United States: In Search Of Financing: Sponsors Willing To Seek Debt

Inflation and rising interest rates are filtering down to leveraged finance markets and impacting the terms and pricing for acquisition finance. Private equity (PE) sponsors are adapting to changing debt dynamics by exploring new financing structures and leaning on lender relationships.

Less than a year ago, abundant liquidity allowed sponsors to secure debt for deals at attractive multiples on loose terms, but through the course of 2022, the acquisition finance landscape has shifted dramatically.

According to Dealogic, high yield bond and leveraged loan issuance for U.S. buyouts and M&A has contracted steadily during 2022, making it tougher for PE sponsors to fund deals on the same terms and leverage levels as were available last year. U.S. buyout financing totaled US$20.4 billion in Q3 2022, down from US$23.1 billion in Q2 2022 and less than half the US$50.9 billion secured in Q1 2022.¹ U.S. M&A financing has faced similar pressures, reaching just US$7.9 billion in Q3 2022, down almost 70% from the previous quarter.²

Private debt has not been immune to the effects of tightening liquidity either. According to PitchBook, private debt fundraising for the 12 months ending June 30, 2022, came in at US$211.3 billion, down from the US$228.1 billion raised in the 12 months ending December 31, 2021.³

Volatile stock markets (the Dow Jones has shed close to onefifth of its value thus far in 2022⁴ ) and climbing inflation, which is running at the highest levels observed since the early 1980s,⁵ have contributed to the slowdown, with lenders and investors resetting risk thresholds and pulling back from leveraged finance deals.

"It has become much harder for sponsors to raise the same quantum of leverage and find the lenders to provide it. PE sponsors are having to go out to a much broader range of providers to pull a lending consortium together," says Stefanie Birkmann, a finance partner at Ropes & Gray and co-head of the firm's global finance practice group. "Syndicated loan and high yield markets are noticeably quieter, and even direct lenders that had strong appetite to underwrite debt packages in the hundreds of millions are taking a more cautious approach."

Rising interest rates, meanwhile, have also seen borrowing costs spike. The U.S. Federal Reserve has been increasing interest rates throughout 2022 to keep a lid on inflation—in September, the Fed upped rates to the highest level observed since early 2008.⁶

As benchmark rates have increased, so have financing costs. In Q3 2022, the average margin on U.S. loans climbed to 4.73% versus just 4.34% in Q2 2022. ⁷ In addition, borrowers have also had to offer lenders steeper original issue discounts, which have driven the

weighted average yields on U.S. leveraged loans up from 6% to 8.9%.⁸

Analysis from Oaktree Capital, meanwhile, shows that coupons for senior mid-market loans provided by private debt players have increased between 0.5% and 1% since the middle of June 2022.⁹

Rising debt costs and skittish investor sentiment have deterred many PE borrowers from braving the market with new deals, while deals that have proceeded have encountered challenging syndication processes.

For example, banks underwriting debt for the US$16.5 billion leveraged buyout of software company Citrix Systems, led by Vista Equity Partners and Elliott Management, had to offer steep discounts on the US$8.55 billion in bonds and loans funding the deal to secure buyers for the paper. Banks have also been holding a larger proportion of the debt on their own balance sheets than planned. Many banks are now putting LBO financing activity on hold until markets stabilize.¹⁰

"It has been a tough period for the syndicated loan market, and several banks are pretty much wound down for this year. Even if there is a huge amount of flex on new deals, I don't sense that there is much appetite from investment banks to provide underwritten commitments," says Birkmann.

PE adapts as direct lenders step in

While the headwinds facing PE borrowers have intensified this year, sponsors have adjusted to shifting market dynamics by working with direct lenders and exploring new financing structures and products. Sponsors focused on smaller mid-market deals, meanwhile, have found acquisition finance to be more resilient than for jumbo leveraged buyouts thanks to long-term relationships with lenders.

For both mid-market and mega-market buyouts, private debt funds have become an increasingly important source of funding for deals in a period of uncertainty.

While private debt funds have felt the effects of a tough macroeconomic backdrop, the fact that private lenders amassed a record US$1.2 trillion of dry powder by the end of 2021 (according to Preqin¹¹) has enabled them to remain active despite strengthening headwinds.

