Debt funds celebrate strong dealflow following Covid stress-test

Buyouts in the European market have continued to recover from their six-year low point in Q2 2020, which saw 157 deals with an aggregate value of €18.7bn recorded. In Q1 2021, by contrast, 346 deals totalling €72.2bn were recorded, according to Unquote Data.

While financing for primary and secondary buyouts remained fairly stable as a portfolio of LBO activity in 2020, a busy market for add-on financings made up for a fall in refinancings and recaps, according to GCA Altium's Q4 2020 Mid-Cap Monitor. Add-on financings made up 28% of deals completed in the German market in 2020, compared with just 16% in 2019. In the UK, add-on financings rose only slightly, from 27% in 2019 to 29% in 2020; however, new LBO activity accounted for 50% of market share in 2020, compared with 39% in 2019, making up for a 12% fall in refinancing and recap activity in the region.

Direct lenders had good reasons to undertake add-on financings in 2020, says Neale Broadhead, a partner at CVC Credit Partners: "A lot of the mid-market deals we do have been buy-and-build, and there has been some good value there through the pandemic. If you have a mature book like we have, you have a chance to do recurring deals with companies and management teams you have worked with before. As an incumbent lender, you can benefit from this – you're close to management, you know the business, and might already have undrawn lines that you have made a commitment too."

Norbert Schmitz, a managing director in GCA Altium's debt advisory and restructuring team, says that, while primary or secondary LBOs might have been approached with a significant amount of uncertainty in 2020, the market has now seen a definite shift. "Dealflow is now about new deals, and many people are quite positive about there being more deals to come in the next few months. Market sentiment is positive – Covid-19 is still there, but vaccines are helping the market to come back."

"Q4 was very busy for us – then, in the early part of the year, especially following the new variant in the UK and the third lockdown, we saw a lower level of activity," says Robin Doumar, a managing partner at Park Square. "But the pipeline has been accelerating over the past few weeks. A lot of deals that were put on ice in 2020 are coming back to life now."

Technology and software were considered safe bets in 2020, Schmitz says, although the market is increasingly crowded. "I think many people will still try to invest in these sectors in 2021, but the valuations are sky high and the question is if there is actually enough dealflow. Having said that, there is now more coming from primary LBOs, where people are thinking about selling their businesses."

Assessing the quality of assets on offer as the market recovers, as well as how they have been affected by the crisis, is essential in getting the best outcomes, says Nicolas Nedelec, a managing director at Idinvest. "We are willing and able to take views on 2021, acknowledging the fact that 2020 was a very difficult year. This actually goes both ways, since you also need to either take it into account or even discard it if companies have really benefited. Depth of experience is extremely important now to properly assess the borrowers' business models and their ability to rebound."

The banks are in the business, but they have moved to holding loans indirectly through the leverage facilities they provide to private credit managers instead" – Robin Doumar, Park Square

Not banking on it
"What changed towards the end of last year is that financing parties began getting more open to sectors beyond software, technology and healthcare," says Schmitz. "Everybody wants to invest in those sectors, but the prices are high and leverage is aggressive. Banks almost don't have a chance. But many banks are looking at the less hyped sectors – not retail or leisure, but those that are in between, with moderate leverage of 3-4x. Some of the bank deals we are seeing now are for companies that have more customer concentration or are a bit more specialised."

There are naturally parallels to be drawn between the direct lending and private equity markets, in terms of fundraising and performance as an asset class, as well as deal-making. "We have issues similar to those of private equity, with an overall abundance of liquidity," says Idinvest's Nedelec. "This is especially true at the larger end of the market, where too much money chases too few assets." The market is increasingly competitive and sophisticated, which brings both challenges and opportunities, he adds. "Lots of US and UK players have set up new funds over the past few years and that has put pressure on leverage and pricing, but, on the other hand, the banks have generally retreated from the market, which is a net positive for us. Covid has definitely accelerated this."

