Q2 Markets Review & Outlook: Leveraged Finance and Financial Sponsors

Speaker 1:

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Warren Estey:

Hi, this is Warren Estey, Head of Investment Banking at BMO Capital Markets, and this is our second quarter investment banking podcast. Today, we're going to discuss the leveraged finance markets and the most significant user of those products, financial sponsors. Taken together, their material contributors to street-wide activity and given the breadth of companies that they touch, it's an always relevant topic. I'm joined by two longtime colleagues and friends. Mike George is Head of our Financial Sponsor Group, and Kevin Sherlock is Head of Leveraged Finance and Private Credit. Great to have you both here. Kevin, how would you characterize leveraged finance markets in the first half of '24?

Kevin Sherlock:

Thanks, Warren. Yeah, 2024 has started as a return to normal, as I would say, after several years of significant market dislocation. The syndicated market's back to being a very, very attractive alternative to the direct lending markets after two years, where, to be honest, direct lenders financed the bulk of our LBO transactions. Very simply, the direct lenders offered yields on credit that were at or better than what banks could offer on a fully flex basis. I think people know we provide terms at where we think it's going to clear, but have to take some protections for potential market moves. That's clearly returned to what I would probably say is an equilibrium now between the two markets, and we've seen that pretty clearly. A direct lending share of LBO volume has moved to just about 50% for the year-to-date 2024, and in 2022 and 2023 it was well more than 70% of LBO volume. So you can see the sponsors are clearly looking between the two markets.

To be fair, in addition, most of that direct lending volume is in deals that are under $500 billion in size of financing, which wouldn't be an attractive investment alternative for the syndicated markets anyway, so equilibrium there. The broader point is that it's been an incredibly busy refinancing market, so in fact, it's been the busiest refi market since 2021. Most issuers did not address their near-term maturities through the dislocation of the last few years as rates were much higher. So a lot of what we've seen so far this year is what we consider catch up of addressing year term maturities that should have been addressed, quite frankly, in the last few years. Loan volumes stand about $290 billion, that's three times, 2023, that's an incredible number and high yield volumes about 160 billion, that's 80% ahead of last year.

So we've worked through a lot of that backlog of deals that should have been refinanced over the last two years, but there are still maturities to be addressed through the remainder this year. It's almost 85% of the year-to-date issuance has been for refi, repriced from an extension trade, so we've tackled a lot of that. A great example of that is our recent transaction for Acrisure. We were originally mandated to lead a $1.5 billion refinancing for their most near-term maturity. Then given our ability to execute that transaction and the market conditions, we were able to upsize that to over 5 billion to take care of 2026 and some 2027 maturities, and all that was done at an FPV positive basis for the company. So you can see how active issuers are at addressing those maturities.

I guess the other thing I would just characterize this year is just unfortunately we've seen a return of competition from other banks. Over the last two years. A lot of banks were hesitant to enter the market given a balance sheet issues they had around some high profile home deals from 2020, 2021. They also had some concerns, we would probably say misguided concerns about the market receptivity of new deals. So BMO was able to profitably take a lot of share, both economic share and our client's mindshare with those sponsored clients over the last few years to grow our business and show our ability to support them through different economic considerations. As the market's come back more broadly, we're seeing many banks that were absent from the underwriting business for the last few years try to build back some of the business they lost over that time. We'll see how that continues as we go into the remainder of the year.

Warren Estey:

Yep. Got it. Taking all that into context, any notable deals or innovative structures that you'd highlight you saw?

Kevin Sherlock:

Yeah, a couple of things come to mind. One, we've seen a return of large syndicated LBO transactions, although it's at a slower pace than we've seen historically. For example, when the largest deal hits 2021 Stone Point Capital and CD&R partnered to buy Truist Insurance Brokerage business, that deal had about $7 1/2 billion of funded debt and over a $12 billion enterprise value. This was the largest LBO since 2021 and went exceptionally well, and we were a book writer on that transaction. So we'd like to believe that that gave sponsors a lot of confidence to continue to look for larger transactions where they can invest a significant amount of their equity capital in one trade. Continue on that theme, and I'm sure Mike will talk some about this, public private transactions have continued to be extraordinarily attractive.