Private debt managers have been able to expand market share and win more deals that would otherwise have gone directly to syndicated loan or high yield bond markets. A group of direct lenders led by Blackstone, for example, provided a US$5 billion debt package to fund the US$9.5 billion buyout of San Francisco-based software maker Zendesk by Hellman & Friedman and Permira.¹² Blue Owl Group, meanwhile, laid on a US$2.5 billion loan to fund Vista Equity Partners' US$8.4 billion purchase of tax software group Avalara.¹³

In some cases, private debt funds have taken out bridge loans that would normally be replaced by leveraged loans and high yield bonds sold to institutional investors. Ares Management, for example, led a consortium providing a US$2.15 billion second-lien loan to replace a bridge facility raised to finance the take private of Nielsen by Elliott Investment Management and Brookfield Asset Management.¹⁴

By working with private debt managers on larger deals, sponsors have been able to reduce syndication risk and ensure certainty of execution, as private debt managers hold debt on their own balance sheets until loans mature.

"Even before the market dislocation observed this year, direct lending was already taking a huge share of the syndicated market," says Michael Lee, a finance partner at Ropes & Gray and co-head of the firm's global finance practice group. "With the syndicated loan market slowing, that market share has probably increased even further in 2022, and, with a few exceptions, direct lending is pretty much the only game in town at this point."

For direct lenders, the current situation has allowed them to win more deals at attractive prices while

also mitigating risk. Direct lenders have generally become more selective and have reduced the size of the commitment they are willing to provide for a single transaction. For sponsors, this means that they have to assemble a club of direct lenders for any meaningful commitment amount versus being able to rely on one or two providers to underwrite the entire deal

"Direct lenders have been able to compete for market share with syndicated loans without having to loosen their terms," says Lee. "This is an ideal time for them to be even more prominent in larger financings for high-quality businesses at the same time as pushing up prices and spreading the risk by clubbing up with other direct lenders."

Private debt managers have also remained open for business in the mid-market, focusing on lending to sponsors that have long-term lender relationships. The flexibility of the private debt offer has also come to the fore, with lenders in the space able to put together bespoke structures tailored to the specific requirements of individual deals.

Footnotes

1 Dealogic data, U.S. Pricing Date by Quarter, 1Q22 through 3Q22 (LBO and M&A, ex-LBO); see also https:// community.ionanalytics.com/levfin-highlights-3q22 - See par 15

2 Dealogic data, U.S. Pricing Date by Quarter, 1Q22 through 3Q22 (LBO and M&A, ex-LBO); see also https:// community.ionanalytics.com/levfin-highlights-3q22 - See par 15

3 https://www.ai-cio.com/news/after-a-record-setting-2021-private-debt-fundraising-declines-in-first-half-of-2022/

4 https://www.marketwatch.com/investing/index/djia - as of 14 October 2022

5 https://www.cnbc.com/2022/09/21/fed-rate-hike-sep-tember-2022-.html

6 https://www.cnbc.com/2022/09/21/fed-rate-hike-sep-tember-2022-.html

7 Debtwire U.S. Leveraged Insights report, September 2022 - See bottom row, page 10

8 https://community.ionanalytics.com/levfin-high-lights-3q22 - See par 9

9 https://www.oaktreecapital.com/insights/insight-com-mentary/market-commentary/the-roundup-top-take-aways-from-oaktrees-quarterly-letters-3q2022 - See heading 6

10 https://on.ft.com/3CMNEn9

11 https://www.ft.com/content/824a7fc3-a8a3-4a78- a565-bd663ba71520 - See par 2

12 https://www.bloomberg.com/news/articles/2022-06-24/ blackstone-led-group-provides-5-billion-of-debt-for-zendesk

13 https://www.bloomberg.com/news/articles/2022-08-08/ blue-owl-led-group-provides-2-5-billion-loan-for-avalara-buyout

14 https://www.bloomberg.com/news/articles/2022-05-03/ ares-led-group-snaps-up-2-billion-chunk-of-nielsen-buy-out-debt

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