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Coronavirus - Private equity and the pandemic: Debt finance trends – Global

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Articles about Government-backed financial schemes have become as common as my daughter’s demands to recreate the Great British Bake Off during ‘break time’. So rather than regaling you with tales of bank standard form loan agreements and waiver letters, I thought that it would be more appropriate to take this opportunity to provide a brief overview of some of the trends that we are seeing in the debt finance markets and why.

One of the apparent advantages of lockdown and remote working (aside from ease of access to home-baked goods) is that clients, advisers and other lawyers are less able to politely decline our requests for calls to catch up and share market insight. The following thoughts are therefore based on a combination of our own deal experience, and input from a wide range of market participants – with thanks to those concerned for indulging us over the last few weeks.

The good news is that against the backdrop of a pandemic, political and civil unrest, and social bubbles rather than economic ones, I think that there is cause for positivity. I agree with Richard’s comments last week that the private equity industry, along with its portfolio companies, advisers and lenders, are very well placed to respond to the current challenges and emerge quickly, provided that everyone is willing to remain nimble and continue to seek constructive solutions.

It’s fair to say that the leveraged buyout market is still pretty-much closed for business at present. However, our finance group remains busy. Our restructuring and special situations teams are inevitably in demand, and as Richard eluded to in his introduction last week, they are likely to remain so for some time as a result of the unfortunate repercussions of the pandemic, as well as the usual array of business-as-usual restructuring and refinancing.

However, unlike in 2008, the current economic downturn is not due to systemic failures, and there is a huge amount of liquidity out there. My sense, which seems to be shared by those that we have surveyed, is that the market really wants to break through the current barriers to business and get back to business as usual. As a result, the regular calls for advice on “liability management” exercises are interspersed with questions about potential refinancing options, DCM alternatives to traditional bank debt, and potential acquisition activity. The interesting question will be at what price…

One obvious reason for this positivity is that until shortly before lockdown started in the UK on 23rd March, private equity had been enjoying a very lengthy period of friendly debt markets. Confidence in the market was clearly demonstrated by the number of deals getting done with equity cheques, in the knowledge that buyers could refinance with readily-available third party debt within short time-frames post-closing. Terms achievable in the UK market afforded lots of flexibility, with pricing at levels that we hadn’t seen since 2006/7. It’s well documented that both banks and private credit funds had been highly active, with the latter raising funds at a rate and of a size that the European finance market had not seen before. All very good news for borrowers.

And then we were all asked to stay home for an indefinite period. Most of the work that the team has been involved with since late March can be very briefly summarised as follows:

  • Amendments and waivers – often kicking the can down the road in the hope of a return to ‘normality’
  • Incremental facilities, exercise of accordion options, and other facility increases - plugging liquidity needs
  • Government-backed financing measures – principally CCFF and C(L)BILS

Complexity of implementation of one or more of these alternatives varies significantly based on the sophistication (or otherwise) of the borrower’s existing capital structure, treasury function, and/or ownership structure. Despite the apparent additional hurdles (such as the “undertakings in distress” test), even some private equity clients have now found that they are able to raise funds via the Government schemes.

What themes are we seeing?

Lenders have been very receptive to ‘good’ borrower clients - whilst inevitably some lenders have been unable or unwilling to assist their clients with amendments, waivers, covenant resets or incremental debt, a significant percentage have done so. As always, lender comfort levels vary depending on underlying credit strength, but we have seen a significant number of concessions made by banks and alternative lenders alike in order to keep such businesses alive until lockdown is relaxed.

Key changes that we have seen implemented include:

  • incremental tranches of debt or the re-purposing of existing undrawn commitments
  • interest payment deferrals (or incurrence of short-term funding to meet payment requirements)
  • deferrals and/or waivers of financial covenant testing, in certain cases for a full year, thereby buying some breathing space

Lenders have been very amenable to amendments requested by otherwise healthy businesses that are hitting EBITDA issues attributable to the pandemic. Last twelve month EBITDA is fairly meaningless after a month of lockdown, and the focus has quite rightly been on liquidity as a measure for the short term health of businesses.

Consequently, as a quid pro quo, we have seen lenders requiring some combination of:

  • equity injections
  • a replacement covenant such as a minimum liquidity test
  • additional reporting requirements around cashflow and liquidity
  • aggressive prepayment fees to avoid borrowers refinancing any new tranches or incremental debt in the near-term

Whilst CBILS, CLBILS and CCFF have been usefully deployed in numerous situations for the ‘right’ borrowers, lenders have preferred to agree terms without the use of any of the Government-backed measures. The level of complexity of introducing new tranches of debt with slightly bespoke terms and/or additional restrictions, is natural dis-incentive. Private credit lenders, in particular, have shown a preference for agreeing minor variations to existing terms rather than introducing alternative tranches of debt. The requirement for CBILS and CLBILS to rank at the most senior level of the capital structure has provided significant incentive for senior lenders to work with sponsors and their portfolio companies to find alternatives.

As always (and not just because my tax colleagues have asked for some air-time), the tax implications of any of these potential options require careful consideration. More to follow from our tax team in a couple of weeks.

Short-term implications?

The combination of the interruption to normal business activity and its impact on clients’ cashflows, the inevitable start-up costs for moth-balled businesses, and the increased debt burden as a result of the race to liquidity is going to keep us all busy for some time.

It would be naïve to think that the next few weeks and months are going to be business as usual. Whilst PE sponsors have capital to deploy, they are more likely to support existing business than to seek new targets. We are already having early discussions in relation to bolt-on acquisitions and potential refinancing options. Buyers and lenders alike are endeavouring to adapt to virtual due diligence and conducting management meetings via Zoom.

PE houses have got on top of their portfolios and have dealt with the problems efficiently. Longer term solutions for the real problem cases are taking longer as people wait for something resembling visibility.

In our recent webinar focussed on kick-starting the UK economy, the panel were unanimous in their view that it will take a combination of debt and equity to get UK businesses through and out the other side of the current challenges. In the private equity and leveraged finance world, a holistic approach is going to be required, not only by advisers, but also by businesses and their stakeholders. The good news is that the debt markets remain open, lenders are chasing yield, and with lockdown easing, it is likely that there is going to be an action-packed few weeks and months ahead.

Later in this series of articles I will dust off the ES finance team’s crystal ball and take a look into the future of debt funding. Next week my colleague Chris Archer, a Principal Associate in our Corporate team, will focus on alternatives to debt funding and, in particular, considering what tricks private equity houses might have at their disposal.