Analysis: European dealmakers face shrinking debt options as recession risk looms

By Pamela Barbaglia and Yoruk Bahceli

LONDON (Reuters) - European dealmakers are struggling to finance corporate takeovers as concern that the region's economies may dip into recession is prompting debt investors to demand bigger rewards for the risks they're taking to get deals over the line.

Global economic uncertainty and market volatility triggered by the Russia-Ukraine war, coupled with monetary tightening from the Federal Reserve and the Bank of England and expectations the European Central Bank will follow suit, have made deal financing costlier and harder to access, bankers and analysts say.

More than $390 billion worth of M&A deals have been announced in Europe since January compared to $365 billion in the same period last year - almost doubling 2019 volumes of $199 billion in the same pre-pandemic window, according to Refinitiv data.

While banks have agreed to provide the necessary financing, some are having to sweeten terms to find lenders willing to take on chunks of their debt.

"There are many variables in the market and investors will be careful until these settle and the bid/ask gap tightens, especially in Europe," said Anthony Diamandakis, global co-head of Citi's asset managers franchise worldwide.

"We are not seeing many new debt commitments at the moment because the M&A deal volume feels light."

Global corporate debt yields have soared nearly 200 basis points on average this year. Those on euro-denominated high-yield bonds have doubled to 5.5%, ICE BofA indexes show.

Dealmakers say the financing struggle has not marked a death sentence for new deals, and while M&A volumes are currently subdued they could still recover later this year.

But in the meantime some debt sales have run into trouble.

In Britain, supermarket chain Morissons' 7-billion-pound ($8.6 billion) takeover by U.S. buyout fund CD&R is the most notable deal to have hit a snag as the syndication of its debt pile has been delayed by about six months.

Lead banks who fully shouldered the Morrisons financing are now left with more than 3 billion pounds of debt yet to be syndicated, one source familiar with the discussions said.

The banks - Goldman Sachs (GS), BNP Paribas, Bank of America and Mizuho - had to place a chunk of its debt worth about 1 billion pounds at a discount of around 10% to be able to sell it to private lenders, the source said.

Goldman Sachs (GS) and CD&R declined to comment while Morrisons and the other banks were not immediately available.

M&A financing packages are usually underwritten months in advance. Investment banks guarantee a certain interest rate to prospective buyers but also include so-called "flex" provisions in the deal terms allowing them to adjust the final pricing by a certain amount if markets move significantly.

If those are not enough to cover the increase in market rates, the debt gets syndicated at deep discounts with banks making up the difference, which may lead to a loss if it exceeds their fees.

UNDER SCRUTINY

Leveraged buyouts came under increasing scrutiny after the financial crisis as they are typically funded by loading a significant amount of debt onto the target company against its assets.

Because of their high debt/equity ratio, they often involve the issuance of non-investment grade high yield bonds, often dubbed junk bonds as they carry a higher risk of default.

But money is fleeing the asset class this year; European high yield retail funds have suffered $20 billion of outflows, or 6% of assets under management, according to BofA citing EPFR data.

"A lot of fixed rate high yield investors have cash today, but are worried about outflows. As long as that worry is out there it's going to be difficult to price sizable new deals," said Daniel Rudnicki Schlumberger, head of EMEA leveraged finance at JPMorgan.

Global high yield bond issuance is down 77% since the start of the year, Refinitiv data shows, with European volumes down nearly 75% compared to last year.

After a 10-week shutdown of the European high yield market, the longest since 2009, a pool of banks led by HSBC (HSBC) and Barclays (JJCTF) launched an 815 million pound bond sale in April to fund Apollo's takeover of British homebuilder Miller Homes.

A sterling tranche was priced at a deep discount of 93.45 cents to lure investors, with the banks also offering a higher yield than indicated at the start of marketing, a lead manager said.

HSBC (HSBC) declined to comment while Barclays (JJCTF) and Apollo were not immediately available.

Similarly, French private equity firm Ardian opted for a junk bond to fund its 1.1-billion-euro ($1.2 billion) purchase of Italian drug firm Biofarma Group on May 6.

BNP Paribas and Nomura arranged a 345 million euro floating-rate bond to finance the Biofarma buyout and ended up granting a large discount as well as tightening investor protections in the bond documentation to get the deal over the line, a document seen by Reuters shows.

Nomura declined to comment while BNP Paribas and Ardian were not immediately available for comment.

Buyout fund CVC Capital Partners' foray into a major European football league also struggled as the private equity firm funded a 1.99-billion-euro investment in Spain's La Liga through a 850-million-euro bond sale.

Goldman Sachs (GS), which led the bond sale, had to offer heavy discounts on both tranches, according to a deal document seen by Reuters. CVC and Goldman Sachs (GS) declined to comment.

While most M&A financing is slated for the leveraged loan market, which has fared better than junk bonds as floating rates offer investors protection from rising rates, loan sales have also slowed. Dealmakers say banks have become more selective in funding transactions.

"You want to have a clear understanding of any pass-through issues like energy exposure or a potential drop in consumer demand," said Simon Francis, head of debt financing in EMEA at Citi.

"It's about making sure you have a grasp on how performance will be impacted by what's going on in the wider world."

'MIX AND MATCH'

Private lenders such as Ares, Blackstone and KKR are trying to fill the gap by charging higher interest rates to provide cash to prospective buyers and rescue their deals, bankers and investors say.

The trend has been gaining traction since Russia invaded Ukraine on Feb. 24.

"Any staple financing that was agreed by banks before the war in Ukraine will probably need to be re-evaluated," Francis said.

This year U.S. private equity firm Thoma Bravo has repeatedly bypassed traditional banks and turned to a group of private lenders including Owl Rock Capital (ORCC), Blackstone, Apollo Global and Golub Capital to finance the $10.7 billion purchase of enterprise software firm Anaplan (PLAN) in March.

The U.S. tech-focused investment firm went on using Golub, Blackstone and Owl Rock in April to finance the $6.9 billion takeover of New York-listed cyber security company SailPoint Technologies (SAIL).

In Europe, private lenders have mainly operated as part of so-called hybrid deals, where financing is sourced from both private and public markets.

Chris Munro, head of global leveraged finance at BofA, said a number of upcoming financings could be backed by hybrid structures.

"Banks are still open for business and underwriting deals, it's just terms have changed and structures are a bit more conservative," he said.

Yet, with banks turning leery, private credit funds are set to extend their gains.

"We're moving to a phase of mix and match. Private equity funds are going to get quite creative around some of their financing," Citi's Francis said.

(Reporting by Pamela Barbaglia and Yoruk Bahceli, additional reporting by Andres Gonzalez; Editing by Emelia Sithole-Matarise)