Private equity managers are turning to specialist borrowing facilities to ensure their highly leveraged strategies can survive the coronavirus pandemic, but there are growing concerns that the use of these complex financing deals poses new threats to investors.
Demand for additional financing globally has shot up during the health crisis as private equity managers battle to help companies they own to survive the sharp downturn in economic activity.
Specialist lenders are increasingly being asked to provide bespoke loans, known as NAV credit facilities, which are based on the estimated net asset value of the companies owned by the fund.
“We have helped to arrange record numbers of NAV credit facilities over the past 12 to 18 months. We have seen more managers looking for defensive liquidity to help them ride out the coronavirus storm,” says Leon Stephenson, a partner at Reed Smith, a London-based law firm.
Demand for NAV credit facilities has increased because other options for private equity managers to raise money have declined. Increased funding strains on PE-owned companies combined with uncertainties about valuations have suppressed activity in the secondary market, where private equity managers buy and sell businesses to each other. Raising money by selling a private equity owned company via a stock exchange listing has become more risky due to volatile market conditions.
The pandemic has led to a “step change” in interest in NAV credit facilities, according to 17 Capital, a London-based fund financing specialist. It has provided about $1bn in financing for private equity managers in just the past few months alone.
“Many more private equity managers now recognise NAV credit facilities as an invaluable addition to their toolbox as they seek to help their portfolio companies weather the [coronavirus] storm, capture strategic opportunities, or access the liquidity needed to return capital,” says Stephen Quinn, a partner at 17 Capital.
17 Capital expects the usage of such credit facilities to increase because about 900 private equity funds globally have already invested all of their investors’ cash and are “fully called” in the industry jargon.
Mr Quinn says a “permanent shift” is under way in private equity managers’ approach to financing the companies for which they are responsible and this will persist after the coronavirus crisis abates.
“NAV credit facilities, like any tool, once successfully used become something that can be deployed repeatedly,” he says.
Mr Stephenson says demand for NAV credit facilities from UK-based managers is driven in part by uncertainties arising from the Brexit process, which have weighed on valuations.
Private equity managers have generally spent the money provided by their clients on buying businesses by the midpoint of a fund’s life but they can still have substantial ongoing needs for cash.
The borrowed money is used in some instances to repay investors. Keeping investors onside is vital for future efforts by private equity managers to launch new funds, as they often ask those same clients to make fresh commitments in subsequent fundraising rounds.
Investors, however, pay interest on the additional borrowed money. This reduces the final returns earned by investors, while the astute use of the extra credit facilities can also help private equity managers to hit returns targets that trigger lucrative performance fees.
More money is borrowed in some cases to make additional acquisitions or to ensure that businesses that have hit a rough patch can survive.
Rapid growth in the use of NAV credit facilities provides more evidence of how ultra-low interest rates are fuelling a greater reliance by private equity managers on financial engineering ploys, such as subscription lines and dividend recapitalisations, to drive returns.
Interest costs on these loans range between 5 per cent and 10 per cent annually depending on the quality of the fund’s portfolio, according to a person familiar with these arrangements. The advantage to the lender is that it has a claim on a range of businesses if any one of them should run into trouble.
But a default by a portfolio company can have significant implications for the entire private equity fund as the lender will then have a claim on other assets that have been pledged as security.
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“The private equity manager is in effect mortgaging its stronger investments in order to support its weaker ones,” says Peter Morris, an associate scholar at Oxford Saïd Business School.
The Institutional Limited Partners Association, a trade body representing investors, has also expressed concerns about the risks posed by NAV credit facilities.
“Investors are concerned that such facilities allow private equity managers to take on risks with portfolio companies in excess of what investors have committed to the fund,” says Jennifer Choi, managing director of industry affairs at ILPA. “Investors are not as supportive of NAV facilities as they are of other means of providing for the liquidity needs of portfolio companies.”
Mr Stephenson says that there will always be investors that oppose the use of more leverage so private equity managers have to make it clear that they have the option to use a NAV credit facility when the fund contract is first drawn up.
Paul Cunningham, chief financial officer at Helios Investment Partners, an Africa-focused private equity manager, has used NAV credit facilities for several years.
He admits that some clients were “very sceptical” when Helios initially suggested employing more leverage, but he rejects the criticism that NAV credit facilities are only used to enhance the returns to the private equity manager at the expense of investors.
“Disclosure should be sufficient to ensure investors can do like-for-like comparison between managers. But some private equity managers will chose not to use a NAV facility if the disclosure requirements are too onerous. The ultimate loser will be the investor, not the manager,” he says.