Earlier this month, CMS’s private equity and leveraged finance teams hosted a roundtable to discuss the state of the leveraged market. Joined by clients from leading UK mid-market PE sponsors, acquisition finance providers and several advisory firms, there were a number of useful insights that we thought we would share.
The key takeaways are summarised below:
- PE sponsors looking for flexibility and support: In the current climate, the key criteria for PE sponsors in choosing a lending partner is someone who can offer flexibility and support their portfolio companies throughout the investment journey. Sponsors are likely to choose this over the beneficial rates that a senior bank structure may offer. Although, senior banking structures are more prevalent than they were 18-24 months ago.
- The market is still cautious: Notwithstanding an easing of inflation and projected interest rates reductions, there is still an overriding feeling of caution which suggests that a bull leveraged market is unlikely for at least the first half of this year. All-equity funded acquisitions remain an option until the lending market improves, providing time for operational improvements/economies of scale to be realised without the cashflow pressure of a debt service burden.
- Some sectors remain resilient: Healthcare, manufacturing and engineering sectors have been steady and resilient whilst not generating the headline-making returns on investment associated with the technology and managed services sectors. However, much like sponsors, lenders are keen to ensure that their portfolio is suitably diversified, and this is factored into credit committee discussions. As expected, discretionary spending sectors such as consumer, casual dining and leisure continue to be tricky for lenders notwithstanding the promise of a more settled economic environment.
- Valuation gaps: As there is less cash available in buy-outs due to the lack of debt and there continues to be a valuation gap between buyers and sellers, PE sponsors are having to be more creative in how they transact. We are much more frequently seeing:
(a) earn-outs to incentivise the sellers to prove their valuation; and
(b) co-investing by both institutional and management sellers.
However, some sponsors have held on to assets rather than sell in sub-optimal circumstances, which has resulted in a rise in transfers from funds in their realisation phase across to a newer vintage. We are seeing more refinancings occur as a result of this. - ESG: The expected flood of ESG-driven deals has not materialised so far. While we are seeing some ESG ratchets on deals, largely lenders’ credit committees are only factoring ESG credentials from a negative perspective (i.e. they will consider not lending to a company with poor ESG credentials) rather than from a positive perspective (i.e. actively lending to those companies with good ESG credentials).
- Interest rate swaps: When comparing to mid-2023, the SONIA yield curve has become materially inverted due to the assumption that interest rates have peaked in the UK. The forward curve implies rate reductions over the period with the 3-year swap rate at c. 4% - a saving of 125bps on the 1 day rate. This interest rate swap would only be out of the money should the blended rate over the hedged period reduce below 4%.
Get in touch if you’d like to discuss any of the issues outlined above.
