A volatile and challenging time creates opportunities if the right pockets of liquidity can be tapped.
Current Market Status
In line with the wider global financial markets, conditions in the European debt mid-market have worsened dramatically over the last few weeks. The Market iTraxx Cross-over index, a closely watched gauge for sentiment in the large cap credit markets (and effectively measuring the credit default swap cost protection for non-investment grade companies), spent most of last week ranging between 600-700 basis points (bps), often recording 70-100 bps swings in a single day. This compares to a trading range of roughly 200-300 bps throughout 2019. This higher risk premium on non-investment grade credits has sent yields soaring to high single digits and average bid levels in the secondary markets dipping below 80. There are of course questions regarding the loan volumes actually being traded at this level.
The dislocation in the secondary market has contributed to dampening primary appetite from alternative lenders (who have provided much of the liquidity since the 2008 global financial crisis), many of whom are seeing a relative opportunity to acquire well-known credits in the secondary market at attractive yields. In addition, many are focused almost exclusively on their portfolios.
We outline below a summary of the key themes in the European debt mid-market, which is based on discussions with a broad spectrum of lenders.
Banks Shifting Their Focus to Portfolio Companies
The shift in focus is largely driven by uncertainty around the wider economic environment, but it has also been impacted by M&A deals currently being withdrawn from the market. Deals are being withdrawn or paused as many companies are yet to fully understand the full earnings impact of COVID-19 and bidders and lenders have no clear way of pricing it into their models. However, several banks and asset-backed lenders remain open for new business to date and are set for busy times if lending appetite remains.
Early Requests for Payment Holidays and Covenant Waivers
Lenders are seeing early approaches from borrowers for revolving credit facility (RCF) drawdowns, capital and interest payment holidays/rolling up as well as covenant waivers/renegotiations. While lenders seem amenable to repayment and covenant waivers, interest waivers pose more difficulty, as non-payment of interest is a Basel trigger and has a direct impact on capital weighting for banks. The ability to do this is yet to be worked out, and most lenders seem keen to focus on short-term fixes.
Issues Surrounding UK Government Initiatives
The Covid Corporate Financing Facility (CCFF) and Coronavirus Business Interruption Loan Scheme (CBILS) initiatives have been received favorably by the market; however, two key issues remain. First, there is a major funding gap between “larger investment grade firms” who can benefit from the CCFF and those with revenue below GBP 45 million (mn) who can benefit from CBILS. Second, with both schemes the business will need to go through some form of credit process with the lender or Bank of England (BoE). This will take time and there are some concerns around resources available to deal with the flow of requests under both schemes. In speaking with lenders who are part of this scheme, it is clear that there are many questions still unanswered, and a number of lenders have commented that they are in dialogue with the British Business Bank.
Increased Yield in the Secondary Markets Adversely Impacting Primary Debt Fund Lending Appetite
Many credit funds also invest in syndicated loans (and bonds). As a result, several alternative lenders are shifting their focus to the secondary market, as spreads have recently widened and they feel there is a short to medium opportunity to obtain superior returns. As a result, this is requiring primary mid-market financing opportunities to be comparable on a relative value basis.
Key Stimulus Programs
- BoE reduces base rate from 0.75% to 0.1%
- Grant support to cover 80% of salary costs for furloughed workers as well as the earnings of the self-employed, up to GBP 2,500 per month
- BoE to purchase commercial paper of investment grade companies that make a material contribution to the UK economy (CCFF)
- Government to back 80% of loans between GBP 1,000 – GBP 5 mn to primarily support small and medium-sized enterprises (CBILS). The first 12 months to be interest free and terms range from three months to six years
- Retail, leisure and hospitality companies provided with business rates holiday for the 2021 tax year
- VAT payments deferred during the period March 20 to June 30, 2020
- Statutory sick pay of GBP 945.25 per week
- The European Central Bank pledges EUR 750 billion (bn) to buy EU government and private sector paper and commercial paper. Declare no limit on policy
- Negative rate on deposits from commercial banks of -0.5%
- EUR 20 bn per month bond purchases
- Up to EUR 2.3 trillion of negative interest credit offered to banks (effectively paying them to borrow as long as they keep credit flowing to companies)
- Germany - KfW (the German state-owned bank) pledges up to EUR 550 bn to companies to ensure they survive the pandemic and EUR 50 bn to provide direct grants to small businesses
- France – EUR 45 bn aid package for small businesses and other hard-hit sectors and will guarantee 70-90% of bank loans of up to EUR 300 bn
- Italy – EUR 25 bn fiscal rescue package, EUR 500 per person for self-employed
- Spain – EUR 200 bn total package which includes state loan guarantees, suspension of social security payments and EUR 600 mn to support vulnerable people and those depending on social services
Despite the increased liquidity provided by central banks, the lending environment will likely be volatile in the near term, and until infection rates start to decline and we see the full economic impact, conditions in the European debt mid-market will likely remain very challenging. Furthermore, the strong yields in the secondary market on high-quality names is increasing the credit bar for new deals coming to market. Difficulty is added by overall lender sentiment that the macroeconomic picture will likely get worse before it gets better.
We do however see positive signals from lenders regarding existing clients and solid appetite within the direct lending community to engage in difficult situations with the right borrower. Having both lent and raised capital through previous downturns and with a strong global lender network, Duff & Phelps is experienced in navigating difficult markets. If you would like more information about current market conditions, or would like to discuss a current or possible transaction, please feel free to contact us.
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