Sponsor-to-sponsor trades have been slower than usual the last two years. That's mostly due to LBOs being executed at high valuations at low interest rates from the 2019, 2020, 2021 period, still working through their growth plans and the valuation considerations for them to profitably exit. As an example of the public-to-private trade, we launched a $2 1/2 billion term loan supporting Advent's acquisition of Nuvei Corporation, which is a Canadian public company, and there are several others. Like I said, I'm sure Mike will talk about a lot of this on his comments on sponsors. Then the final thing, which is also a good development is we've seen junior capital underwrites returning to both the unsecured bond market and more recently, a second liens. There's a couple of reasons for that.

One market debt unsecured paper has returned that was limited mostly due to fears of additional interest rate hikes. Those interest rate hike concerns have abated a bit given recent inflation reports, money has floated back into I yield accounts bolstering their cash positions and their need to invest in capital structures with yields above what they can achieve in the corporate high-yield market. So the unsecured bond market and our ability to bridge that feels very good. Lately, we've seen more sponsor requests for second lien underwrites. As I mentioned before, the share paper go into private market as abated a bit given the relative attractiveness of the syndicated market. At the same time, fundraising for private credit funds has been very strong. So fund managers have cash and are looking at way to deploy that at yields that meet their investment hurdles. So the second lien market fits that bill very well.

Warren Estey:

Okay. Got it. So let's switch to financial sponsors. So Mike, activity levels clearly picking up but doesn't really feel yet like we're back in full force. How do you think about the sponsor activity in the first half of '24?

Mike George:

First, thank you. Thank you for having me. I appreciate the signed. I would say it's a mixed bag to slightly good-

Warren Estey:

Okay.

Mike George:

... and I'll talk about what I mean by that. There's been a lot of positive developments, but there certainly are some things that are very frustrating. So let's put that into some context. First of all, to your point, sponsor M&A activity is up significantly in 2024 for us last year. In fact, deal volume was up approximately 50%. To Kevin's point, that activity is being driven by take privates and corporate carve-outs. So let's unpack that. Take privates comprise 45% of deal volumes and carve-outs comprise 31% of deal volumes in 2024. So that means 76% of activity is being driven by public companies. Let's say that again, 76% of deal volume with sponsors is being driven by public companies. This compares to 8 and 38% respectively in 2023. So essentially take privates, Kevin said this, are driving activity.

I would also note that the size of transactions are average. Average take privates in 2024 so far is $3.5 billion. So the average take private is 3.5 billion, and that compares to under 2 billion in 2023. So volumes are up and sizes are up. Look, this isn't surprising. Many public boards and management teams are frustrated by stock prices and valuations, and they're looking to make sure that businesses without the scrutiny of quarterly short-term public investors who focus on something else. So again, this is not surprising. Examples include GTCR's $2.7 billion acquisition of AssetMark. Kevin mentioned Advent's 6.3 billion acquisition with Nuvei and our client's $2.8 billion acquisition with [inaudible 00:09:01]. I would also note that BMO is an active book runner in each of those deals, so the activity is there.

So you're probably looking at me and saying, "So what are you talking about? Why is it just a mixed bag?" The flip side of it is that the sponsor-to-sponsor deals have been tough. Again, Kevin alluded to this. In many situations there seems to be a valuation disconnect in sponsor-to-sponsor deals. Look, this is due to many factors, mostly the valuations that were paid for deals many years ago, and sponsors are not willing to pay those valuations today. Maybe that changes. Maybe the existing holder of those assets come to realize their baby is not worth what they thought it was or maybe the financing markets with interest rates coming down gets a little bit better so that the deals make more sense. So again, mixed bag, trending into the right direction, again, all being driven by take private activity.

Warren Estey:

Okay, I'll take the trending in the right direction comment as the way to go. So any notable deals or structures or trends that you'd want to highlight, Mike?

