Debt Advisory Insights from Clearwater International...
6
The appetite for alternative credit is soaring with debt funds raising record amounts. In this Clearthought, we examine the impact on corporates. Introduction The speed of change and return of confidence in debt markets is notable. Debt markets were largely closed for raising finance in 2009, it was a struggle even for some of the best credits. Since then we have seen a return in the banks’ appetite to grant loans - partly driven by the need to lend after a number of years of shrinking balance sheets, and partly as a result of the improvement in risk appetite - as they seek higher returns on their lending. There have been fundamental changes across Europe, as alternative finance providers and debt funds have seen their market share increase, often at the expense of traditional lenders. This structural shift has led to a more diverse lending environment than was seen prior to the credit crunch. According to Market Monitor data, non-bank lenders were involved in 17% of deals in Europe with ¤1.3bn or less of debt in 2011. However, by 2013 non-bank lenders were involved in 46% of these deals. clearthought Debt Advisory Insights from Clearwater International Autumn 2014 Debt Funds in the Funding Market An overview of recent trends in the market and expectations for the future After a number of years with limited choice in the mid-market, there is now a diverse range of lenders and lending products available to businesses. Some of the new products in the market, such as the much-discussed unitranche, are not only supporting buy-out transactions and leveraged deals but also offer an alternative form of finance for businesses that require more flexibility in their funding structure. For instance, this could be in the form of lower or no amortisation of the loan, providing the business with additional cash resources to spend on acquisitions or capital expenditure. We have seen loan pricing reduce materially in the last 18 months, as competition in the European mid-market between banks and debt funds has increased. The driver for this has been the relatively low number of deals and transactions taking place, meaning lower demand from businesses, and the entry of new non-bank lenders which have raised large funds from investors that need to be put to use. With the exception of when debt funds participate in club and syndicated deals with banks, pricing from debt funds is generally more expensive than banks. This is a function of returns expected by investors. As a quid pro quo, commitment periods can be longer, covenants lighter and amortisation less or non-existent. Lower amortisation from banks is also becoming more popular in the Leveraged Buy-Out (LBO) market, with larger proportions of non-amortising B tranche term loans forming part of the structure. Within some larger mid-market leveraged finance deals, there have even been some term-loan-B-only arrangements. Seasonal and/or very cash generative businesses have benefitted from amortising Revolving Credit Facilities (RCFs) being offered by senior lenders. This structure is a committed working capital facility where the limit reduces each year. This reduces the refinance risk for the lender and also cuts the interest cost for the borrower during positive periods of their working capital cycle. Term loans and unitranche facilities do not tend to offer this flexibility. Higher proportion B tranche term loan structures and amortising RCFs have been used by senior lenders in order to compete and differentiate themselves from the debt funds offering unitranche style products. The terms in the lower mid-market are not quite so favourable as those in the mid- market, but we continue to see an improvement in liquidity, interest from banks and alternative funders, and an increase in the leverage multiples offered to businesses. This can only be good for increased deal activity and growth. Trends in detail n Deals including non-bank lenders n Bank only deals * 12 months to end of September. Multi-banked transactions with ¤1.3bn or less of debt 2011* 17% 46% 31% 83% 54% 69% 2013* 2012*
Transcript of Debt Advisory Insights from Clearwater International...
The appetite for alternative credit is soaring with debtfunds raising record amounts. In this Clearthought, weexamine the impact on corporates.
Introduction
The speed of change and return ofconfidence in debt markets is notable. Debt markets were largely closed forraising finance in 2009, it was a struggleeven for some of the best credits.
Since then we have seen a return in thebanks’ appetite to grant loans - partlydriven by the need to lend after a numberof years of shrinking balance sheets, andpartly as a result of the improvement in riskappetite - as they seek higher returns ontheir lending.
There have been fundamental changesacross Europe, as alternative financeproviders and debt funds have seen theirmarket share increase, often at the expenseof traditional lenders. This structural shift hasled to a more diverse lending environmentthan was seen prior to the credit crunch.
According to Market Monitor data, non-banklenders were involved in 17% of deals inEurope with ¤1.3bn or less of debt in 2011.However, by 2013 non-bank lenders wereinvolved in 46% of these deals.
clearthoughtDebt Advisory Insights from Clearwater International Autumn 2014
Debt Funds in the Funding MarketAn overview of recent trends in the market and expectations for the future
After a number of years with limited choicein the mid-market, there is now a diverserange of lenders and lending productsavailable to businesses.
Some of the new products in the market,such as the much-discussed unitranche, arenot only supporting buy-out transactions andleveraged deals but also offer an alternativeform of finance for businesses that requiremore flexibility in their funding structure. Forinstance, this could be in the form of lower orno amortisation of the loan, providing thebusiness with additional cash resources tospend on acquisitions or capital expenditure.
