressive. They do not have that same pressure and are willing to be flexible."

Nevertheless, sponsors are mindful of the possibility that lenders could take more drastic measures if the economic situation worsens, or if lockdowns are reimposed that impact already struggling businesses. Says one sponsor: "We have thought about that a lot when taking on new investors, be it debt funds or banks: would they take the keys in a worst case? We try to eliminate those for syndication. For some lenders it is an acquisition tool, and they do not want what we want, which is low or light covenants."

Some debt-for-equity swaps have already been seen in the market in situations where sponsors were no longer able to provide equity to support the capital structure. Some of these situations have been initiated by restructuring proceedings in hard-hit industries; so far, these have generally been limited to the areas of automotive, retail and restaurants, which were also struggling prior to the pandemic.

You are not doing any new deals and all your origination staff are working hard putting pressure on sponsors to put in equity and hoping they do not end up owning too many assets" – Direct lender

Sun European Partners' Flabeg was acquired by incumbent lender Cordet Capital in October 2020, following its insolvency filing in May. In the UK, casual dining has been hit particularly hard, with both lenders and sponsors on the buy-side. Partners Group acquired French bistro chain Côte from BC Partners; in a deal that The Sunday Telegraph reported could have been made via a debt-for-equity swap. It was also reported in July 2020 that China-based GP Hony Capital was to lose control of Italian dining chain Pizza Express, with the company's bondholders set to exchange their debt-for-equity. In the UK retail sector, It was reported in June 2020 that Bridgepoint-backed FatFace was to be acquired by lenders including Alcentra and Oak Hill.

"The question for PE funds is how debt funds would react in a restructuring," a second lawyer tells Unquote, noting that how supportive debt funds would be remains a key question. "A number of funds are gaining a reputation for being very aggressive – nobody talks about this, but there is a battle going on between debt providers and equity providers, with the ‘debt-to-own' business model. This will now come into play and it is just starting."

Many direct lenders have dedicated teams with restructuring expertise, which means they have capacity to take command if times get tough. Some GPs and advisers anticipate that a wave of debt funds taking the reins in debt-for-equity swaps could still happen. However, it is not necessarily in the interest of debt funds to do this, given the vast amount of time and operational resources involved, as one direct lender says: "What can you do if a third of your portfolio makes zero revenues? You can try to hire more restructuring experts, but they are in fairly short supply at the moment. You are not doing any new deals and all your origination staff are working hard putting pressure on sponsors to put in equity and hoping they do not end up owning too many assets."

"Due to availability of capital on equity and debt, debt documents are not what they might otherwise have been to navigate tough periods," a third lawyer tells Unquote. "Conversations have broadly been supportive with lenders and banks. These conversations will get more difficult when banks allocate their files from their lending to their restructuring arms, although there has not been much of that yet, and some do not have a big enough restructuring arm."

We talked to eight debt funds we worked with – there have been significant differences, and, in hindsight, we would not have gone with those with the lowest margin, but those who are real partners in an external shock that is not caused by mismanagement" – PE sponsor

Litmus test
The crisis response of lenders, and, in particular, of the new debt funds, will be a deciding factor for many sponsors in deciding which financing partners to choose in the future. "I would like to see how different debt funds have acted; this will be important," one sponsor tells Unquote. "We talked to eight debt funds we worked with – there have been significant differences, and, in hindsight, we would not have gone with those with the lowest margin, but those who are real partners in an external shock that is not caused by mismanagement. Some will always believe that the sponsor is not doing anything. If some parties are already being referenced badly, there might be a reason."

The pandemic and the resulting economic shock have been the first real tests for debt funds, given the fact that the market was relatively new across much of Europe during the GFC. Says Schmitz: "Debt funds have always said they would be there in a more difficult market. It is one of the reasons why they started in the first place in 2011/12. When things were difficult after the last crisis, they thought they would be there when the banks were not."

Market participants also attest to the fact that debt funds are keen to attract new opportunities to deploy, rather than seeking to take over companies in their existing portfolios. Reflecting on their communications with banks, one sponsor says: "We had better communication with debt funds – they are really keen on doing new business."

"Going forward, people will focus on their key relationships," says a fourth lawyer, who adds that they were generally impressed by the constructive discussions between sponsors and lenders. "Debt funds and banks have generally behaved very well: they did not take waiver fees or restructuring fees, and many gave covenant holidays of 12-18 months. There has been good will all round, but even more so on the debt fund side, since they are newer, and they were lucky in that they did not need to do paperwork for state loans."

It remains clear that the initial debt-for-equity swaps, and the most difficult conversations, have been limited to the industries hit hardest by the coronavirus pandemic and its related lockdown measures, with most interviewees telling Unquote that their experiences have been constructive.

However, sponsors and lenders are by no means out of the woods, particularly as uncertainty persists over how long the economic impact of the crisis will continue. "I have always thought that the crunch will come later, because debt funds and banks do not have the capacity or desire to take over businesses currently. Their portfolios are too big," says one sponsor. "Covenants are breaking, but they are letting the liquidity flow right now and being very flexible. The highest point of danger is when businesses can see the light at the end of the tunnel, and the lender can be confident that, should they take over the business, they would be likely to recoup their investment. That will be a more dangerous time for owners than now, when things look so bleak that the debt fund would not be able to make money by taking control of the business."

With additional reporting by Katharine Hidalgo and Oscar Geen

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