The leveraged finance market continues to show resilience despite macroeconomic challenges, with competition for high-quality assets driving pricing pressure on lenders. However, valuation gaps and extended due diligence are affecting transaction timelines and deal activity. Sponsors are focusing on refinancing and bolt-on acquisitions, while lenders are tightening financial covenants and adjusting terms to reflect market conditions. Regulatory complexities, particularly in sector consolidations, and borrower stress in highly leveraged deals are also shaping the landscape. Staying ahead in this dynamic market requires careful navigation of documentation, pricing, and regulatory frameworks.
The leveraged finance market remains resilient despite ongoing macroeconomic challenges. Record levels of liquidity in the lending market, coupled with competition for high-quality assets, have placed pricing pressure on lenders, particularly those financing private equity sponsor-backed acquisitions.
In the current economic climate, we are seeing buyers undertake more extensive due diligence, which is extending transaction timelines and often leading to late-stage price adjustments.
Transaction timelines and diligence challenges
However, valuation gaps between buyers and sellers continue to constrain leveraged buyout activity. In the current economic climate, we are seeing buyers undertake more extensive due diligence, which is extending transaction timelines and often leading to late-stage price adjustments. This has prompted many sponsors to focus on refinancing their existing loan arrangements and hold investments until exit conditions improve.
Where a sale is expected in the short term, we are increasingly seeing sponsors negotiate portability provisions into new loan documentation. These provisions allow ownership of a business to transfer to a new sponsor without triggering mandatory prepayment under the loan agreement. This can be an attractive proposition for purchasers who are comfortable with a target's existing loan arrangements.
Additionally, sponsors are paying closer attention to prepayment fees that are due in connection with the redemption of a loan. Often, buyers will arrange their own funding requirements, meaning that a target's existing loans will be repaid. To remain competitive, we are seeing some lenders reduce the period for which those prepayment fees apply (for example, from 18/24 months to 12 months), while also relaxing the circumstances in which they are payable.
Focus on bolt-on acquisitions
We are finding that sponsors are prioritising "bolt-on" acquisitions, targeting smaller businesses to complement larger investments and increase portfolio value. This approach is often considered a safer way to deploy capital than making a significantly larger outlay into a new investment. Earn-out arrangements, where consideration is contingent on the target achieving specific financial metrics, are frequently being used to mitigate risk further.
We have seen a wave of consolidation in the financial services sector, most notably among accountancy firms adopting tech-driven platforms. We anticipate that the legal services sector will follow next (and indeed, we have already seen activity in that sector). However, regulatory approvals are typically needed for the disposal of professional practices, which often delays completion. This also raises valid questions about the level of commitment a purchaser has from its lender when sale contracts are exchanged. Regulatory frameworks can also complicate security arrangements, as material companies in a group may be unable to secure assets in favour of lenders.
Borrowers will typically require committed loan facilities to support acquisitions, so we are seeing sponsors scrutinise the pricing of those arrangements. Loan documentation may also include mechanisms to adjust financial covenants automatically, taking into account significant utilisations and the profit contributions of acquired businesses.
The rise in bolt-on acquisitions has also driven an increase in group reorganisations, as sponsors aim to simplify corporate structures and reduce costs ahead of a sale. While lenders generally support these actions, they are keen to ensure that their loan documentation is not impacted. It may be necessary for guarantees and security to be re-taken, which can be a time-consuming exercise for borrowers with a global footprint.
We have seen a wave of consolidation in the financial services sector, most notably among accountancy firms adopting tech-driven platforms.
Some stress and covenant adjustments
In highly leveraged transactions, we are seeing some borrowers show signs of stress. Payment-in-kind (PIK) options are being used to capitalise interest payments to ease cashflow pressures, though this is often a short-term solution that may pose refinancing challenges in the future. However, the market has also seen a number of lenders take the keys of their borrower clients in the last 6-12 months.
As a result, we are witnessing a rise in financial covenant resets, particularly where higher interest costs in legacy transactions have reduced borrower cash balances. In response, lenders have agreed to replace leverage financial covenants with minimum EBITDA and/or liquidity controls on a temporary basis and have generally remained supportive.
Demand for more robust financial covenants
Whilst loan margins and arrangement fees face downward pressure, it appears that lenders are (where they can manage it) increasingly demanding more meaningful financial covenants in return. Sponsor-backed borrowers are typically allowed to adjust EBITDA by including anticipated cost savings from acquisitions, disposals, and reorganisations. However, tighter caps and controls on these adjustments, as well as stricter definitions of exceptional items, are becoming more common to preserve the integrity of financial metrics.
Next steps
The leveraged finance market continues to evolve, presenting both opportunities and challenges for lenders, sponsors, and borrowers. As competitive pressures mount, stakeholders must remain vigilant in navigating documentation, regulatory, and market dynamics to achieve successful outcomes. Addleshaw Goddard's experienced team is on hand to provide expert guidance in this complex and fast-moving environment.
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