Working Through Uncertainty

The European Central Bank has so far taken a more gradual approach to rate hikes than the US Fed—a 50-basis point (bps) increase announced in July 2022^[1] compared to the Fed's total of 125 bps year-to-date.^[2] However, underlying uncertainty about the timing and broad economic impact of EU hikes has affected the pace and timing of transactions in loan markets. Similarly, the Bank of England has brought rates up to 1.25% in a series of hikes beginning in December 2021.^[3]

The Sources of Uncertainty

Two sources of uncertainty continue to affect loan market activity.

First, borrowers, lenders, and other market participants are watching the potential for additional hikes over the course of 2022.

Second, the market is unsure whether rate hikes will successfully tame inflation and whether they will over-adjust economies into a recession. Factors such as multiple supply chain crises, energy costs, and further implications from Russia’s war in Ukraine feed further into the uncertainty. It is unclear how those factors inflect theability of rate hikes to operate as effective policy levers under complex conditions. We highlighted uncertainties about the impact of rate hikes in the US earlier this year.^[4]

Lull or No Lull?

In terms of the deal activity Wilmington Trust has supported in the region, we have seen a pattern of sporadic pauses that we anticipate will continue over the year. The net level of lending and secondary loan trading activity for 2022 is likely to be strong. At the same time, volatility has created slower periods lasting a few weeks, alternating with sudden peaks. Summer in Europe may well involve such a lull, especially given the role of summer holidays in the pacing of the market here. Finally, markets may already have adjusted to the new realities of energy constraints and instability in Eastern Europe.

It is challenging to price transactions in a volatile environment that sees future rate hikes as inevitable. On the other hand, entering the second half of the year creates pressures to move deals forward, closing transactions that have been on hold and initiating transactions once rate hikes occur.

Liquidity also plays a role, especially in private transactions. Accumulated dry powder continues pushing private lenders to find ways to deploy their capital.^[5] As a result, we have seen a pickup in mid-market private deals over the past couple of months. Mergers and acquisitions are also an accelerating factor that works against the sense of a market lull.

Key Market Dynamics

The current period of working through uncertainty in the UK and EU has resulted in several trends above and beyond those we have discussed in prior Loan Market Insights pieces, such as the rise of ESG, growth in the private market, LIBOR cessation, and the role of agents and trustees.

Among these, we would highlight four changed market dynamics:

1. Deal Structures

Unitranche structures that pull multiple facilities into a single agreement with a blended rate have become much more common recently in Europe’s middle market, just as they were several years ago. While we have not seen any compelling market analysis to explain the trend, it seems plausible that the greater simplicity, flexibility, and potentially lower cost of a unitranche deal might counterbalance the sense of risk and uncertainty around rates and macroeconomic conditions. This trend also ties back to the rise in private lending, even pre-dating COVID-19.^[6] The potential structural protections for lenders may be even more relevant today.

Payment In Kind (PIK) loans may also benefit from this lift, allowing borrowers to weather potential liquidity challenges caused by current economic conditions. At the same time, lenders see them as sources of higher return even as rates generally adjust upwards.

2. Credit Spreads and Hedging

Whilst there remains a lot of liquidity in the market, there are many concerns about credit spreads widening. This phenomenon has noticeably cooled the European CLO market. Per Fitch Ratings, only five new European CLOs were priced in May 2022 at a total of €2 billion with an average spread of 115.8bps, up two bps from the average spread in April 2022.

As a result, demand for credit hedges and hedging costs have increased dramatically. Anecdotally, we have heard from some lenders that their hedging costs have risen by as much as 2500% in just a couple of months.

3. Potential Restructuring

Loan market stakeholders have long expected an increase in defaults, restructurings, and workouts as government stimulus tapered off. While that expectation has yet to manifest itself, we note that additional concerns increase the likelihood of a gradual increase in distressed debt. For example, rising energy costs, supply chain turbulence, and the impact of sanctions imposed on Russia are increasing companies’ input costs while at the same time putting pressure on demand. These factors could potentially push more borrowers into distress, even if governments step in to provide some degree of support.

4. Infrastructure Change

The cessation of LIBOR continues to have an impact as various markets adopt various replacement rates. The availability of term SOFR for forward-looking rates in the US means that new rates can work similarly to LIBOR in calculating interest on loans. Daily simple SOFR also presents less complexity for loan systems and the operations of loan agents. But in the UK, there is no term SONIA. Calculating interest using SONIA depends on point-in-time compounding in arrears. Euro-denominated loans will continue to use the forward-looking EURIBOR. The differences in the pace of transition and in the underlying methodology continue to require changes to loan systems and ongoing training for teams that service loans. In this context, we believe that converging standards and interoperability remain one of the industry’s most significant operational challenges.^[7]

Conclusion

Overall, the geopolitical and economic picture for the UK and Europe includes new challenges and concerns in the loan market. But we still see an active market. New money deals continue to close, with a lesser emphasis on succession and refinancing. As uncertainty and volatility rise and fall in the next few turbulent quarters, windows of loan deal activity are likely to open and close throughout the year. Our response has been to keep a strong team in place and grow to meet potential capacity surges. Even if conditions seem to suggest that scaling back is in order, being at the ready will play a critical part in getting deals handled properly and closed quickly when the opportunities are there.