Sector Activity Shift in Key Markets
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Q1 2023 saw 78 unitranche transactions closed, 18% below Q4 2022, due to the ongoing difficult macroeconomic and geopolitical landscape.
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The UK, Germany, and France, together with the Benelux region, continued to remain key financing geographies, though activity declined in Q1 due to the prevailing economic conditions and the number of completed unitranche deals fell by 11%, 29%, 32%, and 13%, respectively.
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Debt funds continued to pursue add-on acquisitions in Q1 2023, with 39 deals, fractionally down on Q4 2022, comprising 50% of overall activity due to the continued focus on buy-and-build transactions and capital deployment into existing portfolio assets.
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While the mid-cap LBO market has proven its robustness throughout 2022, many direct lenders (as well as private equity sponsors) have become very selective on new transactions since Q4 2022 and have rather been focusing on their portfolios. With inflation and energy prices generally declining and interest rate increases becoming smaller, debt financing is expected to increase again.
LONDON/FRANKFURT — 26 May 2023 — Houlihan Lokey, Inc. (NYSE:HLI), the global investment bank, today announced its Q1 2023 MidCapMonitor analysis of pan-European private equity (PE) sponsored debt financing activity across the UK, Germany, France, Spain, Benelux, and the Alpine and Nordic regions.
Pan-European unitranche financing activity showed a decrease during Q1, with 78 transactions (compared to 95 in Q4 2022), an 18% decrease quarter on quarter, against deteriorating macroeconomic conditions and continued geopolitical uncertainty.
The UK, Germany, France, and Benelux markets continue to be active unitranche geographies. However, the number of completed deals fell in Q1 2023 by 11%, 29%, 32%, and 13%, respectively, versus Q4 2022 due to deteriorating market conditions.
Deals Landscape and Market Share
Out of the 78 unitranche deals in Q1 2023, the UK remains the most active market with 25 deals, followed by Germany with 15, France with 13, Benelux with 13, and Spain with eight.
During Q1 2023, debt funds were still able to maintain their market share versus banks in Germany, with 54%, and in the UK with 62%. However, in France, banks are currently more competitive and taking market share from debt funds, which has increased from 52% in Q4 2022 to 68% in Q1 2023.
Debt funds continued to pursue add-on acquisitions very actively in Q1 2023, with 39 deals closed (50%). This was driven by sponsors looking to create additional value through buy-and-build transactions and direct lenders keen to deploy capital into performing portfolio assets.
Financing Purposes
The transaction market showed a mixed picture. Add-ons formed the core financing purpose in the UK, with 41%, compared to new financings comprising 44% in Q4 2022, while in Germany, add-ons made up 46% compared to 37% in Q4 2022. In France, new financings were the majority with 46%.
Sector Activity
The main market focus for debt lending in the UK and Continental Europe continued to be the software, technology, and healthcare sectors. However, in certain European markets, the balance has shifted. In Germany, for the first time since 2018, deals from the industrial products and manufacturing segment (23%) outnumbered software and technology (22%) and healthcare (20%) deals in Q1 2023. Since the high of software and technology transactions (36%) in 2021, the sector’s share has constantly declined, whereas industrial products and manufacturing, as well as services, were able to regain market share over the period as well as in Q1 2023, with 23% and 18%, respectively, implying that lenders have somewhat refocused their credit appetite. Other factors, such as the need for less leverage in the sector and the lower valuations applicable to industrial products and manufacturing, helped the shift in sector priorities.
“Debt market financing in Germany has been lower in Q1 after a strong Q4, which illustrates the impact of a rising interest rate environment and raw material costs. However, the first quarter of the year is a traditionally slow period for deal activity. Debt funds and banks were equally active, with 54% compared to 46%,” said Norbert Schmitz, Managing Director in Houlihan Lokey’s Capital Markets Group.
Commenting on the UK, which continues to be the most active market for unitranche financing, and on France, Charles Martin, Director in Houlihan Lokey’s Capital Markets Group, said: “The UK market continues to be dominated by debt funds, with a 62% share, in line with last year. Banks have, however, gained market share since the end of Q3 2022 as credit funds have deployed significantly at the beginning of 2022 and are now more selective. Banks have been particularly active either on smaller mid-market transactions or where a lower level of leverage is appropriate. The drivers of the market continue to be shifting, with add-on financings now representing a higher share than new financings, 42% versus 35%, which is partially driven by the decrease in middle-market M&A activity due to valuation gaps.
“With 41 transactions in Q1 2023, the French market has seen a sustained level of debt activity this quarter. This deal flow in France represents a decrease of only 11% compared with the last quarter (46 deals in Q4 2022), despite Q1 being usually a low-activity quarter. Banks have been much more active than credit funds in terms of number of deals in the market with, 28 and 13, respectively. This is driven by banks continuing to be open for business across sectors and competitive, especially on pricing, while the credit funds are being more selective,” added Mr. Martin.
In relation to Spain, Martin Aleñar Iglesias, Director in Houlihan Lokey’s Capital Markets Group, explained: “Similar to in other countries we cover, LBO activity was lower in Q1 and refinancing and add-on activity have formed the majority of the mid-market financing activity in Spain. In fact, some of the LBO transactions in Q1 were closing overhangs from transactions that were initiated at the end of last year. Banks have continued to be quite active in the region, leading transactions that also incorporate institutional investors participating in TLB tranches.”
Outlook for Q2 2023
“Despite global headwinds, the mid-cap LBO market has proven its robustness compared to the much more volatile capital markets up until Q4. However, starting in Q4 2022 and continuing into the first quarter of 2023, many direct lenders (as well as private equity sponsors) have become very selective on new transactions and more focused on their portfolios.
Although there is still uncertainty around the level of M&A activity, the past few weeks have shown some encouraging signs, and an increased pipeline of new transactions has built up. With inflation and energy prices generally declining and interest rate increases becoming smaller, we may experience an increase in financing interest again.
Nevertheless, the quality of the underlying asset is important, and we expect European markets to remain challenging in the short term,” said Mr. Schmitz.