The European private credit sector is holding firm as it enters the second half of the year despite a shaky economic backdrop and ongoing rate hikes. However, some softness around the edges of the market emphasises the importance of a selective investment approach. 

Higher interest rates push up the amount that companies have to pay to service their debt. Fidelity International research suggests that in 2021 private companies in our coverage were committing around 23 per cent of ebitda to debt servicing, while this year the figure has risen to around 36 per cent. Not only does this mean that firms have less capital to dedicate to capex and growth, but this will also prompt a modest uptick in defaults in the coming year. And although the maturity wall is being chipped away, we also anticipate that some companies will struggle to refinance at higher yields in the coming years, bringing more challenges. 

Within our universe it is the industries that have traditionally been more stable (such as telecommunications or software) where companies carry the most leverage, and these are seeing the biggest impact of declining interest coverage ratios. Where problems emerge though, they are unlikely to be specific to any one sector, rather they will hit companies where there are idiosyncratic credit challenges.

The picture is certainly not gloomy everywhere. Within the names in our coverage, we are still seeing more than half of companies deleveraging, and despite the higher interest burden, most can still access liquidity via their revolving credit facilities (RCFs). We calculate that only around 15 per cent of these are drawn upon, suggesting there is still plenty of flexibility available to firms to weather whatever lies ahead, and even thrive. With yields rising towards double digit levels for performing strategies and terms turning increasingly lender-friendly, we believe that the upcoming 12-18 months could bring about a strong vintage of deals for investors to capture.

- Michael Curtis, Head of Private Credit Strategies 

Senior Secured Loans 

• The maturity wall continues to be chipped away, with sponsors finding solutions in amend and extend deals as well as via private transactions
• The default landscape in Europe will play out differently than in the US
• Any uptick in large scale leveraged buyouts (LBOs) is unlikely to emerge before late in the year

In the second half of 2023 private equity firms' focus will be on managing their upcoming maturities as the backdrop of rising rates increases refinancing costs, a trend we witnessed in the second quarter with a flurry of amend and extend deals that pushed out the tenor of existing agreements.

We have also seen sponsors taking an active approach in managing their portfolio companies’ liquidity and leverage through equity injections. For example, early in June we saw SVP inject €150m to its portfolio firm Kloeckner Pentaplast. The Issa brothers and TDR Capital are also contributing equity to support Asda’s acquisition of EG Group’s forecourts, along with privately placed debt and sale and lease backs. This transaction should enable EG Group to refinance the large 2025 maturity wall it currently faces.

Elsewhere, we are seeing borrowers come to the market looking to place opportunistic add-ons to either term out RCFs or fund smaller M&A. A large majority of these are now being placed privately, with borrowers preferring the certainty of placing a deal versus trying to squeeze an extra 50bps on the original issue discount if launched to the wider market. We have seen this in deals such as Socotec, IU Group, Stada, and Nemera over the second quarter.

The extension of the maturity wall in Europe combined with improving liquidity positions through RCFs and supportive sponsors offers some optimism for the second half of the year, balancing the increase in defaults we expect as conditions become more challenging and rates continue to rise.

Activity in the European primary market across the first half of the year has fallen to €18.3bn (to June 20), down from €25.8bn in the same period last year[1]. This decrease has been driven by a downturn in buyout activity, with the volume of deals funding LBOs falling to €3.2bn this year to date from €13.3bn in the same period last year. There is still a mismatch between buyers and sellers’ expectations on valuations, and although the gap is narrowing we do not expect the pace of M&A financing in this space to drastically increase before later this year at the earliest.

- Ellie Piper, Assistant Portfolio Manager 

Structured Finance

• New CLO volumes fell after the banking crisis in March, although the market is slowly returning to normal
• Pricing has also stepped back from the tight levels seen earlier in the start of the year, but despite some caution deals are getting done
• Investors in European deals are increasingly discriminatory in their approach, and more tiering has been seen in the European market 

It has been a year of contrasts so far for the collateralised loan obligation (CLO) market in Europe. After a strong start, with 18 deals pricing from mid-January to March, the market was spooked by the collapses of SVB and Credit Suisse, leaving the number of new issues from mid-March to the end of April at a paltry two. However, the market now seems to have picked itself up, with seven deals pricing in May and another four in June (to June 20). 

This choppy first half has meant that some issuance forecasts for the year have been revised. Barclays, for example, has confirmed its expectation of €22bn of issuance, the lowest end of the €22-28bn range predicted at the start of 2023. As of June 20, the European region has seen €11.7bn of volumes from 31 deals. 

Notably, this year’s deals have been light on ‘print and sprint’ transactions (when a CLO is priced without having any assets already bought and ready - or ramped - in a warehouse). This reflects investors’ increasingly cautious approach, fearful that if they buy into an empty portfolio the asset sourcing process could be derailed if loan prices went up. Now, the more ramped you can be at pricing the better.

Pricing has also settled at a more conservative level than it was at the beginning of 2023. The tightest CLO of the year to date was seen in February, with the triple-A liabilities priced at Euribor+165. Since then, the widest transaction has been completed with triple-A notes at E+210 (albeit from a debut European manager). Broadly speaking, the market has settled at around Euribor+185-195.

However, there has been a greater level of pricing dispersion across the CLO market, particularly in the secondary sector, with investors making greater distinctions between what they regard as a good manager with a good portfolio and a bad manager with a weaker portfolio. Pricing differentials between where different deals are trading has widened from 100 to 200bps for BBB tranches, and it is now possible to see the worst double-B rated tranches trading at around the same level as the worst of the single-Bs. This sort of tiering is more common in the US and has previously been unheard of in Europe, where before there would have been no appetite for the weakest names. 

- Cyrille Javaux, Portfolio Manager

Direct Lending

• The market is normalising after years of overexuberance, with rates of both fundraising and capital deployment slowing
• Leverage levels have dropped from eye-watering highs, while the club structures involving more than one lender have made a comeback
• Sponsors may look to deploy dry powder in the second half, prompting more buyout activity

A sense of caution developed across European direct lending in the second quarter as the market acknowledged the economic headwinds of recession, interest rate rises, and continuing supply chain issues. We’re seeing some slower fund raising, and a more conservative approach to capital deployment, but this represents a normalisation of the markets after some years of overexcitement, rather than a step backwards.

This caution is most evident in the re-emergence of club deals. Whereas bilateral deals with one single lender dominated the last couple of years as lenders felt compelled to deploy large blocks of capital in the boom, the recent resurgence of small clubs marks a healthy return to the type of deals that were more typical of the market in the previous two decades. 

Sponsors have changed their attitude to club deals, often preferring the “safety in numbers” approach that provides options should they need to come back to their lenders for additional capital down the line. 

The market has also seen a normalisation of terms and pricing after a flood of liquidity available to borrowers from flush lenders fuelled overexuberance. Leverage levels, for example, often seen with debt at more than 6 times ebitda have now settled at a more palatable average of around 5-6 times. 

None of this is to say that funding capacity has been dramatically restricted, or that the market has dried up. Sponsors are also still awash with capital. While this has yet to elicit a wave of buyouts, we expect activity to pick up in the second half of the year as sponsors look to sell companies they’ve been holding longer than originally planned. Private equity may soon follow as purchase price multiples reset in those markets. This in turn could lead to a surge of activity after the August break. 

- Marc Preiser, Portfolio Manager

[1] All data sourced from Pitchbook Leveraged Commentary & Data (LCD)