In early March, Carlyle Group appeared close to a takeover that valued healthcare software company Cotiviti at $15bn. It was just the sort of audacious deal that large private equity firms have been pulling off for much of the past decade.
More than a dozen private lenders, including the credit arms of Blackstone, Apollo Global, Ares and HPS, were ready to sign off on a record $5.5bn private loan that would have put Carlyle in control of Cotiviti.
But the process dragged on for weeks. According to more than a dozen people involved in the transaction, the key hold-up was a stunning setback in an industry managing $3.3tn of assets: Carlyle, one of the most powerful private equity firms, had been unable to raise all of its roughly $3bn equity commitment from investors.
The yield on the debt financing, around 12 per cent at the time, would have been approaching the return Carlyle was hoping to earn, stifling interest from potential investors, according to one person involved in the deal. When Carlyle attempted to renegotiate the $15bn valuation, Veritas Capital, the existing private equity owner, walked away from the sale.
“It was an extraordinary ‘fall on your face’ by Carlyle,” the person adds.
That, at least, is how it looked at the time to many in the industry, some of whom put the collapse of the deal down to company-specific factors at Carlyle or the fears that month about a banking crisis in the US.
But in retrospect, it was also a harbinger of the sorts of pressures that are starting to bite the private equity industry as interest rates remain higher than most finance industry executives had expected just 18 months ago. No alternative deal has emerged since March for Cotiviti, suggesting problems that go well beyond one private equity firm.
The prospect of rates staying higher for longer is having powerful ripple effects across the economy; companies large and small are struggling to refinance debt, while governments are seeing the cost of their pandemic-era borrowings rise.
But private equity is the industry that surfed the decade and a half of low interest rates, using plentiful and cheap debt to snap up one company after another and become the new titans of the financial sector.
“Many of the reasons these guys outperformed had nothing to do with skill,” says Patrick Dwyer, a managing director at NewEdge Wealth, an advisory firm whose clients invest in private equity funds. “Borrowing costs were cheap and the liquidity was there. Now, it’s not there,” he adds. “Private equity is going to have a really hard time for a while . . . The wind is blowing in your face today, not at your back.”
Facing a sudden hiatus in new money flowing into their funds and with existing investments facing refinancing pressure, private equity groups are increasingly resorting to various types of financial engineering.
They have begun borrowing heavily against the combined assets of their funds to unlock the cash needed to pay dividends to investors. Some firms favour these loans because they remove the need to ask their investors for more money to bail out companies struggling under heavy debt loads.
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.
Private equity executives insist that the present difficulties will be shortlived and that periods of stress are often the times when the best deals can be struck.
“We’re not forced sellers of assets on the one side and yet we have the ability to move very quickly when there is dislocation to take advantage of an opportunity,” Blackstone president Jonathan Gray recently said.
On this optimistic telling, the unusual financing tactics are a solution to temporary challenges within an industry that remains flush with about $2.5tn of uncalled investor cash, commonly referred to as “dry powder”.
However, others view the financial engineering as a symptom of a deepening crisis. They say a modus operandi that thrived in an environment of low interest rates will look very different if rates stay higher for some time.
The co-founder of one of the world’s largest investment firms points out that almost the entire history of the industry has played out against a backdrop of “declining rates, which raise asset values and reduce the cost of capital. And that’s largely over.”
“The tide has gone out,” says Andrea Auerbach, head of private investments at Cambridge Associates, which advises large institutions on their private equity investments. “The rocks are showing and we are going to figure out who is a good swimmer.”
The peril of heavy debts
After central banks around the world slashed interest rates to near zero in response to the 2008-2009 financial crisis, private equity embarked on its longest and most powerful boom. In 2021, the market’s zenith, a record $1.2tn in deals were struck, according to PitchBook data.
But a series of rapid interest rate rises in 2022 brought this to a halt and many buyout houses have been left sitting on large investments they bought at the top of a bull market.
Higher interest rates have been particularly problematic for heavily indebted companies with borrowings nearing maturity. An example is Finastra.
The payments company, owned by Vista Equity Partners, faced $4.5bn of debt maturing in 2024 but found itself shut out of public markets, which have increasingly been closed to riskier borrowers. Just $3bn of risky triple-C rated US bonds and loans have been issued into the broad market this year, down 78 per cent from last year, according to data from PitchBook LCD and Refinitiv. Even higher-quality companies are getting shut out, with single-B and single-B minus rated loan issuance in the US down more than 70 per cent from 2021 levels.
Vista turned instead to the burgeoning private credit sector, pushing over several months for a refinancing that avoided it having to put more money into the company, at one point entertaining a loan with an interest rate approaching 18 per cent.
But lenders were wary. Some firms, such as Apollo, Blackstone and Sixth Street, dropped out of the financing altogether because of concerns about the strength of the lender protections in the documentation, according to people briefed on the matter. With little cash left in the fund that had originally invested in Finastra, Vista turned to Goldman Sachs for a loan secured against a group of companies Vista owns. The firm used $1bn of the money secured to pay off some of Finastra’s debts.
Vista’s loan — which was not disclosed to the lenders who ultimately did lend it $5bn to refinance Finastra’s obligations — has been described as “leverage on leverage” because fund assets were being collateralised to cut debt at one troubled company. The tactic, dubbed “defending the portfolio”, by lenders, is becoming increasingly common.
The head of one of the largest private credit firms describes Finastra as “a preview of the next three to five years”. Moody’s analysts have warned that by year’s end, more than half of single-B minus rated US companies will not be generating enough cash to cover their capital expenditure while servicing their debt. That means those businesses will be forced to dip into their cash reserves to cover their spending.
