PE deal teams can increasingly access direct lending for large, cross-border buyouts but regulatory and structuring challenges across jurisdictions remain.
By Marcello Bragliani, Tom D. Evans, Michel Houdayer, Joseph Kimberling, David J. Walker, Thomas Weitkamp, Antonina Semyachkova, Catherine Campbell, and Yien Ee
Direct lending has long been a feature of the debt market, and has recently taken market share on predominantly small- to medium-cap deals. However, as syndicated debt markets remain dislocated, direct lenders are stepping up on a growing range of European PE transactions, such as The Access Group’s c.£3.2 billion refinancing, one of the largest unitranche deals in Europe to date.
For sponsors seeking certainty of execution in the current market, direct lending is rapidly becoming a preferred option on large buyouts, across sectors. These larger direct lending deals are typically multi-jurisdictional, adding structuring and regulatory complexity. PE deal teams must navigate evolving terms and pricing while considering differing European regulatory and legal frameworks.
Narrowing and converging
While most direct lending continues to be in the mid-cap space (typically with one or more maintenance financial covenants), some direct lenders are moving into large-cap deals and clubbing together to hit the mark on quantum, as seen in The Access Group’s financing. Direct lenders are also becoming more competitive and flexible on larger deals, with “cov-lite” financing increasingly 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 pricing differential between syndicated debt and unitranche financing also seems to be narrowing, adding further momentum towards direct lending and helped in no small part by depressed secondary pricing in the syndicated debt markets (and the implied yields for any new primary issuance) as well as anticipated central bank responses to rising inflation across Europe. Sponsors will be looking carefully at the impact on their models of higher debt costs.
Recent deals have also seen direct lenders increasingly willing to accept more permissive covenants, moving towards terms that are commonplace in sponsor-backed syndicated loans. We expect that covenant flexibility on unitranche deals likely will continue to converge with the syndicated debt market, as direct lenders compete with investors in the syndicated markets on large transactions and sponsors insist on the flexibility to which they have become accustomed in the syndicated debt markets.
While the emergence of large-cap direct lending is a welcome development for PE, the absence of EU-wide harmonisation on direct lending means there are regulatory differences across jurisdictions.
For example, in Italy, large-cap syndicated bank debt is not a feature of the market for tax and regulatory reasons, and the bond market has typically dominated PE transactions. However, as the bond market remains volatile, sponsors have begun to seek alternative forms of financing. Only entities licensed under Italian banking law, or those that hold a European banking passport, can provide a loan to an Italian company. However, direct lenders can operate in Italy by structuring the finance as a private note issuance (as entities do not need to be authorised or passported into Italy to subscribe to bonds). PE firms are now more comfortable using direct lenders adopting this structure, and consequently more large-cap Italian deals are tapping the direct lending market. Direct loans on Italian PE deals are increasing in size, reaching the €700 million range and rising.
Sponsors operating in France are also increasingly receptive to direct lending. Like in Italy, only licensed entities or those holding a passport can provide credit to French borrowers, so direct lending is structured as a private note issuance. The French legal framework for such bond issuances has become more flexible over the last decade, and as direct lending becomes more prevalent, lenders have started to collaborate on large unitranche packages.
Lending to German borrowers generally also requires a license or passported license. For that reason, historically direct lending tended to be structured as capital market bond financing, which does not require a license. However, more recent changes in the regulatory framework allow a structure where debt funds set up alternative investment vehicles regulated in Luxembourg, that may lend into Germany. A large number of direct lenders now operate through such Luxembourg AIFs, widening the options for PE buyers.
Dislocation in the syndicated loan and bond markets and the need for certainty of execution will incentivise sponsors to look to direct lending options even in circumstances that would have previously been the preserve of the syndicated markets. As the market becomes more flexible, and terms and pricing converge, sponsors across Europe are increasingly likely to consider direct lending as a viable alternative to the syndicated markets (even when those markets revive).
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