We have seen loan pricing reduce materiallyin the last 18 months, as competition in theEuropean mid-market between banks anddebt funds has increased. The driver forthis has been the relatively low number ofdeals and transactions taking place,meaning lower demand from businesses,and the entry of new non-bank lenders
which have raised large funds frominvestors that need to be put to use.
With the exception of when debt fundsparticipate in club and syndicated deals withbanks, pricing from debt funds is generallymore expensive than banks. This is afunction of returns expected by investors.As a quid pro quo, commitment periods canbe longer, covenants lighter andamortisation less or non-existent.
Lower amortisation from banks is alsobecoming more popular in the LeveragedBuy-Out (LBO) market, with largerproportions of non-amortising B trancheterm loans forming part of the structure.Within some larger mid-market leveragedfinance deals, there have even been someterm-loan-B-only arrangements.
Seasonal and/or very cash generativebusinesses have benefitted fromamortising Revolving Credit Facilities(RCFs) being offered by senior lenders.
This structure is a committed workingcapital facility where the limit reduces eachyear. This reduces the refinance risk for thelender and also cuts the interest cost forthe borrower during positive periods oftheir working capital cycle. Term loans andunitranche facilities do not tend to offerthis flexibility. Higher proportion B trancheterm loan structures and amortising RCFshave been used by senior lenders in orderto compete and differentiate themselvesfrom the debt funds offering unitranchestyle products.
The terms in the lower mid-market are notquite so favourable as those in the mid-market, but we continue to see animprovement in liquidity, interest frombanks and alternative funders, and anincrease in the leverage multiples offeredto businesses. This can only be good forincreased deal activity and growth.
Trends in detail
n Deals including non-bank lendersn Bank only deals* 12 months to end of September. Multi-banked transactionswith ¤1.3bn or less of debt
2011*
17%
46%
31%
83%
54%
69%
2013*
2012*
Debt Advisory Insights from Clearwater International
Tell us aboutPricoa
Pricoa Capital Groupis the direct lendingarm of PrudentialFinancial Inc* (NYSE:PRU), and has been
one of the leading global providers of privatedebt to companies for the past 75 years.We have been in the UK for over 25 ofthose years. Pricoa is also active in Europe,with offices in Paris and Frankfurt.
Long-term lending has been a consistentpart of our investment mandate and ourbusiness has grown steadily, even duringthe recent global economic crisis.
If anything, the crisis has helped our
growth - when banks were turning away
companies in the depths of the crisis,
businesses turned to us as an alternative
capital source. In 2013, we provided more
than ¤1.5bn in capital out of our London
office alone. We have long-standing
relationships with many corporates and
have been in the private debt space for a
long time.
How does the Pricoa model work?
What we do breaks down into two mainareas. Firstly, private placement financingfor medium to large companies with long-term fixed rate funding. Secondly,mezzanine and senior lending to lower mid-market companies (¤5m EBITDA upwards).
The fact that our model is built around long-term relationships gives us a big advantage.Half of what we do is offering repeatbusiness. We find a company, deliverfinance, and then continue to provide capitalin the future for that business.
We provide capital in both sponsored andnon-sponsored transactions. Private equity(PE) and corporates are becoming moreaware of non-bank options. Non-sponsored transactions still lack funding
alternatives and this is where we find ourproposition resonates strongly. As a termlender, we are under less pressure to getour money back so quickly. Therefore, weprovide a longer-term funding option thanbank debt. Much of our activity this yearhas been funding companies’ growth andinvestment plans.
What is your view on the newfunds that have entered themarket?
There is a considerable structural shift yetto happen in a region such as Europe, and itis the beginnings of this shift that havebeen driving our business in recent years.
However, one of the challenges is that thereare barriers to entry in setting up the funds inthe first place. You have to have people on theground who can structure the transactions,and it is a very hands-on asset class.
Big US insurers have been doing this for awhile, but it is a big investment to launch aplatform. That has been a barrier forEuropean institutions which are seriousabout entering this market. However, anew asset class has undoubtedly emergedover the past few years.
What is your view on the currentmarket?
Over the last six months, the marketdefinitely feels far more positive whetherfrom public or private companies. There aremore conversations about M&A andinvestment opportunities, which is startingto drive deal flow. We have also seenactivity pick up in the PE market.
Ultimately, company default rates are verylow right now. Many corporates haveweathered the storm and paid down theirdebt. The main factor that could derail thecorporate debt market in the short term issome kind of big global economic shock.