Although many geographies have seen the role of banks in the LBO market shrink, GCA Altium's Schmitz notes that there are regional differences. "The German banking landscape is still stronger than the UK one. In Germany, you have more mid-cap banks that are willing to lend." However, he anticipates that the market share of debt funds is still likely to increase in DACH. "I think debt funds have another 10% to go to dominate the market here and I would not be surprised if it reaches a 70:30 ratio. Ticket sizes from banks have decreased, so you need more banks for the same debt amount. The debt funds have some good arguments on their side."

Nevertheless, although banks have receded from traditional LBOs, Doumar says they are continuing to participate through fund financing facilities: "There has been a tipping point at which debt funds have become the relationship lenders to private equity. But banks are lending in other spaces – they are big providers of fund leverage to private credit firms, where the regulatory capital treatment is more beneficial. So the banks are in the business, but they have moved to holding loans indirectly through the leverage facilities they provide to private credit managers instead."

In praise of covenants
While many debt funds benefited from the market factors that played out in their favour in 2020, it was also a year in which covenants and documentation were tested. Sponsor-lender relationships also underwent their first real test in the European direct lending market during the crisis, as reported by Unquote.

"If covenants trip then it means they're working and that you have set them appropriately," says Broadhead. "Clearly you would not want this with every company, as that would mean there was something systemic happening in the portfolio, but having a few of them tripping is not a big issue at all. It means you have another reason to be engaged with the sponsor and the company, and it proves that your controls are operational."

The signs to date are that the asset class has weathered the storm relatively well, due to the good downside protections that direct lenders have, including covenants and large equity cushions, and the stability of long-term closed-ended fund structures" – Jane Turner, Schroder Adveq

"It does underscore the importance of safeguards against a one in 100- or 200-year event," says Doumar. "A lot of things that we put in our documents that we don't expect to routinely use did come into effect at the start of the pandemic. It does demonstrate the value of covenants. It underscored the importance for senior lenders of a maintenance covenant, specifically of the financial covenants rather than the incurrence-based ones."

Jane Turner, an investment manager at Schroder Adveq, is of the view that the covenants exercised by many managers are likely to put the asset class in a strong position. "It's a little early to tell, but the signs to date are that the asset class has weathered the storm relatively well, due to the good downside protections that direct lenders have, including covenants and large equity cushions, and the stability of long-term close-ended fund structures."

Reaping returns
Although many managers have had portfolio success stories during the crisis, not all market players will have fared as well. "I expect there to be an increase in the dispersion of returns among managers, depending on their pre-crisis lending decisions and overall portfolio diversification," says Turner. "We have seen larger fund managers absorb a greater proportion of industry capital in the past year. From a risk mitigation standpoint, there has been a preference for those groups that can point to having the resources and experience of managing assets in a more challenging economic environment, while from a practical perspective it has been easier to support existing relationships."

Indeed, names with significant weight behind them were able to reach successful closes during the crisis. Ares had raised €7bn by November 2020 against a €9bn target for Ares Capital Europe V; the vehicle held a final close in April 2021 on €11.5bn. Kartesia also held a final close for Kartesia Senior Opportunities I in March 2021 on €1bn, following a first close in December 2019 on €352m.

"For firms like ours in private credit, the big theme that the crisis has underscored is the importance of asset selection and credit picking skills," says Park Square's Doumar. "This is a real first test for the industry, and in my view we will see very big differences in manager performance based on credit-picking skills."

"We would expect an increase in the dispersion of returns," says Turner, "but it will remain a systemically important asset class, especially since banks, for regulatory and capital-efficiency reasons, have had to move away from lending to mid-market companies. While we expect defaults to increase, and recovery rates may decline from historic levels, our expectations are that on a net-loss basis, private credit asset classes remain attractive relative to public fixed-income asset classes."

CVC's Broadhead is positive about the industry's future as the market continues to recover: "In Europe, this has been the first full cycle that most direct lenders have seen and it is healthy for the industry, and if we get through it without many lenders taking the keys to companies when they have the opportunity, it will prove the longevity of the asset class. Being able to provide patient capital and continued support shows direct lending is there to stay."

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