Mike George:

Yeah. So Warren, two come to mind in addition to the deals that I mentioned earlier, first are dividend recaps. So given that many of the sponsor-to-sponsor deals are not closing, there is an increased appetite from sponsors to pursue dividend recaps. The team is spending a lot of time on many of these situations, financing markets are [inaudible 00:10:31] and accepting those dividend deals. Couple that with the need to return capital by sponsors to the LP, so this is a way for them to do that in lieu of pursuing outright sale. Again, the healthy credit markets are certainly supportive and conducive to this.

So just because a company doesn't trade does not mean there's not something to do. The second thing I'll notice, there's the portable capital structures that are in place. So our teams, as you know, are pitching for many M&A deals or already have mandates where there are portable capital structures in place. These have been put in by the direct lenders so that it's something to keep in mind, and certainly from a sale process, many people believe that this de-risks part of the sale process as part of the sale going forward. So those are two things to keep in mind, and I want to make sure that our teams are hyper-focused on what the implications for those are on deal dynamics.

Warren Estey:

So switching back to you, Kevin, private credit, it's gotten a bunch of exposure over the last few years as leveraged finance markets and underwriters have faced some really challenging situations, and private credit has really stepped into the void that frankly a lot of our competitors on the street have left. So what's your view? Competitors, partners, take it away.

Kevin Sherlock:

Yeah, it's been a really interesting year for private credit. You go back a year and a half ago and there were plenty of articles written about the golden age of it, and that's led to a couple of different things. One, fundraising is very active across the board, and the growth continues with ultimate investors looking to get access to that asset class. There's been some more negative press on it of late, which has brought some concerns from those same investors. So it's been very, very interesting. So as I said earlier, the syndicated market's become a lot more attractive, relatively speaking for sponsors to finance their LBOs and put a little meat on that bone. Your average direct lender has a minimum yield requirement somewhere in the SOFR plus 500, plus or minus, and that was very attractive a year and a half ago when we thought LBOs would clear somewhere in the low 400s.

But again, with our flex, we were probably through that pricing. Single B spreads have now tightened to the high 300s, mid to high 300s. With our flex, we are still very competitive relative to that alternative asset class. So, like I said, it's an equilibrium, so they're around it. There's been a lot of fundraising, and they're still very active, particularly in deals that can't be financed by banks for a number of reasons. Regulatory reasons, which is part of the genesis of this asset class was when leveraged lending guidelines came around. Then there were some other specific reasons where sponsors either don't want to get ratings or they're limited in the number of financing sources they can go to. So it is becoming a lot more sponsor specific and deal specific whereby someone chooses private credit over a distributed deal. As I hope everyone listening to this knows, we have one of the longest running and most successful private credit JVs with our partners at Oak Hill Advisors.

So we get to see almost every transaction where sponsors are debating between going private or public markets, and we can provide a view on both of those. So in this case, we obviously view private credit as a partner, and we're in a unique position in that partnership with private credit to provide solutions to our clients that plenty of other banks cannot. We've done a syndicated first lien with a private credit second. We've underwritten portions of private credit transactions where Oak Hill will take a large share of the deal but not the remainder if we can step into that. We've refinanced several deals out of the private credit market into syndicated markets and vice versa. So it does present a opportunity to bank more companies that we want to bank on behalf of our clients.

Warren Estey:

Yep, that's a great perspective. Okay, so as we turn to the second half of the year, there are a lot of events and issues that investors and issuers are dealing with and they're going to have to contend with as we look over the next six months. So Kevin, same with letter [inaudible 00:14:42] what's your outlook for the remainder of the year?

Kevin Sherlock:

It should be a good remainder of the year. Over the last few weeks, we've seen a modest uptick in M&A activity, both public-to-private and sponsor-to-sponsor. To refer to Mike's comments earlier about seeing some of that come back, it's been tougher, but I think there's some more confidence to be able to get that down. Given the traditional August slowdown where we cannot effectively de-risk some of those transactions, we should see a fairly busy new issue calendar in September and October, and that could go up a bit from here if the deals we are working on currently get announced over the next few weeks. We have a bunch of deals that are also in the early stages of M&A processes that may add to that pipeline, and so we feel very good about that. The market is looking for new paper to invest in.

