Private Equity Financing: Rising Trend of High-Cost Loans

Private equity financing (“PE”) has always been about navigating the complexities of financial structures, seeking out lucrative deals, and balancing risks and rewards. But recently, PE firms are financing their deals and commitments in curious new ways. And with these shifts come new risks and opportunities for investors.

Emerging Private Equity Financing

Historically, private equity has thrived in an environment where returns are ample, and borrowing is reasonable. However, rising rates during 2023, marked by a decline in PE deals and reduced available cash, has forced many PE firms to look for new ways to finance. They are now diving deeper into the borrowing pool, exploring financing options that were previously off the beaten path.

Manco loans and Net-Asset-Value (NAV) financings are two such strategies:

• Manco Loans: These are borrowed by the management companies overseeing PE investments. A novel concept, this debt is collateralized against non-traditional assets like fee streams and equity returns. Manco loans cater to diverse needs, from seeding new strategies to supporting partner stakes in funds.
• NAV Financing: Backed by a group of portfolio companies, NAV loans enable PE firms to return funds to investors. They’re not entirely new but are becoming increasingly relevant as cash on hand becomes scarce.

Why the Shift?

The catalysts for this trend are multi-faceted:

• Changing Dynamics: The PE industry is grappling with rising interest rates, economic uncertainties, and reduced takeover volumes. PE’s cash reserves are nearing their lowest since the 2008 crisis.
• Stakeholder Pressures: Limited partners (LPs), or investors in PE funds, have upped the ante. They now want general partners (GPs), or PE managers, to have more “skin in the game,” pushing for increased commitments from them.
• Operational Needs: With the slowdown in exit opportunities and more challenging fundraising, GPs are feeling the squeeze. Many are finding it necessary to fund existing commitments and navigate volatile valuations.

Risks and Concerns

While these unconventional loans are filling a need, they also come with significant risks:

1. High-Interest Rates: Some of these loans carry interest rates as high as 19%, reminiscent of consumer borrowing rather than corporate finance. Even junk-rated companies have recently secured bonds at 10%.
2. Valuation Complexities: There’s a growing trend of diluting or removing “valuation challenging rights”, which would ordinarily allow lenders to question a borrower’s fund valuations.
3. Multiple Claims: As PE firms take on varied forms of loans, they could face simultaneous claims from different loans, creating a financial whirlwind.
4. Default Uncertainties: While there haven’t been known defaults yet, the nascent nature of these loans makes the long-term risks unclear.

Navigating the New Terrain of Private Equity Financing

While the demand for these innovative loans is surging, PE investors must tread carefully. It’s crucial to understand the intricate web of borrowed capital, its implications, and potential pitfalls.

PE firms, once outbound callers for funds, are now being inundated with inbound loan offers. This shift suggests a fertile ground for opportunities, but with it comes an obligation for due diligence.

Investors beware. Private equity‘s foray into unconventional financing methods represents both an adaptation to current market dynamics and a testament to the industry’s resilience. But, investors need to balance the allure of returns with the realities of risk. Whether new financing trends will prove sustainable remains to be seen. Either way, investors are advised to stay informed about the financing stack of their PE investments.