* Prudential Financial Inc is not affiliated in any mannerwith Prudential plc, a company incorporated in theUnited Kingdom.
clearthought | Autumn 2014
Interview: Ed Jolly, Pricoa Capital Group
clearthought | Autumn 2014 Debt Advisory Insights from Clearwater International
Hot Topics
New funders
A number of new debt funds have enteredthe European market, adopting a range ofdifferent strategies including private debt, mezzanine, special situations anddistressed debt. This inflow of liquidity hashelped to drive a number of leveragedrefinances, leading to the high issuanceseen opposite.
Debt funds can generally be split into twodistinct categories. Firstly, the directlending arms of pension funds andinsurance companies; and secondly, thosethat have raised a specific lending fundfrom an investor pool. The debt funds oftenhave structures similar to those seen in thePE market, with investment periods ofthree to five years and a life of around 10years. The limited partners in these fundsare usually insurance companies, pensionfunds, private wealthy investors, banks andsovereign wealth funds.
Key differences in the debt funds comparedwith banks are:
n Higher leverage multiples (asdemonstrated in the graph opposite)
n Non-amortising / bullet structures
n Structural flexibility around covenants,headroom, cash sweeps and dividends(lower graph shows loosening ofcovenant controls)
n Options across the capital structurewith senior, second lien, unitranche,mezzanine and quasi-equityinstruments, including warrants
n Shorter credit decision processes
Limitations of debt funds include:
n Inability to offer clearing or ancillaryfacilities
n Higher pricing to account for theincreased flexibility offered
n Lack of track record managingdistressed situations
Increase in Leverage
Leverage has increased over the past 18months, moving gradually towards pre-credit crunch levels. Leverage levels in theEuropean LBO market have risen steadily
European Leveraged Loan Issuance Volume (¤bn)
10
20
30
40
50
60
70
80
58
2008 2009 2010 2011 2012 2013
15
42 43
29
67
Average Number of Covenants per European Leveraged Transaction
1
2
3
4
5
4.3 4.2 4.3 4.2 4.2 4.1 4.23.9
3.53.7 3.6 3.7 3.7 3.6
3.0
1999 2001 2003 2005 2007 2009 2011 2013
European Leveraged Loan Pro Forma Debt/EBITDA Ratios
1
2
3
4
5
6
4.5
5.25.4
5.9
5.1
4.1 4.2 4.4 4.54.7
5.3
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Q1 2014
clearthought | Autumn 2014 Debt Advisory Insights from Clearwater International
The growth of new lenders in the mid-market hasbrought many new options to businesses anddealmakers looking to raise finance.
Summary
There remains some scepticism aboutdebt funds, with a need for lenders tobuild further trust and relationships withadvisors and businesses. Credibility is key.There is a track record with the traditional“known” funders, but they should not beput on a pedestal given differing levels ofsupport during recent distressed times.
There are concerns that increasedcompetition amongst lenders is pushing thelending market back towards the leveragemultiples and minimal covenants seenahead of the credit crunch, however theseterms are only available for the bestcompanies. We see increasing confidence in
both operational management andinvestors, with the current low levels ofinterest rates assisting here. There will begreater collaboration between traditionallenders, debt funds, asset based lendersand the direct lending arms of pensionfunds & insurance companies, resulting in anew mix in the funding market, longer term.
Our opinion is that the entry of debt funds to the European markets and theimproved risk appetite of traditionalfunders has benefitted businesses,with improved flexibility and betterterms supporting deal activity andbusiness investment.
n Debt funds’ share of the market willcontinue to increase, but the bankswill fight to retain market share
n Appetite for a wider range ofdeals will grow to get funds outthe door
n Term loan B tranches will increase inpopularity as banks look tocompete with credit funds
n Lower mid-market space tobecome more competitive,offering options for borrowers
n Europe will see further liquidityinflows from the US
n Greater collaboration betweenbanks and debt funds
Market Outlook
“The entry of debt funds to the European markets and the improved risk appetite of banks has benefitted businesses, with improved flexibility and better termssupporting deal activity and business investment.”
since a low in 2009 of 4.1x, up to 4.7x in2013 and now a high for the first quarterof 2014 at 5.3x. The pricing of senior loansin the European mid-market also appearsto be following that seen for larger loans,with margins now reducing to sub 5%.
This increased appetite from senior lendersand banks could cause issues for debtfunds which may struggle to achieve thereturn required by their investors. In turn,increased supply and reduced margins maylead to looser terms being offered by thedebt funds as a differentiator to competeon flexibility.