As we talked about earlier, it's been a refinance, refi, reprice, extension market, and so there have not been a lot of new names to invest in. We normally at the end of August coming into the post-Labor Day break have a pipeline that has to get syndicated. In prior years, this has been massive, and right now, it's not massive. It seems to be something that should be an orderly market will readily absorb all that paper. So we feel a pretty good market for both new issue, new names and a potential for refinancing. Like I said, while the market remains wide open for refinancing, a lot of issuers have addressed their near-term maturity, so it should slow down from an absolutely record-breaking and torrid pace that we saw in the beginning of the year. We believe that the market should stay in a similar condition than it is now.

There's not a lot from an economic perspective that would lead you to believe that it will fall off, and so we expect that refi activity to continue. There's over $200 billion of loans and high-yield maturities that are coming due in 2025 and 2026, and so those maturities will obviously need to be addressed. So we expect those to be taken advantage of, market conditions to go ahead times to get that out. BMO economics is still calling for a September rate cut, and there are plenty of other firms that are doing the same with some questions. So we'll see if that happens. If that happens, that obviously provides another bit of wind at the back for being able to do that. The fourth quarter is an interesting one because it's marked by a lot of discreet windows to access the market, right?

So we have a few weeks in September post-Labor Day before holidays at the end of the month, October has Columbus, Indigenous People's Day, you have Thanksgiving. So it's very much going to be a question of picking market windows to address the market. Obviously, this year we have a very important election, and so our view is that most investors and issuers will want to watch what happens and stay out of the market for those two weeks regardless of what the outcome may be. So that just adds another window. So we're telling all of our clients, you need to be ready to go. You need to be talking to us constantly and try to find those right market windows to go take advantage of the opportunities that are there.

Warren Estey:

That's the right advice. Okay, that was great, Kevin, and great context. Mike, what about the sponsor activity for the rest of the year?

Mike George:

Well, I would start off by simply saying there's a trillion dollars of dry capital across the private equity [inaudible 00:18:00] So what does that mean? Sponsors will continue to put money to work. Sponsors will also look to continue to sell their assets in order to generate returns and provide capital back to LPs. This is interesting on this point because there are a lot of funds out that are currently fundraising, and the fundraising environment is much more difficult than it was two or three years ago. In order to raise their next funds, they actually have to return capital. So my point about the sponsor-to-sponsor deals maybe not getting done due valuation, well, that might change because the sellers in order to return capital may be willing to, I don't want to say take something lower in terms of valuation, but maybe more rational in terms of what they're willing to sell assets for.

So overall, look, I think that activity levels will be higher than they were in 2020. See that I continue, but Kevin went through a lot of dynamics that are going to continue to play for the rest of the '24. So again, from an overall perspective, 2024 should remain to be higher than 2023. I'm not smart enough to say by how much, but it'll still be better. One other thing that I do believe is notable to talk about is the IPO market, while not back to historical levels, it is much stronger than it was in 2023.

There is no doubt that that return to activity will continue and that'll provide the opportunities for sponsors to monetize activity, not only by selling their businesses, by taking it public. The teams are spending a lot of time with sponsors on this dynamic, and I'm not saying that we're going to be guns blazing for the rest of 2024. But there is, and there are a lot of conversations taking place about taking their companies public in 2025. We shouldn't lose sight of that, and teams shouldn't lose sight of that market as a viable option for sponsors to monetize their assets. I'll just end it by saying that's what's great about working with sponsors. There's always something to do.

Kevin Sherlock:

Always something to do.

Warren Estey:

That's exactly right. Look, let's call it there. Great perspective. Really appreciate the time that you both spent with us today. So be on the lookout for the Q3 podcast early this fall. We'll see you back here then. Thanks for listening.

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