Is private equity taking too many risks with debt structure?

Private equity firms have been increasingly adding another layer of debt to their complex borrowing arrangements, raising concern among some investors about potential risks to the wider industry and the financial system.

Hit by a drought of deals and dwindling cash, some buyout firms are starting to resort to backroom financing to help meet fund commitments or enable succession planning. The loans — backed by assets including the promise of future income — carry interest of as much as 19%, a rate that's more akin to the charges faced by consumers rather than corporate borrowing. Even a junk-rated company in the US paid 10% on a bond recently. 

Those high costs aren’t deterring private equity firms and experts say demand is at an all-time high. While some of the biggest lenders — such as Carlyle Group Inc. — say these debts are relatively safe, others are already starting to take precautions by adding covenants that enable seizure of other underlying fund assets, highlighting worries about possible losses. Some are warning of perils when a firm faces claims from more than one type of loan simultaneously.

“If the value of the fund drops, for example, you’re looking at a margin call situation,” said Jason Meklinsky, chief revenue and strategy officer at Socium Fund Services, a New Jersey-based firm that helps administer PE portfolios. “It would be like a volcano meets a tornado.”

For an industry long used to easy money, the rush for such loans marks a reversal in fortune. Buyout firms have been battling rising interest rates and economic uncertainty, forcing takeover volumes to almost halve this year. Cash on hand at PEs is near the lowest since at least 2008, according to data from PitchBook.

That’s spurring these high-cost loans, which use collateral rarely heard of before.

One of these types of financings is the relatively new manco loan, for which appetite is soaring. Taken by the management company or the entity that oversees the PE investments, this debt uses cash flows such as fee streams and equity returns as collateral.

The manco loan proceeds are used to meet various needs: seeding new strategies, succession planning and even funding an individual partner’s equity stake in the PE fund.

Another comes in the form of the more widely known net-asset-value, or NAV, financing that’s backed by a pool of portfolio companies. This is typically used by PE firms to help them return money to investors.

For instance, Vista Equity Partners recently tapped lenders including Goldman Sachs Group Inc. for a NAV loan to finance a cash injection for Finastra Group Holdings Ltd. The debt is secured by investments held in a fund through which Vista holds its stake in Finastra, Bloomberg News reported this month.  

Lenders such as Carlyle, Oaktree Capital Management-backed 17Capital and Hark Capital say they are doing more business than ever. 

“We’re now getting in-bound calls,” said Rafael Castro, partner and co-founder at Hark Capital, an NAV lender. “Ten years ago we were the ones that were doing all the dialing.” 

About 83% of lenders reported an increase in the number of NAV transaction opportunities over the last year. Average number of deals rose to 22 in 2022, from 16 the previous year, according to a report by Rede Partners.  Augustin Duhamel, a managing partner at 17Capital, said his firm’s average lending in 2022 was over $250 million, reaching as much as $500 million. The volume of NAV financing is set to swell sevenfold to about $700 billion by the end of the decade, according to estimates from his firm.

Manco loans are a more recent phenomenon, with no data available showing the outstanding amount. 17Capital said deal sizes are getting larger, while Carlyle said it saw a range of $50 million to $350 million.

“The investor universe is unbelievably unaware of the underlying leverage throughout this entire ecosystem,” said New York-based Dan Zwirn, founder and chief executive officer of Arena Investors LP, an institutional manager overseeing more than $3.5 billion in assets. “That hasn’t hit the PE investors yet, but it’s becoming more clear for real estate investors,” he said, referring to the recent delinquencies in the commercial property sector.  

The need for extra financing sometimes comes from pressure from the investors in private equity funds, known as limited partners or LPs, requiring private equity managers, known as general partners, to make larger commitments to their own funds to ensure they have more skin in the game. The required amount of GP investment has crept up to as much as 5% of the total fund size, in some cases, from a norm of around 1%, according to Duhamel. 

The management companies ultimately have control over where the proceeds from the new style of borrowing go, though there’s been no evidence of them being used for dividend payouts so far, said Josh Ufberg, partner at NAV and GP lender Atalaya, a New York-based alternative investment advisory firm.

“A lot of it is driven by GPs’ need to fund existing commitments as the pace of exits declines and fundraising is more difficult and valuations are rocky,” said Michael Hacker, global head of portfolio finance at AlpInvest Partners, a core division of Carlyle. He was referring to the PE business model of buying up companies, taking them private and selling them back to the market at a profit after a period of time.

Richard Sehayek, managing director in Ares Management’s alternative credit strategy, said manco loans can be highly customized and don’t typically fit into traditional debt models.  

Though there have been no known incidents of defaults — it’s all just still too early — that doesn’t mean some lenders haven’t seen losses, said Socium’s Meklinsky. 

But Carlyle’s Hacker, whose firm allocated about 80% of its first portfolio financing round of about $1 billion to NAV and manco financing, says he isn’t too concerned as these deals are based on mutual interest.

“There’s a lot of flexibility baked in,” said Hacker. “These financings are designed to be worked out quietly — and not default, as its harder to enforce against the collateral of management fees and carried interest.”

Lenders say loan-to-value ratios of deals of this nature can be fairly conservative, from about 15%. However, for very bespoke loans, it can run as high as 50% in some cases.

As demand for these unconventional loans rises, more credit funds are jumping in, sweetening their offers with friendlier terms. They include watered down “valuation challenging rights” — where lenders can question the borrowers’ fund valuations. In some cases, the clause is removed altogether. 

But some creditors are also getting tough. They are adding so-called step-in rights into terms, which enable them to seize the underlying fund assets, according to Rede Partners.

“As a lender we're really looking for stable predictable cash flows and diversified underlying assets,” said Atalaya’s Ufberg. “Given it's complex financing with a wider range of outcomes, there's an associated cost for this.”