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With banks hung on LBOs, direct lenders will reshape buyouts in their own image

The carnage in the syndicated bank market looks set to continue and the near-term liquidity of direct lenders is being squeezed. Private equity sponsors are looking for other levers to pull on their buyout financing, writes Colin Leopold 

The carnage in the syndicated bank market looks set to continue and the near-term liquidity of direct lenders is being squeezed. Private equity sponsors are looking for other levers to pull on their buyout financing, writes Colin Leopold 

There is a problem in the bank market.  

The leveraged buyouts, or LBOs, which have characterised private equity over the past decade have left banks on the hook for more than $50bn in financing commitments, which they underwrote in more stable times. Loans that haven’t been pulled by sponsors or offloaded by banks at a steep discount are expected to be “puked into the market” by early next year, says one New York-based banker.  

“The downside is that in 2023, as banks figure out how they’re going to deal with this, you then have a real economic slowdown, which creates an even bigger problem,” says the banker. 

For now, the situation has left banks acting “flaky” on buyout transactions, says a second banker in Europe, and private equity dealmakers without a major source of funding.  

“There is no sugar-coating it,” says a partner at a European private equity fund with over EUR 10bn AUM, “the public debt market for LBOs is virtually shut and that has a lot of ramifications for investment in that zip code, but also for the entire industry. If you are large cap fund, and that is historically the way you finance yourself, you are facing a significant way of changing the way you operate.” 

Just $10.6 billion of leveraged loans were raised to fund buyouts by US companies in Q3 – the lowest reading in almost seven years, according to Leveraged Commentary & Data. In Europe, it’s possible for GPs to “piece some debt together if it’s below EUR 200m but it’s super expensive and getting above EUR 200m is virtually impossible”, says a managing director at a well-known global private equity firm. 

In a survey by Private Equity Wire during October, over 70% of private equity GPs said they expect a decrease in deal volumes during H1 2023 due to new borrowing conditions. The same number said increased debt pricing was their greatest concern.  

The crisis has presented an opportunity for others in the lending market, however.  

In a second advance since the Global Financial Crisis and the stricter bank regulations that followed, private credit has a solution. “In 10 years, [direct lenders] have gone from being a backwater to now, they’re like the Pacific Ocean,” says Jonathan Bray, partner and fund specialist at law firm Clifford Chance.  

Yet, at the same time, concerns are growing about the depth of their near-term liquidity, their selection bias towards certain sponsors and sectors and whether, in a deep recession, they may face some problems of their own.  

Bank bellwether 

One of the largest LBOs of year was also a bellwether for banks and their private equity clients. The take-private of software company Citrix, announced before Russia’s invasion of Ukraine, saw banks in September selling $4bn of bonds at a discount of around 83.6 cents to yield 10% and one of the co-sponsors stepping in to rescue $1bn of the debt. Speaking to the Financial Times, one banker involved described it as a “bloodbath”. 

For the lead sponsor Vista Equity Partners, it was a turning point. A second and third LBO, for Avalara and then KnowBe4, continued but the billions of dollars in combined loans required went to a group of private lenders. In a recent interview, Vista’s CEO and Founder Robert F. Smith described it as a dynamic he is now seeing across the marketplace. “[Private lending market has gone] from 10 or so lenders to now about 30 or 40, and so you may have to go to a few more, but we still see the ability to get deals like KnowBe4 done, Avalara done in these private markets as opposed to relying on syndicated debt markets”. 

Others agree. The first banker quoted says he has handled 80 direct lending transactions since the Ukraine war began – twice last year’s total. Earlier this year, Hg and TA Associates concluded the largest private debt financing transaction ever undertaken in Europe, with 16 funds competing. Direct lending’s roots lie in smaller, mid-market transactions, typically with higher pricing and tighter covenants. But in the current market they represent certainty of funding. The typically smaller lender group involved can also move quickly on transactions, price loans that don’t ‘flex’ upwards during syndication and take a longer-term view on more risky private equity buyouts, say people working in the market. It’s a situation where in some cases, as with Elliot Investment Management on Citrix, the same company is providing debt and equity on the transaction. 

“Often, direct lenders are clearly aligned with the strategy of the companies,” says Thierry Aoun, a partner who leads acquisition financing at private equity firm IK Partners, “and they allow you to grow there notably by putting at the disposal of the borrower incremental indebtedness swiftly, so we have been embracing that technology.” 

With banks launching their own debt funds and direct lenders opening the door to co-investment from their LPs, lender groups are becoming increasingly blurred. But as more private equity borrowers are forced to open up to these new lenders, there are fears that short-term private credit liquidity may be running dry and borrowers without strong relationships in the space may struggle to raise debt at all.  

