This article looks at current trends and influences and how we expect them to impact the market in 2023.

Whilst the market rebounded tremendously following COVID-19, it is now facing fresh challenges with rising interest rates, inflation and increased regulation featuring heavily on board room agendas. It was a slower end to 2022 compared to last year, but this unrest will no doubt present opportunities (as well as risks) in the coming year for lenders and businesses alike.

General Market

Interest Rates 

The rising cost of borrowing cannot be ignored. The Sterling Overnight Index Average (‘SONIA’) was tracking around 0.5% on 1 December 2021 compared to just shy of 3.5% at the time of writing. Commentators are suggesting that interest rates will continue to rise in at least the first half of 2023 before levelling off and borrowers will need to adapt to the rising costs of borrowing. On the flipside, lenders will need to position themselves carefully to ensure they remain competitive. 

Hedging

As interest rates have increased, so has demand for hedging. Worth a reminder here that if hedging is a possibility during the term of a facility agreement, it is far easier (and cheaper) to set up documents at the outset which cater for hedging rather than needing to heavily amend finance documents and re-take security further down the line.

Repayment of COVID-19 Financial Support

Whilst many British Business Bank loans borrowed in the midst of COVID-19 have been repaid, a number will be approaching maturity in 2023 (most were on a 3 year term). Refinancing these loans in a market which is not so borrower-friendly will be challenging. This, along with an increase in other costs, may be the final straw for some businesses and a number of commentators are expecting the maturity of these loans to coincide with an increase in administrations.

Deal Trends

Rise in ARR Financings

We have seen a rise this year in annual recurring revenue (‘ARR’) financings following the success of the product in the US, particularly in the technology sector. Initially used in venture debt (where there are no traditional financial covenants) it is now being used to calculate facility amounts in some leveraged financings too. Traditionally EBITDA has been used as the measure to lend against, but we expect lenders to increasingly look to lend against ARR instead (i.e. revenue that is truly recurring, such as service contracts and subscriptions), determined on a trailing 12-month basis. This has benefits for both borrowers and lenders in the current climate; borrowers can access financing which would not necessarily be available based on traditional EBITDA covenants and, in turn, lenders can gain access to growing businesses where competition for investors is increasingly intense. 

Shift in Financial Covenants

Whilst we have seen a shift towards inclusion of only a leverage covenant over the last few years (particularly for strong borrowers), we are expecting to see that change in coming months. In the early stages of the COVID-19 pandemic, a number of lenders introduced an interest cover covenant, whether as part of a fresh financing or an amendment and restatement. The interest cover covenant may become commonplace again, providing lenders with an early warning if a borrower begins to struggle to pay its ongoing interest costs. 

In terms of grower baskets and flexible equity cure provisions, we anticipate these will continue to feature for strong borrowers, particularly in those sectors which are better placed to weather the economic storm.

Accordions

We have seen a number of borrowers activate their accordions (or incremental facilities) in recent months. Where these accordions are being exercised, it is unavoidably expensive (in terms of increased cost of lending) although unquestionably cheaper (in terms of legal fees) than negotiating a new suite of credit documentation. Lenders are relying on most favoured nation clauses and/or yield caps to ensure the incremental facilities are not on more favourable terms to the borrower which sometimes means, for example, increasing pricing of existing facilities. Looking ahead, we anticipate that those borrowers who have already been afforded the flexibility of an accordion may look to call on that option to assist with their increased debt needs in the coming months.  

A shift in the market

In last year’s article, we commented that the UK M&A market remained strong and in certain sectors (particularly technology and e-commerce), the competitive processes led to very strong borrower terms in the mid-market. The second half of 2022 has seen a slight slowdown in M&A activity and, against the backdrop of a turbulent economy, as well as the various socioeconomic and political challenges, the market feels like it is moving back in the other direction, although competition for solid borrowers is still strong. Once interest rates level off, there may be a catch up in M&A (as well as refinancings) as deals which have stalled take advantage of some stability. 

Environmental, Social and Governance (‘ESG’)

ESG remains a hot topic across all sectors - in recent years ESG often took a back seat when other challenges hit the market, mirroring political agendas and consumer demands; we don’t expect this to be the case any longer. ESG loans provide a great opportunity for borrowers with a genuine commitment to ESG to reduce their borrowing costs, particularly where they are able to negotiate ESG-linked margin ratchets into their documents. In the mid-market in 2022, we saw a number of margin ratchets linked to the borrower achieving B Corp Certification (an initiative operated and overseen by B Lab). This type of incentive will be particularly appealing against a backdrop of rising interest rates and we expect ESG to increasingly come to the fore. 

LIBOR for US Dollars

Whilst we have largely said goodbye to LIBOR for sterling, US dollar LIBOR will be in use until 30 June 2023. The European market seems to favour the Secured Overnight Financing Rate (SOFR) as the replacement for USD LIBOR.  This, like SONIA, is a backward-looking rate.  The US market has instead gravitated towards Term SOFR, a forward-looking rate. We therefore expect to see a mix of SOFR and Term SOFA deals as the market settles.

Increased Regulation

National Security and Investment Act 2021 (‘NSI Act’)

This wide-reaching legislation came into force in January 2022 and created a national security screening regime for acquisitions (both share and asset) where the transaction falls within one of 17 “specified sectors”. Failure to comply can result in heavy penalties, including turnover-based fines and criminal liability, as well as the risk of transactions being void. Over the past year, we have seen acquisitions take longer: both those subject to mandatory notification and voluntary, with buyers taking a cautious view in relation to the latter. The potential penalties are too severe to ignore. For more detailed information please see our article: The NSI Act 2021 – What does National Security mean? (shoosmiths.co.uk)

Economic Crime (Transparency and Enforcement) Act 2022 (“ECA”)

The ECA has come into force this year and we expect it to really bite during 2023. It introduced a new Register of Overseas Entities intended to deter the use of UK property as an avenue for money laundering through investment by foreign entities. There may be delays to transactions as UK property owning overseas companies comply with the registration requirements. For more detailed information please see our article: The Economic Crime Act 2022: Why lenders need to act now - (thebanker.com)

Economic Crime and Corporate Transparency Bill  (the ‘ECCTB’)

The ECCTB follows on from the ECA and will particularly impact limited partnerships (‘LPs’) who are likely to be required to maintain a connection to the UK as well as seeing tighter registration requirements and increased transparency obligations. This would impact a number of stakeholders in the mid-market, where the use of LPs in fund structures is common.

The ECCTB, coupled with the ECA and NSI Act demonstrate a landscape of increased regulation. 

Conclusion

2023 is going to bring a lot of changes, both from a regulatory and compliance perspective but also as we see trends develop alongside market, political and socio-economic changes. We look forward to working through these with our clients.