Member Article

This article looks at current trends in UK mid-market debt finance and what we anticipate for 2024.

Businesses have faced a perfect storm of challenges in the last twelve months: slow economic growth, rising interest rates, geopolitical unrest and struggles to curb inflation.

Despite all that, Q4 of 2023 was a busy one, with a definite uptick in new deals off the back of more positive economic news towards the end of the year.

With green shoots in the economy bringing deals out of hibernation, challenges in other markets providing opportunity, and a willingness amongst stakeholders to look at different debt structures, we step with cautious optimism into 2024.

General market and economic challenges

The increase in the cost of debt resulting from interest rate rises slowed the market in 2023. Whilst economists aren’t predicting a sharp decrease, it does look as if rates may have peaked or at least plateaued. An ability to map out likely debt costs should provide some confidence.

On a domestic level, inflation has slowed and economic growth levels were not as bad as had been feared. That said, rates of company insolvencies increased in 2023 vs the year before (although this may form part of a ‘catch up’ following particularly low levels during the pandemic). Some economists have suggested fragile conditions may have masked a downturn in business performance.

It is impossible to ignore the dreadful events happening overseas which will undoubtedly impact things closer to home. Coupled with elections in the UK, US, India and across Europe this year, the geopolitical climate is particularly unsettled. As well as being unnerving, events will push up prices, impact regulation and mute appetite in some sectors.

However, the challenges have also brought opportunity for some - private capital and acquisitive businesses have seen some easy wins thanks to the natural caution of bank credit and increased debt costs. It was less than a year ago that Silicon Valley Bank collapsed; what seemed catastrophic has been a success story for HSBC. Some even predict the reduced volume of larger leveraged deals will drive activity in the mid-market.

Market trends

We continue to see short term extensions used to buy time to allow the market to settle. Naturally some of those bring a margin increase and we’re also seeing bullet loans amended to amortise to allow extra flexibility. It seems likely that the volume of event driven deals in the mid-market will remain dampened. When new money deals do get the go ahead, they’re often at full throttle to minimise market movements during the execution phase.

2024 will likely see a continued increase in refinancings as loans reach maturity, lender appetite to amend & extend diminishes, and shareholders look to refinance capital they have fronted in recent months.

In terms of sector trends, tech remains front of pack, along with businesses with an environmental, social and governance (ESG) spin. Our real estate colleagues have seen this too, with data centres and lab space still being battled over as AI and life sciences continue to defy a downturn.

We have seen an uptick in public to private transactions as private equity investors (and in some cases management teams) use the dip in the market to take private those public companies in which they see investment potential.

As many stakeholders we have spoken to recently have recognised, seller aspirations remain high, but the cost of finance for buyers is fast becoming a leveller. Aggressive term sheets aren’t so well received from anyone other than the strongest borrower. Given the change in appetite for lending, expectations have had to change.

Deal structures and document trends

The cost of bank debt means we’re seeing diverse solutions to plug funding gaps. As well as an increase in the use of equity and loan notes for acquisitions and wholesale PIK facilities, we’re seeing multiple lenders on transactions that wouldn’t have warranted it in the past, as well as debt funds providing direct lending alongside private equity.

As well as looking to shareholders to bridge funding gaps, many businesses have made the most of PIK toggle provisions to free up cash – more on this in our private equity team’s recent update.

Whilst it’s great to see the tenacity of the mid-market, these structures do come with challenges: often deals take longer because of the number of parties involved and intercreditor issues can be difficult to iron out. This is exacerbated on lends to businesses with defined benefit pension schemes, with pension trustees added to the list of creditors, and additional layers of due diligence for credit committees particularly since the introduction of The Pension Schemes Act 2021’s criminal offences which have the potential to apply to both borrowers and lenders.

For borrowers who have already been afforded the flexibility of an accordion facility, they’re an efficient inlet for the wider market (as well as existing syndicates) to assist with their increased debt needs. As predicted last year we have worked on several accordion activations in recent months. For the most successful businesses we expect to see some reduction in pricing in the early part of 2024 (compared to late 2023).

In terms of documents: equity cures have long been standard on PE backed transactions, and again these have proven an efficient mechanic to allow equity injections to those businesses that have needed a boost in recent months. We continue to see Annual Recurring Revenue financings and other innovative structures which allow growth businesses opportunity despite not meeting normal covenants.

As anticipated last year, more trying times have triggered a move back to interest cover covenants sitting alongside leverage (and others). Unsurprisingly hedging has become more widely used which does add an extra layer to intercreditor documentation.

ESG considerations

The accessibility of Sustainability Linked Loans (SLLs) means they’ve become a more prominent feature in the mid-market than Green Loans. The focus of KPIs is more often on the ‘E’ than the ‘S’ or ‘G’. From a documentation point of view, the Loan Market Association’s (LMA) SLL principles (Principles) have evolved again this year and will need to continue to evolve as this market develops in order to provide a useful benchmark for lenders looking to ensure their KPIs and testing mechanisms are sufficiently robust.

There remains a gap in the market in terms of specialists who can advise on and provide independent audits of ESG related covenants, and ESG data in the market was considered the most significant obstacle to the integration of ESG issues in the syndicated loan market in the LMA’s end of year survey, with second place going to limited availability of ESG information from borrowers.

‘Sleeper SLLs’ have become a regular feature in the market - where (usually due to time constraints) KPIs and related targets are not finalised at completion and so certain SLL provisions are triggered later. The guidance to the updated Principles provides that only in exceptional circumstances and within 12 months of completion can SLL provisions be ‘switched on’, and that in the meantime the loan cannot be referred to as a SLL.

The FCA confirmed their Sustainability Disclosure Requirements (SDR) at the end of 2023. Intended to ensure transparency, the measures introduce an anti-greenwashing rule for all authorised firms (ensuring ‘sustainability related claims are fair, clear and not misleading’) as well as product labels and naming requirements to ensure investors have a clear and honest picture of how funds are being used.

Whilst the SDR will no doubt bring about positive changes, in the shorter term we anticipate increased caution with the attention of both borrower and lender boards (and legal teams) turning to DD and reporting requirements, as well as scrutinising their own supply chains and practices.

Continued increase in regulation

2023 saw the Economic Crime (Transparency and Enforcement) Act 2022 (ECT) really bite.

Hot on the ECT’s heels is the Economic Crime and Corporate Transparency Act 2023 (ECC), which became law in October 2023. The ECC is again aimed at improving transparency, introducing liability for ‘failure to prevent fraud’, extending criminal liability for corporates to include ‘senior managers’ and changing requirements for board constitutions, filing and other identification requirements. Companies House will take on a bigger role in recording and scrutinising company information to ensure compliance with the ECC. 2024 should see secondary legislation and some significant changes at Companies House to ensure these changes can be effectively implemented.

We know that behind the scenes, changes to capital adequacy requirements (specifically Basel 3.1) are starting to impact our lender clients too, particularly those with a real estate focus. Sanctions remain a hot topic given the geopolitical climate, Consumer Duty has impacted some of our lender clients and the FCA’s new SDR (see above) all point towards a continued increase in regulation, as well as evidencing the FCA’s commitment to ensuring the UK remains a safe and forward-thinking place to do business.

Outlook and conclusion

Whilst market conditions remain tricky, and last year’s headwinds continue to apply, there is a huge amount of opportunity in the mid-market in in 2024, and we look forward to working alongside our clients to make the most of it.

 

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