Private debt is here to stay, though it's distinctions are fading
Hear from the FitchRatings analytics team on the developments in private debt and what might change in the future
Private Debt appears here to stay as a European leveraged credit alternative asset class. However, the conditions that led to declarations of its “Golden Age” in late 2023 may not last. Fund managers and investors must prepare for new challenges as interest rates moderate, corporate credit narratives adjust to higher cost bases, and syndicated markets and their arranging banks return to compete aggressively for a limited set of borrowers.
Financial sponsor private equity firms turned almost exclusively to Private Debt funds during the 2022 and 2023 period of rising inflation, rising benchmark rates, recession fears and accompanying volatility in publicly-rated debt markets. With arranging banks unable to syndicate debt in size and requiring expensive flex terms on any new underwrites, Private Debt Direct Lending funds proved the reliable underwriting partner promised since developing as a first-lien lending alternative in the aftermath of the global financial crisis. Multi-billion Euro underwrites in 2023 signaled that Private Debt funds now have the lending capacity necessary to compete for prized large European LBOs.
Prior to 2023, in Europe Private Debt Direct Lenders relied on smaller borrowers less able to access syndicated markets, or complex multi-phase transactions not suited to the execution risks inherent to syndicated solutions. Private Debt Credit Funds provided second-lien or subordinated HoldCo payment-in-kind (PIK) instruments to add leverage to syndicated first-lien.
During brief periods of syndicated market stress, sponsors turned to Direct Lending and Credit funds for their ‘Unitranche’ facilities. These would often refinance once syndicated markets stabilized.
During brief periods of syndicated market stress, sponsors turned to direct lending and credit funds for their ‘unitranche’ facilities. These would often refinance once syndicated markets stabilized.
Unitranche instruments effectively blend first and second-lien leverage at a modest credit spread premium to syndicated first-lien. During the zero-bound interest rate policy years this credit spread, generally around 600bps, plus the underwriting fee generated the 8% hurdle rate most European Direct Lenders targeted. Rising rates in 2023 generated excess returns on these Unitranche facilities. Investors appreciated the comparatively steady performance of Private Debt fund managers, especially the absence mark-to-market volatility. Defaults were limited, and those that did occur clearly had limited impact on sector fundraising.
Since the last quarter of 2023, however, abating inflationary pressures, peak interest rate sentiment and resilient operating outlook for most sponsor-owned European businesses have fostered a more confident landscape for all leveraged credit products. Large volumes of recently launched highly leveraged collateralised loan obligations (CLOs), sustained high-yield bond fund inflows, and record private debt fundraisings indicate that sponsors will have greater choice of funding sources than at any time since the industry developed in Europe in the 1990s. Under pressure to distribute funds to limited partners and source new deals, sponsors will embrace their enhanced bargaining position, especially for expensive yet prized larger highly cash generative borrowers in asset-lite services, IT and healthcare sectors.
CLO formation at the start of 2024 is at a record pace. The cost of CLO liabilities came down dramatically in 2H23, with the largest and most senior note liabilities, typically rated ‘AAA’, declining from Euribor plus 225 bps in 3Q23 to sub-150 bps by 1Q24. With over 80 open CLO warehouse facilities in demand of new assets, underwriting banks can offer sponsors 7-year term-loan-Bs (TLBs) at 400bps on covenant lite.
The constraints for syndicated markets relate principally to banks’ inability to underwrite beyond first-lien. Even though single-B first-lien credit spreads are attractive, Euribor remains at 4%, so total cost for first-lien TLBs has doubled since the zero-bound years. With CLOs subject to weighted-average-rating-factor (WARF) tests, arrangers must solve for credit metrics that generally fit with single-‘B’ issuer default rating profiles. Fitch Ratings’ median single-B EBITDA-to-Interest coverage ratio on its portfolio of European leveraged credits currently indicates 2.5X. Importantly, this also corresponds to median free cash flow margins of 1.5%. This compares to ‘B-‘ median metrics of 2.1X EBITDA-to-Interest and negative free cash flow.
Private Debt therefore maintains the advantage of offering more leverage on cost-effective Unitranche as well as certainty of execution.
While many inputs factor into the distinction between rating categories, arrangers remain constrained on how much leverage they can offer sponsors by the impact of higher interest costs. Current pricing on cash-pay subordinated debt can further threaten these thresholds and the syndication risk on unsecured or PIK notes remains too great for arrangers and sponsors.
Private Debt therefore maintains the advantage of offering more leverage on cost-effective Unitranche as well as certainty of execution. Moreover, they can offer a portion of the coupon as PIK, limiting the impact on debt service and free cash flow. Lastly, Private Debt emphasizes loan-to-value in their credit evaluation in addition to credit metrics. Comfortable equity cushions and lack of rating requirements provide Private Debt much greater discretion than available to underwriting banks.
However, challenges remain when sourcing new deals. We recorded only 9 primary market LBO transactions in 2023. Part of the scarcity in primary activity reflected tighter underwriting standards, although the main reason relates to the large gap between the enterprise valuation (EV) multiples of what buyers of businesses are willing to pay and sellers willing to accept. The start of 2024 signals more activity. The valuation gap appears to be narrowing. The recovery in syndicated markets has helped. While we expect M&A activity to pick up in 2H24, the pipeline remains limited.
In the interim all credit providers will continue to vie for refinancing opportunities. Private debt now appears a more expensive option. Arrangers have already seized upon lower bond and loan spreads to refinance some Unitranche facilities from 2022 and 2023 on cash-generative credits that have de-leveraged to single-‘B’ profiles and have passed their non-call periods. In some cases, Private Debt may be forced to compete by lowering coupons. We have already seen large Private Debt covenant-lite Unitranche transactions in the Euribor +500 bps area. There must be a limit, however, to the spread compression between illiquid Unitranche at higher leverage and tradable, less-levered TLBs. We note, however, that price has not typically been the selling point of Private Debt - the asset class will still remain competitive in some situations based on flexibility and information provision.
A further challenge lies ahead if, as we expect, central bank monetary policies pivot toward rate cuts. Highly leveraged CLOs can pass on lower funding costs to borrowers. More modestly leveraged Private Debt funds will see less benefit to their cost of capital as rates fall. Private Debt funds may need to increase leverage on assets with lower coupons in order to maintain the double-digit returns they have provided in recent years.
Private Debt will continue enjoy execution advantages, particularly on complex M&A and public-to-private transactions. They will also maintain pricing power in the less-competitive, smaller (less than €75M EBITDA) part of the European leveraged credit market. However, the lack of deals will compel them to look to existing issuers and perhaps share balance sheet space with syndicated lenders.
A few refinancing transactions in early 2024 highlight the new precedent of pari-passu first-lien Unitranche and first-lien TLB and senior secured notes. The latter are rated and traded. This may dilute the benefit of valuation opacity that served Private Debt well during 2022 and 2023.
Despite multi-bullion Euro fundraisings, European Private Debt funds are increasingly forming clubs of lenders among themselves and their limited partners (LPs) to underwrite large LBOs. They do this partly to diversify risk and partly to raise the volume necessary to compete with the deepening syndicated markets.
However, club deals increasingly look like private syndicates, diluting their “Direct Lender” claims and complicating coordination in the event the credit deteriorates.
… as LPs broaden their exposure to Private Debt, many will require credit ratings for regulatory purposes. Fitch actively provides private ratings and credit opinions to US insurance companies and middle market CLO managers that issue public rated liabilities. Many of these insurance companies are investing in European deals. As Private Debt funds seek to employ more leverage to meet return expectations, CLOs of Private Debt may arrive in Europe soon.
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