Cov-Loose & Cov-Lite
Cov-loose & cov-lite refer to the practiceof reducing or having no covenantsattached to a loan facility. The termsavailable today have improved since thecredit crunch. The average number ofcovenants in a mid-market leveraged deal
reduced to 3.0 in 2013. ClearwaterInternational has also seen an improvementin the level of headroom in the covenantsthat have been set.
Basket levels for acquisitions, demergersand asset disposals have shown animprovement in favour of the borrowers,allowing larger baskets without seeking theprior consent of lenders. We expect thelarger baskets to drive increased acquisitionactivity, although larger deals for anyparticular business will still see borrowersseeking consent from lenders.
Although covenant-loose structures havebecome more common in mid-marketbusinesses, following the trend of largemarket deals, we do not expect to seecov-lite deals proliferating in the mid-market. This will principally be driven bylenders wanting to see greater control oversmaller market deals, due to the increasedrisk of default with smaller businesses.
Tell us aboutChenavari
We are an assetmanager investingacross a broad rangeof credit productsthroughout Europeand Asia, with some
¤4bn of assets under management.Chenavari has grown successfully on theback of very solid results since it wasformed in 2008 and our funding comesfrom a broad range of institutionalinvestors across the US, Europe and Asia.
How does the Chenavari model work?
Chenavari's UK Private Credit businessoffers an alternative to successful, well-runSMEs (EBITDA ¤4m - ¤20m) in a marketwhere there is a significant disconnectbetween the supply and demand for credit.
Our model consists of three principalcomponents which differentiate us fromthe mainstream commercial banks.
Firstly, any debt capital the firm structuresdoes not have scheduled regularamortisations, giving the management teamthe flexibility to reinvest free cashflow backinto the business. Secondly, managementteams and stakeholders gain direct accessto our decision-makers as the UK PrivateCredit partners are members of theinvestment committee. Thirdly, there is goalalignment. Chenavari partners are investedin the funds, which drives a distinctdifference in behaviours and philosophywhen compared with 'salarymen' in themainstream banking community.
Making our funds available to companies inthis SME segment affords managementteams access to a model that until recentlyhad only been available to bigger mid-market companies, where many of thelarger US-owned debt funds operate.
What is your view on the new fundsthat have entered the market?
The recent arrival of debt funds to Europeis a positive move for the market. In theUS, some 70% of debt is sourced fromfunds independent of mainstreamcommercial banks whereas in Europe thereverse is the case. I expect companies inEurope to increasingly reduce their relianceon the commercial banks for credit,although I don’t expect it to approach the70:30 US ratio anytime soon.
Considering the market further, in Europe I seetwo segments. Firstly, there are the coremid-market companies with an EnterpriseValue (EV) of anything between ¤90m and¤650m. These businesses have increasinglevels of choice when it comes to sourcingtheir debt and there has been a wholesaleinflux of debt capital in recent years fromAmerican-owned institutions such as Alcentra,Ares, Babson, BlueBay, Hayfin and HIG.
This influx of capital has been good forcompanies, particularly with regard tohigher degrees of leverage with reducedpricing available for transactions. However,this has reduced visibility over stable returnsfor investors. We therefore deliberatelydon't target this segment, instead focusingon the lower mid-market arena (EBITDA¤4m - ¤20m) where SMEs have hadlimited options when it comes to sourcingcredit, other than the commercial banks.
What is your view on the current market?
The current market is healthy. There aremany great businesses run by talentedmanagement teams seeking funding tosupport their next phase of growth. Whilstthese companies have overcome therecent economic turbulence, privateowners have perhaps been cautious aboutexiting or taking on additional finance. Therelative scarcity of debt in the lower mid-market may have hampered companyvaluations and FDs may also have beenstruggling to garner decent levels oftraction from their relationship bank.
I believe that leverage levels, and theapproach to covenants and documentation,will remain sensible in this lower mid-market segment. In the core mid-market(EV ¤90m - ¤650m), the increasing supplyof debt will push leverage positions andresult in more relaxed documentation andfinancial covenant terms, contributing to anincrease in the volatility of risk and returnsfor investors.
With regard to the 'great wall’ ofrefinancing, whilst the benign interest rateenvironment has led to subdued levels ofportfolio churn amongst the mainstreambanking community, our analysis indicatesthat in Europe Basel III means that bankstoday have a shortfall of core Tier 1 capitalof around ¤1tn that will need to be met by2019. There will undoubtedly be a myriadof further portfolio and individual dealrefinancing opportunities ahead.
Interview: Jerry Wilson, UK Private Credit - Chenavari Investment Managers
Debt Advisory Insights from Clearwater Internationalclearthought | Autumn 2014
Debt Advisory Insights from Clearwater Internationalclearthought | Autumn 2014
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