As the interest rates touch 20-year highs, the business model of private equity firms is coming under severe stress. The low interest rate regime for nearly two decades helped the industry leverage and juice up their returns. Now the tide has turned and PE funds are responding with a new set of financial engineering to raise capital and stay afloat as portfolio companies run out of cash.
The low interest rate regime has been coupled with a slowdown in PE fund raising and weakness in IPO markets that have left PE firms with ownership of companies they had leveraged up longer than they had expected and whose debt servicing now beckons.
Some examples below.
1. The most stunning, egregiously so, model is that of PE funds buying back companies they only recently took public through IPOs. Now those companies are languishing at prices below the IPO listing price. PE firms like EQT, Silver Lake, Cinven, General Atlantic etc have all undertaken such buybacks.
Shares in many companies taken public by private equity firms in 2021 have fallen well below the price at which they initially floated, presenting a chance for the firms to buy them back cheaply, industry executives said. In August, Swedish private equity giant EQT offered to take private German software group Suse in a deal worth about €3bn after a tech sell-off and profit warning dented the shares, about half the valuation at which EQT listed a 24 per cent stake in April 2021. In September, UK private equity house Cinven struck a deal to buy back the outstanding shares in Synlab, a laboratory and medical diagnostic services company in which it retained a 40 per cent stake, after a disappointing run of performance and a profit warning. And Silver Lake said last month that it was considering taking entertainment group Endeavor private again after the company and its chief executive Ari Emanuel became frustrated with lacklustre share price performance. The US private equity group controls just over 70 per cent of Endeavour’s voting rights.
Come to think of it. A PE firm pockets the proceeds from listing a company's shares at a price of $100 per share. In six months, the price tanks to $60. The same PE firm now steps in to buyback the same share at $60 and take the company private again. The investor loses $40, and the PE firm has made $40 while regaining the same company, and all this in the space of a few months! A straight transfer of money from investors to the PE firm!
2. A common strategy is continuation funds where the PE fund sells assets to another fund it manages at a higher valuation.
During the boom times, these deals were a quick way to realise investment gains and own promising companies for longer. But sceptics have criticised the deals because money from one fund is used to cash out earlier investors at values that in some cases now look high.
This allows them to "reset the clock" for several years on some assets in old funds by selling them to a new vehicle that they also control.
4. Another strategy is the Net Asset Value borrowing, wherein PE funds borrow against the collective valuation of their portfolio companies as collateral. This has been described as "defending the portfolio" strategy or "pray and delay" strategy.
They are deploying the proceeds to help pay down the debts of individual companies held by the fund, according to private equity executives and senior bankers and lenders to the industry. By securing a loan against a larger pool of assets, private equity firms are able to negotiate lower borrowing costs than would be possible if the portfolio company attempted to obtain a loan on its own... Vista Equity Partners, a private equity investor focused on the technology industry, used a NAV loan against one of its funds to help raise $1bn that it then pumped into financial technology company Finastra...The equity infusion was a critical step in convincing lenders to refinance Finastra’s maturing debts, which included $4.1bn of senior loans maturing in 2024 and a $1.25bn junior loan due in 2025... Executives in the buyout industry said NAV loans often carried interest rates 5 to 7 percentage points over short-term rates, or roughly 10.4 to 12.4 per cent today... Vista, Carlyle Group, SoftBank and European software investor HG Capital have turned to NAV loans to pay out dividends to the sovereign wealth funds and pensions that invest in their funds, or to finance acquisitions by portfolio companies.
The Finastra deal has also been described as "leverage on leverage" since leverage was being assumed by the fund assets to cut debt at one troubled company.
5. Another strategy is to hope for good times and defer interest payments by adding them to the company's debt burden. It has been aptly described as "Hail Mary"!
Another tactic is to shift away from making interest payments in cash, which conserves it in the short term but adds to the overall amounts owed... Interest payments are deferred, with the payments added to the company’s overall debt burden. This helps alleviate cash flow pressure in the short term, but it is an expensive form of borrowing that eats into the future returns of equity investors. It can also backfire if the company does not grow rapidly enough to ultimately cover its future interest costs. This year, Platinum Equity’s portfolio company Biscuit International raised €100mn of (payment-in-kind) PIK debt at an 18 per cent interest rate to resolve short-term balance sheet issues, according to people familiar with the matter. Unusually, Platinum itself provided the financing, they said. Solera, another Vista-owned software company, swapped some of its existing cash-pay debt with PIK notes this summer, according to filings with US securities regulators.
6. Yet another strategy has been to hold on to the best companies in the portfolio for longer and transferring them across funds.
Hg Capital, one of Europe’s largest buyout groups, has been particularly innovative, developing a model that other firms including EQT and Carlyle are replicating. It involves holding on to its best-performing assets for longer than is normal, transferring them between funds and generating returns for its backers by selling small parcels of these companies to other investors. Through such tactics, Hg has owned Norwegian accounting software company Visma for nearly 20 years. During that time its valuation has gone from about $500mn to almost $25bn, making it one of the industry’s greatest returns on paper, according to people familiar with the matter.
All the strategies mentioned above involve buying time to return money by financial engineering. The presumption that the underlying assets will be able to generate the kind of returns expected by investors is deeply questionable.
This is a reckoning for the PE model itself. The industry in its fully scaled form is less than two decades old, and has not seen a period of normal interest rates. There is a very compelling case that the fortuitous confluence of ultra-low rates and the flush of private capital searching for yields allowed PE funds to usurp credit for what is essentially an excessively leveraged ownership model.
These PE strategies are now catching the attention of venture capital funds. VC funds invest in tech startups typically for 10 years with an option to extend for two years in expectation of a return on investment, without which they can force a sale of the portfolio companies or shut them down. Now with high returns proving elusive and cost of capital rising, the VC funds are looking towards continuation funds, strip-sales, and other strategies of PE funds.
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