Overview
In his 1970 book Future Shock, the philosopher Alvin Toffler introduced the concept of ‘overchoice’, a paradox where having too many options can make decision-making almost impossibly difficult. As an investor looking across the host of leveraged finance products available in both public and private markets, overchoice may sound familiar. For example high-yield bonds and senior secured loans offer very different benefits depending on the expected outlook for rates or the chance of recession, and that’s before other
less traditional funding options such direct lending or commercial mortgage-backed securities (CMBS) are taken into account. So why not take a leaf out of a private equity borrower’s book - rather than choose between various different products, pick them all. In this paper we draw on the experience of experts across the market to review the developments that have happened across the leveraged financing markets since the Global Financial Crisis (GFC) and ask how investors can best approach this new funding landscape.
“If you’re sitting in the capital markets seat, you want to use all the products available to you,” says Mark Danzey, a partner at KKR on the capital markets team, which has arranged more than $1.5 trillion in financing since its foundation in 2007. “If you’re running a credit business, you want to be hedged across multiple different products rather than just being focused on one. With a long-term lens, you’re going to suffer if you’ve got a very niche approach to the world.”
Private equity borrowers didn’t always think this way, and before the GFC, sponsors’ approach to financing was straightforward. For a leveraged buyout, banks would fund a TLA (an amortising term loan) and provide a revolving credit facility, while funds would be tapped for a TLB (a term loan with a bullet maturity) via the syndicated market. Even the pricing of the different strands of debt was standardised.
But the past two decades have brought about a shift in how private equity firms access capital for their portfolio companies, and the picture is now far more complex - and arguably more interesting for market participants. Sponsors are adept at tapping the entire range of markets and products available to them, and their approach to funding has become far more sophisticated.
There are some key lessons Fidelity’s Private Credit team has learned from our colleagues on the other side of the funding fence.
Lesson one: Keep your options open
Private equity firms recognise that high-yield bonds and senior secured loans (TLBs) are two sides of the same coin, and their approach to financing takes these similarities - as well as their nuanced differences - into account.
Over recent years these public and private products have become closely aligned, and many of their terms now seem interchangeable. For example, the two products increasingly occupy the same portion of the capital structure. While TLBs traditionally occupied the senior secured part of the capital structure and bonds were issued as unsecured or subordinated debt, since the GFC, a growing proportion of bonds have been issued as pari passu senior secured products. This means that they sit in the same stratum of capital seniority and are treated equally in the case of a deal defaulting.
Elsewhere, differences between the markets remain. In high-yield bonds, for instance call protection periods limit how quickly a borrower can return to the market to refinance their borrowings (and cut their costs if spreads are tightening). However, although the average duration of call protection periods for high-yield bonds has been shrinking over recent years, more than 40 per cent are still between one-and-a-half and two years. Non-call periods in TLBs are typically far lower, limited to six months, meaning that borrowers can return to the market to reprice deals much quicker.
The borrower base is also slightly different between the two products, meaning they have their own idiosyncrasies and react to wider macroeconomic developments in different ways: our own proprietary analysis suggests that less than a third of leveraged loan issuers in our coverage also have fixed-rate bonds in their capital structure. Part of this division between the two markets can be found along rating lines: the high-yield bond market has been the traditional home of a greater proportion of BB-rated issuers.
There are other reasons that certain borrowers favour one market over another. Italian rules around withholding taxes, for example, mean that deals there are almost always financed solely via the bond market. Elsewhere, the high-yield market has been the home of borrowers from cyclical sectors, such as retail
In a number of deals though, sponsors do not choose between one product or another but rather tap into as many pools of capital as possible to maximise the liquidity available.
“This is the leveraged finance world rather than just a syndicated loan world or a high-yield bond world,” says Adil Seetal, a senior managing director on CVC’s capital markets team, the financing arm of Europe’s largest private equity house. “You have to play in all the pockets available.”
This is particularly true of cross-border deals, or transactions where the total amount of debt to be raised is sizeable. For example, in Summer 2023 Apollo Global Management and Abu Dhabi Investment Authority financed their public-to-private buyout of chemicals firm Univar with a $1bn offering of senior secured high-yield bonds, a $2.4bn dollar-denominated loan, and a €870m euro-denominated loan.
In this transaction, the sponsors were able to adjust the deal to respond to investor appetite across the two markets at the time: the high-yield bond deal was downsized by $800m while both the term loans were increased. The final financing package was $4.15bn, having been launched at $4.1bn, and the excess capital was earmarked to be used for general corporate purposes.
Sponsors have become skilled at manipulating the tension between the two markets in situations like this, looking across the landscape as a whole and adapting their strategy when market conditions or prices shift.
Having the option to chop and change between different products is particularly helpful as the rate environment moves, as the long-term spread differential between floating-rate term loans and (predominantly) fixed-rate high-yield bonds grows.
“While terms in the senior loan market may still be more flexible and bespoke, high-yield bonds are still preferrable in some scenarios – particularly if you’re taking a view that the rates curve will remain inverted and you’re looking to lock in some cheaper capital for a relatively long period of time,” says Roxana Mirica, Head of Capital Markets in Europe at Apax. She is responsible for leading acquisition financing and ongoing debt and equity capital markets transactions for the sponsors’ portfolio companies, as well as fund level financing.
Should rates fall in the coming few years, sponsors may take a different approach, opting to replace the wave of bonds reaching maturity in 2025 and 2026 with floating- rate loans. Given loans have a shorter non-call period (typically six months compared to two years for bonds), borrowers may be able to return to the market more frequently to refinance deals at ever-tightening levels.
