Debt special: leveraged finance going strong

The sun is shining on private equity, and private debt is largely to thank. With financing from funds and banks readily available, Alistair Hay of Cavendish asks whether PE has ever had it so good and how these funding solutions can co-exist.

Alistair Hay

A look back over the past 12 months sees private equity remaining in rude health with successful fundraising across both small and large investment houses.

Deal activity – despite continued political uncertainty on both sides of the Atlantic – has remained resilient with a number of noteworthy transactions across the UK mid-market. A significant feature of private equity-driven M&A has been the strength of the debt markets and the ability they give sponsors to leverage their investments in maximising equity returns.

Probably the biggest factor in the vibrancy of the debt markets are private debt funds. Investors, from institutions to private individuals, in their search for yield, are turning to alternative asset classes, and in particular private debt, to secure strong returns.

Private debt fundraising is at a record high and has recovered strongly this year from a dip in 2016, with almost $62 billion raised during H1 2017, according to sister publication Private Debt Investor data.

Europe alone saw its strongest quarter of fundraising ever with large funds such as Hayfin Direct Lending Fund II raising €3.6 billion and Alcentra European Direct Lending raising more than €2.8 billion.

Deals on the up

The growth in the private debt markets comes against a backdrop of a strengthening global economy and equity markets at an all-time high. The number of reported deals, according to a recent Deloitte report, has increased to 1,011 transactions over the past 18 quarters across Europe, and shows a 7 percent increase in dealflow over the past 12 months.

This deal activity, however, is relatively concentrated. A small number of sectors are taking close to half of all alternative debt funding deals. In the UK, technology, business, infrastructure and professional services and healthcare account for nearly half (48 percent) of alternative lending deals. This situation is similar in Europe, where the same sectors account for 45 percent of all deals. This shows the sectors where alternative lenders believe opportunities are and the areas where the highest growth will be achieved.

While the ticket sizes offered by the more established debt funds continue to increase, there has also been a proliferation of new entrants across the small- to mid-cap space culminating in significant dry powder in the alternative lending sector.

Increasingly we are seeing alternative lenders provide debt funding for so-called “event financing” situations, including for company refinancings, dividend recapitalisations, M&A and growth capital. Recent figures show that 55 percent of private debt transactions were involved in M&A activity across Europe last year. The result of this greater availability of debt is a continued cannibalisation of the traditional leveraged finance bank market by alternative lenders with some estimates claiming more than 50 percent of all UK PE transactions in the last year were financed by alternative lenders.

Unitranche facilities are attracting the most attention as they are being used increasingly by private equity houses to help fund acquisitions, thereby driving M&A activity, particularly in the mid-market. In the UK, just over half of alternative lending over the past year has been structured along unitranche lines. In spite of the higher pricing associated with their unitranche product, alternative lenders have successfully emerged as the preferred funding option for a number of mid-market private equity houses attracted by the bespoke nature of the debt fund offering.

For companies, the benefits of private debt from alternative lenders is clear. It is often the case that bank debt will only get you so far – alternative providers will take you further. Alternative lenders are targeting growth companies in particular, encouraging them to put their cash to work.

What makes their proposition especially attractive is they are typically more flexible than traditional bank lenders when it comes to refinancing – more prepared to forgo a payment in the short term if it means maximising the cash yield in the longer term. In many cases this longer-term flexible view can justify the higher costs.

Using alternative lenders to fund a buy-and-build strategy can amplify a company’s growth and substantially grow its shareholder value in a reduced period of time. Alternative lenders tend to adopt a more long-term approach to funding companies than banks do.

This is often welcome in an environment where, traditionally, private companies without access to further shareholder funding did not have the means to make transformative acquisitions. What’s more, because of the amount of capital alternative lenders can provide to a single company, their relationships are often more long term and can include follow-on capital for multiple acquisitions.

Banks still centre stage

Despite the aggressive challenge to their market share from alternative lenders, however, banks are not merely resigned to remaining on the sidelines. In fact, for a number of years it’s been the norm for banks to continue to work in partnership with alternative lenders in the traditional super senior/senior secured arrangement.

Paradoxically there is a sense in which unitranche loans have been helpful for traditional lenders, including banks, because of the additional working capital and revolving credit facilities required to support the high-growth strategies in which private equity houses are investing.

While these market participants continue to work together on a number of transactions, in leveraged finance banks remain a very relevant player in their own right. Those institutions that have remained active through the cycle are responding resolutely to the challenge of the alternative lenders.

The result is banks relaxing some of their more rigid terms within the mid-market to remain relevant. For example, they have continuously reduced covenants to match the headroom levels seen in the unitranche market. In fact, absolute leverage appears to be the only fundamental area where alternative debt funds now typically remain more aggressive than the bank market.

Our view is the market is remaining big enough to accommodate both traditional and alternative lenders. Looking to the future, we see private equity continuing to benefit from the abundant liquidity available across the debt markets.

With their cheaper and more efficient offering, banks will continue to play an important role. Meanwhile, alternative lenders will persist in aggressively seizing market share, bolstered by the amount of dry powder in the UK, as investors continue to allocate capital to debt funds in an ongoing search for yield.

Alistair Hay is a partner in the debt advisory business at Cavendish, the London-based advisory firm. A version of this article first appeared in Private Debt Investor.