Behind the Numbers - Marlborough Partners
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Life beyond the debt fund decade

JP Davidson and Romain Cattet of Marlborough Partners explore the consequence of a higher interest rate environment on mid-market LBO financing structures and how it impacts both the banking market and the private credit community.

JP Davidson and Romain Cattet, Marlborough Partners

SINCE 2010, EUROPE has experienced a sustained period of low interest rates while, coincidently, the world of private credit has ballooned. The adoption of the unitranche product in Europe went from nascent to challenger to mainstream – the ‘debt fund decade’ made its mark.

The attractiveness of the unitranche product has been clear on all sides.

For the borrower it gave a fully levered solution, huge flexibility to support growth through follow-on funding and a partnership approach. It also provided attractive pricing, as the incremental cost of the additional leverage was much cheaper than equity.

In addition, significant ‘hold’ appetite has made the credit fund one-stop-shop solution attractive versus the multi-bank club or syndicated loan alternatives. Similarly, it allowed LPs to find a home for capital in a low interest rate environment with attractive returns for a senior secured product. Meanwhile, the product had no shortage of talent, as ex-bankers flocked to join private debt platforms with exciting opportunities to do deals, build out teams and expand AUM.

However, over the last 12-18 months, interest rates in Europe have gone from negative to 3.5%-4% (5% in the UK) and are now back at the ten-year average before the financial crisis. This has had a profound impact on the maths of LBO financings.

If we start by looking at a typical structure seen in mid-market LBOs over the last 10 years, unitranche financings have been leveraged at approximately 1x to 1.5x EBITDA more than a traditional bank deal. For a medium-sized European business with strong cash conversion the debt service coverage ratio (or “DSCR”) on these unitranche structures has been around the 1.7x level (see figure 2). This means that the annual cash a company generates after taxes that could be used to service its debt is 1.7 times greater than the interest payments and contractual repayments on debt. This is a level that credit investors feel comfortable with because there is a sufficient buffer for underperformance and the lenders will still receive their interest payments.

Moving this analysis forward into a higher base rate environment (margins have also increased since the Ukraine war) the same level of debt is not sustainable, as DSCR levels would be at c.1x. In order to compensate for this, unitranche debt levels have had to dramatically reduce.

Bank structures have been less impacted by rising rates.

When we look at the same DSCR analysis we need to distinguish between bank structures that we see in the UK which typically are 100% bullet structures and those in Europe where banks have maintained a more conservative approach with c.25% of the debt on a repayment basis.

If we compare the DSCR numbers (see figure 2) we can see that a bank deal with 25% amortising Term Loan A at 3.75x EBITDA gives the same 1.4x DSCR. The resulting delta in leverage between the two structures in this example is now only 0.50x EBITDA and, based on assumed pricing, the incremental cost of this additional funding would be c.29% per annum (see figure 3).

These dynamics have been leading borrowers to look more closely at bank financings. Over the last nine months, 45%-50% of our mid-market deals across Europe have been led by banks, which is higher than the c.35% we saw in the prior two to three years. Private credit funds remain active and still play a vital role in the European financing market, but we are starting to see signs of a resurgence amongst the banks. The following are some themes that will be interesting to track.

Deal size

Clubbing multiple banks together remains a complex challenge and we expect to see borrowers continuing to make the effort in putting these structures together up to a certain size, at which point there will be a gravitation towards credit funds for liquidity.

Non-cash PIK interest

We are seeing credit funds offering more permanent PIK toggle options for borrowers to help alleviate the interest burden. This ability to accrue some cash interest rather than pay all cash will go some way to improving the value of a unitranche offering.

Availability of funds

Fundraising activity among the private credit community has slowed down and the availability of capital will have an impact on liquidity options for borrowers until activity improves. By contrast we are yet to see any major shifts in availability of funds from mid-market banks.

The debt fund decade that we have experienced across Europe has resulted in the development of a widely used financing product, with great benefits for borrowers. These capital providers are now having to find more creative ways to offer value for money versus what can be obtained from banks. Whilst interest rates remain high, we expect to see a sustained resurgence from banks in the mid-market.” 

A full version of this article appeared in PLATFORM 09, Summer 2023