A renewed focus on what borrowers can afford

The flourishing deal market of a year ago is becoming a distant memory as more challenging realities are confronted at the negotiating table.

After the M&A boom in the second half of last year, should we be preparing ourselves for the M&A drought in the closing months of 2022? Certainly, with energy costs escalating (albeit with softening measures being worked on by governments) and interest rates climbing, the macroeconomic backdrop is expected to negatively impact the level of deal completions in the period ahead.

There are mitigating factors for the private debt market, including the floating-rate nature of many loans and the high level of dry powder available to fund deals – even through the tough times. Although this may imply a degree of resilience, recent conversations lead us at Private Equity International and affiliate Private Debt Investor to conclude that there is an increased focus at the current time of the levels of day-one leverage that are appropriate for particular businesses and sectors taking into account the pressures being faced.

At the outset of any deals that get done, one key question is how much leverage is affordable for the business, both today and projected forward for the next few years – and, subsequently, what is the appropriate nature and level of covenants that will allow lenders to intervene if things do not end up panning out as envisaged.

Where now?

Some businesses and sectors are likely to be viewed simply as unbankable should we be heading into a deeply recessionary environment. This may accelerate the trend seen since the early covid outbreaks when fund managers gravitated towards areas perceived as more robust in the face of economic downturns, such as healthcare, technology and business services.

Indeed, such has been the level of confidence around favoured sectors such as these, that the trend for covenant-lite structures to creep into the private debt mid-market has shown few signs of slowing. Some of our sources believe that even now capital is still available to be invested on a covenant-lite basis for the right assets.

There is also little doubt that more intense negotiations are taking place around leverage levels and covenants, including attempts to clamp down on the frothier aspects of covenant definitions – including the nature and allowable amount of EBITDA addbacks. The M&A boom now seems a long way off, as investors carefully scrutinise what they should and shouldn’t be signing up to as they seek the support of investment committees and their wider investor bases for those deals that can still be done.