2024 - LEVERAGED FINANCE - YEAR IN REVIEW: FAILURE TO LAUNCH

As we wrap up another year, 2024 stands out as one of the more impactful ones – with the twists and turns of the US election, realising that AI is actually getting very good, Snoop Dogg owning the Paris Olympics and Taylor Swift (respect – who else can be responsible for GDP spikes on concert days and productivity dips on ticket sale days).  But, love or loathe, Elon’s appointment to the DOGE inspired us to trawl through his tweets (Xs?) to guide us through this year’s review.

In Leveraged Finance, while we’ve seen some improvement towards the end of the year (with successful processes for AirTrunk, Lumus, FMH Group and Waste Services Group), the predicted wave of private equity exits didn’t materialise. When one of Elon’s rockets explodes, he calls it a “classic SpaceX successful failure” – and maybe the same can be said about the failures to launch this year.^[1]

It hasn’t been a lack of debt financing options holding things back (despite current relatively high base rates still being very relevant). Where deals have launched, the debt market has been giddy – with a higher-than-normal number of financiers, bankers and lawyers all vying for a limited number of opportunities. For successful transactions, the supply-demand imbalance for debt has created a borrower’s market.

There are some clear bright spots. Data centres are the standouts – we were thrilled to support Blackstone on their $24bn acquisition of AirTrunk (the largest Australian M&A deal of the year and the largest data centre deal globally).

We were also pleased to be involved in the other landmark deals for the year, including for Kinetic on its A$1.6bn refinancing, the arranger for Madison Dearborn’s P2P of APM, refinancings/incrementals for EQT/Icon, EQT/Levande, Navis/Device Technologies, lenders on TPG/iNova and underbidders or their financiers for Perpetual, Lumus and Waste Services Group.

DPI – “Patience is a virtue, and I’m learning patience. It’s a tough lesson.”

No it’s not defensive pass interference – but it’s starting to feel as impactful as a call at the 10-yard line in the Superbowl.^[2]

“Distributed to paid-in capital” (DPI) measures how much money investors have put in vs what they’ve received back – but saying DPI this year is just fancy lingo for “still not exiting yet”.

Many of our PE friends are raising new funds while also feeling pressure for cash returns for existing funds nearing end of life. 

Options in the GP bag of tricks to boost DPI have included:

• Continuation funds (selling an asset into a new fund for liquidity to existing investors) are not available for every asset (eg the challenged ones)
• Div recaps (where a portfolio company raises debt to fund distributions to shareholders) again not suitable for all assets, but at least with a liquid debt market, has been a popular pathway for some portfolio companies (ie the less challenged ones)
• NAV financings (raising debt at the fund level against the equity value of the portfolio) are tricky to execute (we have never been asked more about a single topic since we raised this in last year’s article)

Still, these DPI moves are interim steps – the “real” exit still has to happen ultimately - for some, that will require a reset of expectations on value.

Private Credit – “I could either watch it happen or be a part of it”

Private Credit, while still in The Golden Age era (bet you missed that part of Taylor’s tour), has been a target of media, regulatory and legislative focus this year. 

This focus will increase if some Private Credit investments do not perform as expected (and there have been a few examples this year).  If the Failure to Launch phenomenon continues, certain PE portfolio assets in challenging sectors will add to that pressure.

At this stage the Private Credit asset class is very different to the focus of our last big regulatory inquiry (the banks and insurers), with less retail exposure and a range of wholesale investors.

There is (or should be) a greater appreciation that Private Credit serves areas where banks have pulled back (under pressure from regulators concerned about systemic risk affecting customer deposits).  As with any other type of investment, Private Credit isn’t risk-free. Therefore the focus should be directed at adequate risk disclosures, governance, reporting and management of conflicts of interest – so that this asset class, if appropriately managed, can continue to fulfil an important capital need in the economy.

Rise of the anti-[insert] clauses – “The woke mind virus is either defeated or nothing else matters”

Anyone working in the vicinity of a loan agreement in 2024 is likely to have noticed Australian lenders across the spectrum (banks to private credit) suddenly fixated on American pet stores (PetSmart/Chewy), apparel shops (J.Crew) and mattress makers (Serta).  

Those are well-known examples of offshore (largely US) borrowers using flexibility in their documents (some would call loopholes) to drive a balance sheet restructuring.  Known in newspeak as “Liability Management Exercises” or even more innocuously as “LME”, these transaction are now prevalent in the US – but are fairly new to this region.  The most common forms are:

• Drop-downs:  Create structural subordination by using flexibility in documents to (i) move a valuable asset out of the existing lenders’ collateral pool and (ii) use that asset as collateral for new or exchanged debt.
• Up-tiers:  Raise new debt that ranks ahead of existing debt, with some (but not necessarily all) existing lenders having the opportunity to exchange part of their debt (at a discount) into that higher ranking position – with non-participating lenders left behind in a subordinated position.

The response to these specific transactions has often been a check-the-box approach to inclusion of specific clauses (the “anti-” clauses) to address those moves.  However:

• Some anti- clauses in the market expand the list of things needing unanimous lender consent and cut across the usual majority rule.  This could come back to bite.  A fundamental principle of syndicated lending is that, to the greatest extent possible, decisions should be made by the majority (in Australia, 66⅔% or in the US >50%) rather than by all lenders.  There are good reasons for this (we have seen examples of individual lenders, eg during the GFC, using consent processes to hold out for reasons unrelated to the transaction).
• A more tailored and nuanced risk-based approach to the clauses is needed eg query the time/effort spent negotiating these clauses for a publicly listed corporate without a sponsor.

