With the debt markets tightening in response to rising interest rates and economic volatility, Ropes & Gray partners Michael Lee, David Hutchins, Patrick Dorime and I have examined how private equity sponsors are finding alternative ways to secure debt to finance deals.

High yield bond and leveraged loan issuances for U.S. buyouts and M&A are increasingly hard to come by, making it more difficult for PE sponsors to fund deals on terms and leverage levels available in 2021. This contraction is largely due to volatile stock markets and climbing inflation, which also has contributed to a spike in borrowing costs.

While these forces have deterred many PE borrowers from seeking out new deals, some sponsors are looking for creative ways to finance deals in both the mid- and mega-markets.

Private debt. Backed by US$1.2 trillion of dry powder (at the end of 2021), private debt funds have been a reliable source of funding during this period of uncertainty. Working with private debt managers has enabled sponsors to reduce syndication risk and ensure certainty of execution.

The contraction of the syndicated loan market has been a boon for direct lenders, which are able to win more deals at attractive prices while being selective about their deal commitments. In turn, sponsors are less able to rely on one or two providers to underwrite a deal—rather, they are now having to assemble a club of direct lenders for any meaningful commitment.

Niche products and strategies. In addition to direct lenders, sponsors are considering more and more niche products and strategies to finance deals, including term loan A commitments and annual recurring revenue loans. Sponsors are also using preferred equity, payment-in-kind loans and other junior capital options, as well as seller debt. Some sponsors are providing equity underwrites to finance deals up front and then returning to market post-deal to raise debt financing. Niche debt sources are also playing an increasingly important role in refinancing existing portfolio company debt structures.

While debt markets will likely remain tight in the near term, PE sponsors will have to continue to find creative ways to put together financing to get deals done. By adapting capital structures, exploring alternative funding sources and relying on key relationships, PE will have options on the table to secure acquisition financing.

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The current financing landscape—with liquidity tightening and U.S. leveraged loan and high yield bond issuances steadily declining—has seen lenders and investors take a step back to assess the effects of market volatility on credit quality and availability. These dynamics, along with the rising cost of debt, are pushing PE sponsors to explore new financing structures and lean on their lender relationships.