Soaring inflation and the rapid rise in interest rates delivered a major blow to M&A deals, increasing the cost and reducing the debt finance that helps fuel them. But there are indications that better times lie ahead. Andy Thomson reports.
Signs that the UK M&A market might be picking up after a long period of subdued activity that followed the post-pandemic boom of 2021 and 2022 will come as welcome news to debt financiers.
Some evidence of a revival is provided by Houlihan Lokey’s latest MidCap Monitor (see box, Ups and downs), which shows that unitranche financings between Q1 and Q2 2024 have risen from 35 to 43 in the UK and from 81 to 135 across Europe as a whole.
“We are in an improving banking market,” says George Fieldhouse, a corporate finance debt advisory partner at Grant Thornton. “But we’re still building back from the shocks that reverberated through the market in 2022 and into 2023.” During this bleak period, Fieldhouse says the market witnessed “a very significant reduction in lender confidence and appetite”, resulting in fewer deals completing, lower debt quantums and less favourable terms.
Fieldhouse says that conviction began to return during 2023, buoyed by the consensus that the UK was at the top of the interest rate rise cycle, and that borrowers were able to evidence managing margins and profitability in a higher inflationary environment and forecast with greater certainty. The prevailing view was that interest rates were close to their peak and – however slowly – would begin to fall. “That fed through from the end of Q1 this year to a very clear increase in lender appetite: more confidence, better data available and increasingly more competition among lenders to chase down transactions,” says Fieldhouse.
But while sentiment is improving and appetite returning – and Houlihan Lokey’s data points to an upturn in the unitranche market specifically – there is little evidence yet of the deals tally rising as quickly across the M&A market in general.
Guy Taylor, corporate finance partner at Moore Kingston Smith, says he’s heard chatter about how the market will get busier in the latter part of this year and into 2025 – but he is less sure. “Some people say their pipeline is now pretty good, while others say they’re still not seeing much, so I’m getting mixed messages at the moment. All of us have been saying an upturn is coming for the past 18-24 months, but it’s not quite happened yet. Now everyone has their fingers crossed for the back end of 2024 and 2025.”
Ups and downs
Houlihan Lokey’s Mid-Cap Monitor report for Q2 showed deal activity picking up in the unitranche market in the UK and across Europe. “Companies have adapted to the higher interest rates, and strong deal flow will likely continue into the second half of the year,” the report predicted.
However, a new report from the Office for National Statistics paints a less rosy picture, recording 385 domestic and cross-border M&A transactions in Q2, which is down from 463 in Q1.
Kicking cans
In a bid to defy market conditions, some deals have been done on an all-equity basis – ensuring that financing is in place to enable the deal to complete, while leaving the hassle of arranging debt finance for another day. This is not a new thing. Previously it was done to enable private equity backers time to negotiate the best possible deal terms. Now, it has become one way of making sure a deal completes.
“Private equity houses will do everything they can to put themselves ahead of the competition,” says Taylor, “and one of the things they can do is to bridge the deal to show their commitment to the investee business and smooth the closing process.”
He says it’s rare that the debt financing will be kicked too far into the long grass. If a transaction gets delayed, there might still be time to bring in a lender before close – and no one wants to be caught on the hop. Even where that’s not the case, many private equity firms will want the comfort of knowing debt finance can be brought in soon after the deal has been signed – and will ‘warm up’ lenders for that purpose.
Matthew Judge, debt advisory director at KPMG, says he is aware of some all-equity deals at the smaller end of the market, but makes the point that the all-equity element is often enabled – ironically – by fund finance, a form of debt finance. “Fund finance has boomed and become a huge market for lenders and, while it gives sponsors the ability to fund deals with equity, it’s effectively a debt bridge through to some form of recapitalisation event.”
Across mid-market M&A, the quantum of debt finance available for a given deal has fallen, he adds. But this is not, as might be assumed, because of a lack of appetite from debt providers: “It’s fallen purely as a consequence of companies having less cash flow to service debt, naturally reducing the debt capacity. Cash flows have taken a big hit from the inflationary and interest rate environment.”
Supply of debt finance comes from three main sources: the high street banks such as HSBC, Lloyds and Barclays; challenger banks such as Shawbrook and OakNorth Bank (which tend to target growth deals); and private debt funds such as Ares Management and Kartesia.