The interest coverage ratio for these companies — the extent to which operating earnings cover interest payments — could reach 0.91 by December from 1.32 at the end of 2022, according to Moody’s, and could fall further still. A figure below one indicates earnings are not sufficient to cover interest costs.
That has left many firms turning to so-called payment-in-kind debt to preserve cash. 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 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. One private equity executive, speaking in general about companies deciding to forego cash interest payments, referred to these deals as a “Hail Mary”.
Not all private-equity-backed companies have been able to cope with rising interest costs. Default rates are picking up and lenders are increasingly taking control of creditor companies at the expense of equity owners.
In recent months, KKR, Bain Capital, Carlyle and Goldman Sachs have all lost control of businesses that they backed. By June next year, S&P Global is predicting the US default rate will rise to 4.5 per cent, up from 1.7 per cent at the start of 2023.
Paying back the investors
Before committing new funds to private equity, investors generally like to see returns from previous ventures. Increasingly, firms are resorting to financial engineering and complex fund structures to provide those returns.
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.
The UK buyout group has been at the forefront of another strategy: using the cash flow of its already leveraged assets to borrow more money to fund investor payouts, a practice known as net asset value financing.
The firm has tapped this type of debt to return hundreds of millions of pounds to its backers, according to people familiar with the matter and company filings, with the loans secured against assets across multiple funds.
Other buyout groups are also turning to NAV loans to accelerate distributions as the traditional exit routes from investments — a sale to another company, or a flotation on the stock market — become more difficult.
Eyeing an opportunity, banks are increasingly pitching these loans to investment firms struggling to sell their companies, industry executives say. Carlyle, Vista Equity and Nordic Capital are among the firms that have tapped this market over the past year. Twenty per cent of the PE industry is considering such loans, according to a recent poll from Goldman Sachs.
But this type of borrowing has become more expensive. It has also drawn growing investor scrutiny because of the risk that healthy assets within a portfolio, which have been pledged as security, might need to be sold in order to repay the loans. Firms are also leaning on other borrowings to unearth cash for dividends including swaps, margin loans and structured equity sales.
The Institutional Limited Partners Association, a trade body representing private equity investors, is working on recommendations that will call on buyout firms to disclose more information to investors about the risks and costs of these loans.
Under pressure
The new interest-rate environment will be a particular test for some of the buyout firms that have grown rapidly over the past decade on the back of strong fund returns. A number of once-small US-based buyout groups such as Vista, Thoma Bravo, Platinum Equity, HIG Capital, Insight Partners and Clearlake Capital expanded rapidly but now face their first financial downturn managing large pools of assets.
Clearlake, which last year acquired English Premier League football team Chelsea FC, became an industry champion of so-called continuation funds, where a private equity fund sells an asset to another fund it manages at a higher valuation. From $2bn in assets a decade ago, it now oversees $70bn.
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.
Some of Clearlake’s deals, such as automotive parts distributor Wheel Pros, have soured due to heavy debt burdens and a deterioration in their financial performance. Wheel Pros completed a financial restructuring in September that cut its debt load but made equity returns more remote. Clearlake also renamed the company as Hoonigan, seeking a fresh start.
Clearlake has begun an investment push to buy distressed assets. Groups like Apollo and Centerbridge made large profits during the 2008 crisis by buying such discounted bonds.
Other PE firms have grown and invested at an even faster pace, raising concerns that a flood of investments made at high valuations at the top of the market could now struggle.
Thoma Bravo, under its billionaire co-founder Orlando Bravo, has transformed from a niche investor into a prolific dealmaker as its assets grew from about $2bn in 2010 to $131bn at present. Since 2019, it has taken private more than a dozen public software companies, spending upwards of $30bn in investor money, according to Financial Times calculations.
These deals often involved taking large equity stakes, especially the 2021 acquisitions of cyber security company Proofpoint and real estate software specialist RealPage. In two recent takeovers, Thoma Bravo declined to use debt entirely due to expensive financing costs.
But its aggressive investment pace as the market was nearing its peak means the group is vulnerable to a reset in technology valuations in a world of higher rates. Even with its large equity cushion, RealPage carries a sizeable debt load. This year, the outlook on its credit rating was revised lower due to its “elevated leverage” ratio of 8.7-times adjusted profits and exposure to largely unhedged floating rate debt.
At a recent FT conference, Bravo said his firm had not bet on rising valuation multiples and was adapting investments such as RealPage to increase their overall profitability by both bolstering sales and cutting expenses.
Brian Payne, an analyst of private equity deals at BCA Research, says the valuations of deals struck in recent years could drive poor returns or losses.
“The risk of capital loss is higher than it’s ever been, even when you go back to the 2007 or the 2008 vintages,” says Payne. “The longer the higher-rate environment persists, the higher the risk of capital loss,” he says.
With public listings still unattractive and dealmaking cooling, the number of private equity exit transactions is approaching a 10-year low. Buyout firms are sitting on a record $2.8tn in unsold investments leaving “a towering backlog” of companies to exit, according to consultancy Bain & Co. This is expected to continue into 2024.
“I don’t see a massive rebound in exits next year,” says Pierre-Antoine de Selancy, managing partner at 17Capital.
Some pensions and endowments have even resorted to selling large stakes in private equity funds at discounts to their stated value to raise cash.
“We are having a lot of uncomfortable conversations,” says Dwyer, referring to meetings with private equity firms on behalf of investor clients. “It is year three and I haven’t had a distribution in funds that are fully baked [invested]. When am I going to get my capital back?”
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