Lesson two: Embrace what's new
High-yield bonds and leveraged loans have long been the main funding tools for sponsors (alongside other solutions including CMBS or payment-in-kind notes), but one of the most significant changes of recent years has been the establishment of direct lending as a core financing market for private equity. Just a few years ago, this was a niche product used only by issuers unable to gain traction in syndicated markets, but it has now become a viable choice for sponsors to finance even the most delicate transaction.
“Direct lending is here to stay,” says Apax’s Mirica. “That market has absorbed a great deal of volatility in the last couple of years, and it’s proven to sponsors that the lenders there can be commercial, that they can provide solutions quickly, and that they can maintain confidentiality. We’ve seen a number of situations around take-private acquisitions – where confidentiality is more important than usual – that have been financed by direct lending. That’s an extraordinary development. I’ve been bullish on the private credit market for a while, and I didn’t even think it would go that far.”
Direct loans have been getting bigger too. Late in 2023, Permira and Blackstone funded their buyout of online classified group Adevinta with a €4.5bn loan provided by a club of private credit funds, while earlier that year the largest ever private unitranche was completed as Finastra wrapped a $4.8bn deal to refinance its broadly syndicated term loans. But while size is not a challenge for direct lending, some sponsors note that there is still caution around the resilience of the new product, especially as the current cycle is the first time the market has faced a sustained higher rates environment, pushing up the cost of debt for borrowers.
“As a sponsor, we’ll always be balanced,” says CVC’s Seetal. “We don’t want to be too concentrated in one market over another. When you have a new deal, you look at bonds, you look at syndicated loans, and you look at the direct lending product. Direct lending is a new product, and how that market’s participants behave when things don’t go well is something that’s yet to be tested in a meaningful way.”
Similarly, direct lenders have demonstrated their preference for borrowers from certain sectors, meaning it’s not yet a financing route that private equity firms can take for every deal, but their scope is broadening all the time.
“Direct lenders have a very clear sense of what they do and don’t like,” says Seetal. “While they finance some companies quite aggressively, there’s a lot of stuff they are less keen on. They tend to like software, healthcare, business services, but will typically shy away certain businesses such as cyclicals or those with significant consumer exposure [and so at risk in an economic downturn]. So being balanced and working with different markets is important.”
Lesson three: Don't forget the basics
Direct lenders’ role in financing leveraged borrowers may have increased as banks have cut their corporate lending exposure, but traditional lenders still have a role to play for sponsor-backed firms, as KKR’s Danzey’s experiences illustrate.
“When we bought Wella out of Coty in the spring of 2020, we financed that with a bank club deal in an old-fashioned TLA/TLB format. We were in the middle of Covid, when everybody believed that the financing markets were completely shut and deals were undoable. But we took low leverage, structured the deal as a BB rating profile, and raised €1.5bn from the commercial banks.”The financing for the Wella acquisition was initially completed at the height of the pandemic, when many capital markets were closed, and the bank loan was later replaced with a $1.95bn loan package that was partly syndicated, partly privately placed. But banks have a role to play beyond acting as lenders of last resort to backstop market activity in times of volatility. “Banks are an important part of the ecosystem,” says Seetal. “They can provide services that direct lenders cannot – bank accounts, hedging services, M&A advisory, and all the other stuff you need to run a business.”
Bank lender clubs made up 14 per cent of the direct loans completed in 2023 to June 30, compared to taking a share of just 2 per cent in the full-year 2022, while the proportion of deals with one bank lender also increased from 2 to 5 per cent.
Lesson four: Stay flexible
The ability to dip in and out of financing options - as demonstrated in the Wella deal - has proven to be important over the last few years. Having the flexibility to access alternative funding has been vital when volatility limits access to certain markets.
“That was the point that was really highlighted during the pandemic,” says Seetal. “You need that optionality there so that when markets are closed for three months or longer at a time, you still need to be able to move the jigsaw puzzle pieces around and make it work.”
However, it is not only in acute times of crisis that this ability to tap into different pools of capital has been attractive.
“Once rates started rising, the institutional market became very thin and even disappeared for a while,” says Mirica. “Sponsors then relied almost entirely on the private credit [direct lending] market – it was certainly more challenging at some points, but it was very much there. At that point, it officially became one of the tools in the toolbox, even for large-cap sponsors that hadn’t used the product much previously.”
This flexibility to access different financing products has meant that private equity firms have continued to be able to fund buyouts despite the shifting economic backdrop of recent months - although the volume of LBOs has itself fallen as a mismatch between expectations and valuations has emerged.
“Back in 2009 or 2010, when the markets were closed there was just no deal flow,” says Danzey. “There’s a stark improvement now – I don’t think there’s been a deal that hasn’t happened in the last 15 months or so because a borrower just couldn’t finance it.”
The options enable sponsors to pick and choose the most attractive funding option available at any time, and where necessary to switch between them at speed. Early in 2023, sponsor Blackstone scrapped plans for a mammoth $2.6bn direct lending deal pencilled in to support its buyout of Emerson Electric’s Climate Technologies unit in favour of a high-yield bond and leveraged loan. The direct loan had been rumoured at a price of 675 basis points over the Secured Overnight Financing Rate, while the term loan came at only 350 basis points over.
Investors do not always have the same ability to opt in and out of different leveraged finance products as markets shift. But the lesson here from our private equity colleagues is to stay flexible and to look across the entire investment landscape to gain a strategic advantage.
“From the perspective of allocating capital, you need to be agnostic,” says Danzey. “Private credit is very much the flavour of the month, but if you have an allocation for one product and not the other, you’re probably not doing your job right.”
Globally, leveraged finance has developed dramatically over the last few years, and there are now far more opportunities to participate in the market through different products. Just like our private equity counterparts, investors may find plenty of benefits to being open to all possibilities
