This is the latest article from the Finance and Restructuring team, in which Paul Durban and Michael Crosby examine current trends and opportunities in private capital markets against a challenging macro and micro backdrop.
Returning from their summer holidays some time ago, many lenders and investors are asking “how resilient are private financial markets” and “where are we in the investment cycle”?
There clearly remain attractive investment opportunities, but as financial professionals assess the impact of the highest inflation rates seen since the 1970s (resulting in accelerating borrowing costs and falling stock markets public), the rapidly changing economic and monetary landscape is causing many people to stop and take Stock.
In this challenging environment, what trends do we expect and where do the opportunities lie?
With little clarity on where the market will settle as prices remain fluid, borrowers are increasingly focusing on direct lending options, even for mega credits that would historically have been the preserve of banks. (local and international), rather than private funds.
There are several reasons for this. Private debt dry powder growth in an exceptional 2021 means that direct lenders now have significant war chests to fund larger transactions, either bilaterally or with other like-minded players. ideas. Rising interest rates also benefit lenders who deploy capital using floating rate instruments (provided the base rate rises above the borrowing company’s interest rate floor). Price and covenant differences between direct loans and bank-led syndicated loans are now also less noticeable. Banks still in the market are often seen pushing for higher pricing to offset the higher cost of capital, alongside tighter covenants to counter the perceived increase in risk. Some direct lenders – still keeping tight documentation – sensed an opportunity, ready to issue debt on less stringent terms for certain credit and relationship customers.
Borrowing from assets
Leveraging the assets they hold on their balance sheets to raise capital may well be a good option for borrowers to obtain valuable cash as abnormal market volatility continues. Although asset valuation inevitably becomes more difficult in times of economic uncertainty, private asset values have remained remarkably robust overall. Companies that can go out and find private debt capital in a market that rewards strong balance sheets and growth should be in pole position. Whether it’s a one-end provider funding facility or sponsors looking to augment the firepower of private equity funds, through structures such as NAV facilities1 on the other hand, borrowers may find it easier to structure and secure deals based on asset values rather than future cash flows, which are much more uncertain at present (e.g. what rate is applicable as inflationary expectations continue to rise?).
As capital markets face their challenges, we see no shortage of demand (or capacity) among direct lenders to fund transactions in sectors that exhibit resilient business characteristics, strong cash flow conversion and limited capex requirements which insulate them somewhat from strong inflationary pressures. Below, we highlight two sectors that present attractive deployment opportunities:
Health care: following the surge in fundraising and the fact that demand remains resilient and less impacted by economic fluctuations (the sector has traditionally performed very well in uncertain times), health – and in particular natural health – remains a highly sought after area of investment. With new products coming to market on a regular basis, lenders are also tapping into consumer trends towards healthier eating and sustainable lifestyles.
Energy: The decision of the European Parliament in July to approve draft EU rules qualifying natural gas and nuclear power plants as “climate-friendly” investments has also sparked increased interest in projects for the production of fuel, power generation and energy infrastructure. On the other hand, this is offset by the increased market focus on renewable energy (the abandonment of greenhouse gas emitting projects) and ESG and sustainability related lending (more details below).
In addition to these two sectors, large transactions in sectors such as
music, sports and entertainment, telecommunications, business services and logistics also increased as market consolidation continued to drive activity. And, more generally, at a time of temporary market dislocation, we are seeing increased focus on this broad category.”particular situation”, as disadvantaged firms that may have the potential to generate significant capital growth go through (or risk going through) restructuring processes.
Therefore, we believe that greater market volatility will continue to create opportunities.
ESG and sustainable finance
A subject in itself: ESG (environmental, social and governance) and sustainability strongly influence borrowers and lenders, while the search for common methodologies, reporting standards and key performance indicators in the documentation of transactions is gaining momentum. It is no longer just the concern of a company’s shareholders, direct lenders in particular are looking to fund a growing volume of sustainability-related lending (driven by a genuine commitment to more ethical and responsible investing , but with some associated recalibration of expectations and strategies). On the other hand, companies that have not yet integrated ESG and sustainability into their investment decisions may find it increasingly difficult to obtain financing on attractive terms.
Regulatory pressure also has an important role to play with the entry into force last year of the European Sustainable Financial Disclosure Regulation (SFDR). Among other things, this new regulation requires managers to disclose the degree to which sustainability is integrated into their investment strategy and that lenders provide sustainability-related information with regard to financial instruments. In addition, direct lending funds wishing to become Article 8 funds2 will also need to find an ESG excuse for most of their transactions to comply with the SFDR and ultimately attract investment into their fund.
The pace is frantic in this sector of the market with Bloomberg predicts the ESG debt market will reach around US$11 trillion by 2025 based on recent growth. We’ve only scratched the surface, so watch this space for more updates on this developing area…
1 A key driver of fund funding growth in recent years has been the development of NAV facilities, which allow managers to borrow against the NAV of assets held in their funds.
2 An Article 8 fund under the SFDR is “a fund that promotes, among other features, environmental or social characteristics, or a combination of these characteristics, provided that the companies in which the investments are made follow good corporate governance practices”.
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.