Private equity operations teams can increasingly access direct loans for large cross-border buyouts, but regulatory and structural challenges in all jurisdictions remain.
Direct lending has long been a feature of the debt market and has recently taken market share on primarily small- and mid-cap transactions. However, as syndicated debt markets remain dislocated, direct lenders are stepping up a growing range of European private equity deals, such as the roughly £3.2bn refinancing of The Access Group, one largest unitranche transactions in Europe to date.
For sponsors looking for certainty of execution in today’s market, direct lending is quickly becoming a preferred option for large buyouts, across all industries. These larger direct lending agreements are typically multi-jurisdictional, which adds complexity to structuring and regulation. Private equity deal teams must manage changing conditions and prices while taking into account different European regulatory and legal frameworks.
Shrinkage and Convergence
While most direct lending continues to be in the mid-cap space (typically with one or more maintenance financial clauses), some direct lenders are moving into large-cap transactions and partnering to hit the quantum target , as shown by The Access Group. funding. Direct lenders are also becoming more competitive and flexible on larger transactions, with “cov-lite” financing becoming more common. The growing availability of competitive unitranche financing is good news for sponsors, providing more financing options where historically only syndicated loan or bond markets would have been viable.
The price differential between syndicated debt and unitranche financing also appears to be narrowing, adding to the momentum towards direct lending and being helped in large part by lower secondary pricing in syndicated debt markets (and implied yields for any new primary issue) as well as anticipated central bank responses to rising inflation in Europe. Sponsors will carefully consider the impact on their models of a higher cost of debt.
Recent deals have also seen direct lenders increasingly willing to accept more permissive clauses, moving towards terms common in sponsor-backed syndicated loans. We anticipate that covenant flexibility on unitranche deals will likely continue to converge with the syndicated debt market as direct lenders compete with investors in syndicated markets on large deals and sponsors insist on the flexibility at which they got used to the syndicated debt markets.
While the emergence of large-cap direct lending is a welcome development for equity, the lack of EU-wide harmonization on direct lending means that there are regulatory differences between jurisdictions.
For example, in Italy, syndicated large-cap bank debt is not a feature of the market for tax and regulatory reasons, and the bond market has generally dominated private equity transactions. However, with the bond market remaining volatile, sponsors began to seek alternative forms of financing. Only entities licensed under Italian banking law, or those holding a European banking passport, can grant a loan to an Italian company. However, direct lenders can operate in Italy by structuring the financing as a private note issue (as entities do not need to be licensed or have a passport in Italy to underwrite bonds). Private equity firms are now more comfortable with direct lenders adopting this structure, and as a result, more Italian large-cap deals are tapping into the direct lending market. Direct loans on Italian private equity deals are increasing in size, reaching the €700m range and growing.
Sponsors operating in France are also increasingly receptive to direct lending. As in Italy, only licensed or passport-holding entities can extend credit to French borrowers, so direct lending is structured as a private note issue. The French legal framework for such bond issues has become more flexible over the past decade, and as direct lending becomes more prevalent, lenders have begun to collaborate on large unitranche packages.
Loans to German borrowers usually also require a license or license with passport. For this reason, direct loans have always been structured as capital market bond financings, which do not require a license. However, more recent changes in the regulatory framework allow for a structure where debt funds set up alternative investment vehicles regulated in Luxembourg, which can lend in Germany. A large number of direct lenders now operate through these Luxembourg AIFs, expanding the options for private equity buyers.
The dislocation of syndicated loan and bond markets and the need for certainty of execution will cause sponsors to look to direct lending options, even in circumstances that would previously have been the preserve of syndicated markets. As the market becomes more flexible and conditions and prices converge, sponsors across Europe are increasingly likely to consider direct lending as a viable alternative to syndicated markets (even when those markets pick up).