2023 – Leveraged Finance – Year in Review: we all need more Kenergy

• 2023 was the Year of Barbenheimer – and in the new money leveraged finance world, a tale of two very different halves:
  • The year started with muted deal activity – with parts of the leveraged loan markets still radioactive from the many negative pressures which followed on from 2022 with M&A deals and processes mutating and stumbling to bridge valuation gaps (many didn’t make it…) and a general sense that the golden days of 2021 might be behind us
    
    
  • And then the market started to find its Kenergy and bounced back in Q4 with a string of deals for a strong finish to the year
• Corporate (including PE portfolio company) refinancings continued throughout the year, margins went on a bit of a rollercoaster (up earlier in the year but trending back down as we ended) but terms otherwise didn’t see much in the way of change
  
  
• Private Capital (outside of acquisition funding) managed to find some interesting places to put capital to work (especially for lenders that could find an unloved sector and were able to navigate ESG issues)
  
  
• There were (and remain) pockets of stress in the system – due to macro/sector issues, over-leveraged capital structures or both. This has already resulted in losses for some and/or opportunities for others

We were pleased to support our clients through the ups-and-down of the year, including on PAG’s acquisition of Australian Venue Co, financiers on Brookfield’s bid for Origin Energy, Sponsors bidding on TEG and Aesop, refinancings for Navis’ Device Technologies Australia and Brookfield’s Healthscope, various financings for Kinetic and Pemba's MSL Solutions P2P.

With Just Ken as our inspiration, let us dive into it.

Challenges - “What if there’s beach? You’re gonna need someone who’s a professional in that”

There were a few themes that drove the year: 

1. Sectors – being sector-agnostic product specialists gives us a chance to work across many sectors and develop deep understanding of our clients’ businesses and the challenges they face.  We saw those challenges hit hardest for:

• Sectors facing input cost pressure – eg food, building/construction and related services, manufacturing, mining
  
  
• Sectors facing labour cost / availability pressures – eg healthcare, education, hospitality, childcare, aged care
  
  
• Sectors facing regulatory scrutiny – eg childcare (leading to pause in processes)

2. ESG – we’ve been banging on for a couple of years now about ESG moving from being a pricing issue to an availability of capital issue – this manifested in the financings for several deals in 2023 with not only the obvious ones (eg mining/coal) but also other sectors such as gaming and petrol stations

3. Aging ‘time in portfolio’ for Sponsors – a combination of factors (COVID setting back plans, no IPO exit market, price expectation mismatch) has kept portcos around longer than original expectations.  These will all eventually need to come to market, but for those not quite ready we’re starting to see this play out with the increase in NAV facilities (more below), dividend recaps and continuation funds

PIK – “Without it, I’m just another blonde guy who can’t do flips”

In the previous cycle with low interest rates, debt sizing was generally capped by leverage.  However, in the new (higher) base rate environment, interest serviceability has become the real sizing constraint for some deals. 

In line with our 2022 predictions, we’ve seen an increase in PIK facilities (where all or part of interest payments can be capitalised to the principal balance rather than being paid in cash) to allow more leverage without a corresponding impact on serviceability.  In some deals this has been in the form of Holdco mezz.  However the real movement this year was from some unitranche lenders offering a PIK-toggle feature permitting borrowers to capitalise part of their interest costs (typically subject to caps and other parameters) – which has also helped to keep that product competitive given it is inherently more expensive than bank debt.

NAV - “Why don’t you gear up the whole portfolio, Barbie?”^[1]

Traditionally fund financings for private equity transactions have been capital call / subscription financings – where financiers (mainly banks) lend against uncalled capital commitments from LPs.

However, with Sponsors stuck with longer exit horizons, NAV financings are growing in importance as portfolios age and GPs look for extra capital and returns to spruce up portcos while they position for exits.

NAV facilities involve borrowing at the fund level secured by the portfolio of investments.  Our real estate colleagues have been doing this for years, but traditional PE is of course not RE.  There are a number of hurdles to overcome when doing a NAV financing on a typical PE fund including:

1. who determines what V is and what reserves can the lender place against it

2. documentary considerations on both:

• investor documents which may not contain sufficient flexibility or permissions
  
  
• investment documents which may not permit the NAV financier to take/enforce a security interest over the portco investment

Distress - “Shredding waves is much more dangerous than people realise”

While we didn’t see the economy wide wave of distress that’s been predicted every quarter since 2021, we did see a number of financings go into restructuring. 

A high profile example was cancer care provider, Genesis Care, filing for Ch 11 protection with a creditor led debt restructuring. Key talking points include:

• Transfer restrictions – the inability for lenders to sell down early has focused some attention on (A) transfer restrictions in documentation and (B) what “cov-lite” really means on the downside
  
  
• Lender alignments – lenders’ interests within a syndicate are not always aligned and they may form different groups to pursue different objectives
  
  
• Risk of Chapter 11 “worldwide stay” / US bankruptcy law overlay for any corporate group with a US nexus – Genesis Care was an interesting example where no insolvency procedure was commenced in Australia. Instead the group (which had a large business in the US as well as Australia and Europe) filed for Chapter 11 protection under US bankruptcy law with a group of lenders utilising the debtor-in-possession (DIP) regime for new funding through the procedure.  It is a demonstration of how the Chapter 11 “worldwide stay” can be effective in practice given most financiers have some nexus to US (and so would hesitate to ignore its court orders)

With the high interest rate and inflation environment, there is likely to be continuing headwinds affecting certain sectors and some borrowers with over-levered capital structures that will need to be reset at some point.

The Golden Age of Private Credit^[2] - “Because actually my job…it’s just beach”