“Senior banks, challenger banks, debt funds and other specialist providers are all active,” according to Fieldhouse, reflecting on the current situation. But he says that – from a mid-market and lower mid-market perspective – the banks last year took back market share from the debt funds. This was partly based on narrowed leverage differential and lower pricing, but also reflected a particular market dynamic: “I think it’s fair to say the part of the market that slowed down the most was one private equity firm selling to another and that was the part of the market most dominated by the debt funds.”
Calling a truce
While the banks may have staged something of a comeback in response to market conditions, the headline trend over the years since the global financial crisis has been the retreat of the banks and the advance of the debt funds as traditional lenders have sought to de-risk their balance sheets from certain types of lending.
This does not mean the banks are not interested, though, and while debt financing in the mid-market is often framed as banks and debt slugging it out for supremacy, one method increasingly being used to maintain a presence in the market is to form partnerships.
One recent example was Lloyds Bank’s £1bn mid-market tie-up with debt fund manager Oaktree Capital Management of the US, which was announced in July this year and targets private equity-sponsored transactions. A press release from the firms said the partnership “removes the need for multiple funding parties”, among other benefits.
Earlier in the year, Barclays launched a partnership with AGL Credit Management, while HSBC has recently launched private debt strategies in relation to infrastructure debt and direct lending. “We’re still seeing appetite from the clearing banks,” says Judge, “particularly where cost of debt has brought overall leverage down, but they are looking to use their private credit arms as much as possible to de-risk their balance sheets.”
Another trend being seen in the market – particularly with borrowers sensitive to the cost of financing in a high interest-rate environment – is the combination of cash-flow lending with asset-based lending (ABL). “In a couple of recent deals, we’ve brought in asset-based lending-type facilities where a business has assets that can be financed such as stock or receivables and you can sometimes get a better blended cost of capital,” says Judge.
He adds that, as more of these types of deals get done, ABL and cash-flow lenders are becoming more comfortable working with each other and inter-creditor agreements, while still complex, are becoming relatively easier to agree.
Who you know
It’s always been the case that mid-market M&A is a relationship business, but debt funds have been operating for so long now that the high street banks certainly no longer have a monopoly on close relationships – if they ever did. But whoever relationships are formed between, there’s no doubt that they still matter.
“Where you’ve got a sponsor who has a very strong relationship with a lender what you can find is that, because they know each other well, they have a set of terms that have been previously agreed and that can often make it easier to get to a structure that works for borrower and lender and that can also help the banking process,” says Fieldhouse.
Under pressure
Relationships have been arguably more important during a period where getting deals over the finishing line has been challenging. “There has been a flight to quality and much more scrutiny from lenders than there was before,” says Mickey Patel, investment partner at private equity firm August Equity.
In 2022 and 2023, especially, deal processes elongated as information requests multiplied and due diligence took far longer to complete as a result. Things may be a little less convoluted in 2024, but being close to counterparties is useful in an environment that’s still challenging. “Information requirements are still relatively high and the burden of proof remains greater than it was pre-2022,” says Fieldhouse.
Raising debt finance for UK deals may be getting a little easier – and market participants can afford to look ahead with cautious optimism – but anything resembling a post-COVID 2021 boom is, if it can be seen at all, way off on the far horizon.
The new normal
Falling interest rates are unlikely to greatly influence deal activity – a change in attitude towards valuations is more likely to have a bigger impact. Studying SONIA (Sterling Overnight Index Average) forward curves may not be everyone’s idea of an exciting pastime, but it’s a very useful one to help understand more about the most likely future direction of interest rates in the UK.
It makes for sobering reading for anyone drunk on optimism. Those hoping for a swift return to a rate at or near zero may be surprised to learn that it’s not predicted to nudge below 3.5% until the start of 2027 at the earliest. Indeed, as far as the eye can see, the ‘new normal’ is well above 3% and not much below 4%.
What this means is that borrowers are unlikely to put deals on hold in the anticipation of a lower rate – and cheaper financing – around the corner. Any cuts are likely to be so small and gradual that they’re likely to be relatively insignificant when compared with a business’s overall strategic planning. But in many ways this is no bad thing for M&A.
The biggest obstacle to ending the deal bottleneck, thinks Moore Kingston Smith’s Guy Taylor is the prevailing valuation gap between buyers and sellers. And he thinks the onus is on the buy side rather than the sell side to get things moving: “PE houses, with employees who have carry and want to maximise returns, are not going to sell these assets at what they consider to be an under-valuation. They will do their best to wait until the numbers work for them.”
August Equity partner Mickey Patel thinks the wave has to break at some point: “It’s difficult to say when things will improve significantly but vendors still need to exit their businesses at some stage, which will drive the activity.”