In the fog, we are also seeing some confusion between LME exercises (which, at least in our classification, have an element of lender-on-lender violence) and plain old borrower led restructuring (eg a request to PIK interest for a period and extend the maturity date that is offered to all lenders isn’t LME). 

Direct v distributed – “I’m up for a cage match if he is lol”

Our previous review articles have all summarised the state of the market in a taxonomy between bank debt, unitranche and TLB – followed by a trite observation on some level of convergence.

The convergence in documentation means, at least outside the bank market, the more relevant classification is between direct and distributed products.  In the global sponsor market at least, TLB and unitranche documentation is nearly indistinguishable and the key differentiator is whether the deal is directly placed or sold into the market.  This year direct financiers have had the edge (and have paid for it with lower pricing), with the prospect of flex still weighing against distributed products, but side-by-side both products are competitive and the trend may change next year.

Terms – “Let that sink in”

We’ll publish in-depth on each of these next year (saying it here to keep us accountable):

Covenant lite/loose
While it had been done before in a few Aus/NZ deals, this year saw increased willingness from direct lenders (unitranche lenders in the old taxonomy) to offer covenant lite (or “cov-lite”) loans on large transactions.  

We’re lagging NY and London on that shift.  Our overseas friends have observed that the better credit borrowers have access to cov-lite loans, meaning those borrowers only able to access covenanted loans are generally worse performing credits – so counterintuitively lenders with a mandate for covenanted deals can have a more challenged book.  We are interested to see whether Australia follows suit.

PIK
In our last review, we observed that unitranche lenders had offered PIK-toggle features (permitting borrowers to capitalise part of their interest costs) to help borrowers manage serviceability during a period of higher base rates.

We’ve seen more PIK this year, with some considering the feature now to be a “standard” inclusion. It has also appeared in distributed products – further blurring the lines between product differences.

Portable debt
It would be hard to find a feature which (inbound) sponsor capital markets teams, financiers and lawyers collectively dislike more than portable debt.

“Portable” means the existing debt of a target company can survive a change of control transaction.  Lenders have traditionally pushed back hard against the feature for legitimate aggregation issues (but also, if the target debt is portable, lenders are missing out on the opportunity for fees on the new acquisition financing).  

While not common, true portable debt is being done with portability often introduced as part of a DPI / amend & extend transaction.  There are still some governing parameters such as a list of pre-approved owners, maximum leverage and KYC.

Staples
Staple financing (“staples”) came into their own this year.  These are financing packages provided as part of a sale process, historically by sell-side bankers but nowadays potentially also by incumbent lenders to the target.  And they’re not “soft” anymore eg a 1-2 pager, but hard staples ie = fully credit approved with full papers.

This is introducing a different dynamic into auction processes – which is for some bidders, an invitation to focus on the M&A aspects of the transaction as the financing is “sorted” – depending on whether the Sponsor likes the terms of the staple. Worth watching the take-up rate for staples over time.

Thin cap – “Crazy idea: let's simplify the tax code 🤷‍♂️”

The changes to the debt creation / deductibility rules have now been with us for since April 2024 (although with retrospective effect to 1 July 2023).

To summarise, in line with OECD best practice, interest deductibility for Australian taxpayers is capped at 30% of tax EBITDA (which, unsurprisingly, is very different to financing pro forma adjusted EBITDA).  There is a uniquely Australian exception: the third-party debt test (or, if you want to make it harder to say, “TPDT”) can permit full interest deductibility for debt that only funds commercial activities in Australia, where the lenders are not associates of the borrower and where lenders only have “recourse” to Australian assets.^[3]

For purely domestic assets it’s been business as usual – but it's a new world where there is an offshore element (eg even a small NZ subsidiary).

For many borrowers the benefit of accessing the TPDT does not outweigh the commercial outcome they can achieve by cross collateralising their foreign and Australian assets.  For others, financing structures are changing – and getting more complicated with more geography-specific financing silos and/or lenders being asked to exclude recourse to foreign assets.

Longer term more tax will be paid – and while we’re sure that the Australian Government sees that as a good thing, it may be at the cost of raising barriers for capital investments into Australia.

Predictions – “The future is gonna be fantastic”

• Data centres. Probably (definitely?) the hottest sector in the market at the moment - crossing over private equity, infrastructure and real estate (and not just because we are working on same!).  The capital-intensive nature of these assets will continue to generate opportunities and new financing techniques
• The federal election in 1H of 2025 might put a brake on transactions with caretaker mode slowing FIRB approval process
• Parliament just enacted Australia’s new mandatory and suspensory merger laws (all the details are here) - for parties who prefer the existing informal merger clearance system, there might be a burst of deals before the transition period ends
• Backlog of 2021 vintage deals that will need to be refinanced in 2025 – although many have done their Amend & Extends (maybe with Upsize) already
• For the deals that failed to launch in 2024 – surely 2025 will be a better year for exits.  We’ve said it before, but we will keep saying it until it comes true!