As of Q2 this year, direct lending dry powder stood at $68.7 billion globally, according to PitchBook. The figure has grown only 6.8% since 2018 amid rapid deployment. With single asset concentration limits, even large credit funds can struggle to provide the debt tickets needed on a leveraged buyout: Thoma Bravo needed six direct lenders to provide $1 billion for the Ping buyout it completed in October.  

“The depths of their liquidity may have been plumbed in the last couple of months,” says Richard Day, a partner who works on sponsor-side LBOs at Clifford Chance. “The market has been tested and it seems like direct lenders are becoming more selective, deploying a little bit more slowly and if they feel they have done enough for the year that’s going to really complicate the picture for a sponsor looking to raise debt.” 

This selection bias may disadvantage capex-intensive industries with excessive customer concentration and sectors which don’t align with the ESG mandate of their LPs, as well as specific private equity sponsors.  

“A lot of these funds now are saying ‘look, actually, even though I have a lot of dry powder it is reducing very quickly but I also need to be loyal to the [private equity] funds that I have always transacted with’,” says the European private equity fund partner. “There are some [private equity] funds who are struggling much more to get the love they need from the from private credit funds… and it has become more expensive.” 

“[Direct lenders] have to be compelled by either a strong situation, good returns on the underlying position, or strong relationship with the sponsor to extend credit,” says James Blastland, a partner in Deloitte’s debt advisory practice. “The more resilient sectors, the more predictable sectors that have lower standard deviation of outcomes, will likely be those that get support.” 

Debt fund liquidity could also be squeezed further during a severe downturn in 2023 if fund redemptions spike and cracks appear in credit portfolios. 

“The smaller, less-established companies that disproportionately comprise private credit portfolios are likely to be less resilient to business stresses from inflationary cost pressures and higher interest rates than larger, higher-rated companies,” said credit agency Moody’s in May. In a report, it claimed that a broad deterioration in borrower credit quality in private credit has the potential to cause “cascading disruptions across the capital markets and the broader economy”.  

“As private lending is largely opaque,” it wrote in June, “asset quality risks are growing, which may be hard for market participants and regulators to discern until it is too late to counteract.” 

Dealmaking won’t die

With banks gummed up and direct lenders being squeezed, private equity dealmaking may slump, but it won’t die completely. Sponsors are already turning to smaller bolt-on acquisitions that require less debt and, in many cases, have borrower provisions to incur debt at higher multiples even when EBITDA is deteriorating so long as they can find a less levered target. Others are using all-equity structures to get larger deals away and a stronger dollar is giving US sponsors more purchasing power overseas. But in many cases, a higher cost of debt, or its absence completely, will be reflected in lower valuations, delayed exit plans and fewer sellers.  

“Buying sponsors will be even more focused on the valuation they are paying in an environment where lower debt is available. They will have to work hard to ensure they deliver the IRR for their clients,” says Blastland.  

This may be less of a problem for corporate buyers or strategics using their own balance-sheet funding in an auction process. The situation is also forcing private equity funds to consider ‘off-market’ transactions and pre-empting sales. And, for others, the answer to ‘no debt’ could actually be ‘more debt’.  

Mezzanine financing or junior debt and other, more risky debt instruments are becoming a necessity to meet private equity fund returns, says the second banker. Here sponsors can typically secure an extra turn of leverage, typically on an all-PIK basis without needing to consider debt service cover ratio. In a note to credit investors in August, KKR predicted 2022 could be a “golden vintage” for junior debt. Back-leverage, or NAV-based lending, is also being investigated by many of the major funds as a way to inject equity into portfolio companies and deals. 

“If you can’t access the capital markets as easily as they are on the terms you would want, then getting the financing at the fund level and injecting it down into the individual businesses can allow you to refinance existing positions continue to raise additional financing for M&A,” says David Wilson, a partner at 17Capital, which provides NAV-based loans to top tier private equity firms. “We’ve seen a little bit of that already and are working on a couple of deals like that. If a sponsor is going to hold on to an asset for 1-2 years longer than originally anticipated, then some additional fire power at the fund level can be very helpful to allow them to keep growing the business and protect the returns.” 

The solution will vary depending on the situation and is contingent on the bank syndication market being stuck right into 2023. In certain parts of Europe such as the Nordics, and to a lesser extend France and Germany, traditional bank clubs are still active, says Aoun. 

“Whomever is saying that the syndicated market is dead, and it’s over and that’s it, it’s private credit and private credit only, is in my view mistaken. The syndicated market could go back to completely functioning status in the next couple of years,” he says. “What I believe is happening is private credit today is going through a phase that private equity went through 30 or 40 years ago and these two sources of capital will co-exit.” 

In this period private equity has transformed the corporate landscape with ever larger buyouts across the entire economy. As private credit matures, it is likely to redefine again the size and type of companies being bought and the people who are doing it.  

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