Perils of a private equity bias

Private equity has been crucial to the evolution of private debt as an asset class, but have the two industries become too friendly? John Bakie explores

The private debt industry remains heavily reliant on its relationship with private equity funds, despite attempts to tap into other avenues of origination. Research by the Alternative Credit Council points out that only 40 percent of private credit deals are reliant on a financial sponsor, but this is still a very large percentage, and private debt’s fortunes remain highly dependent on the business model of the private equity community.

The real question is whether it really matters that private debt and private equity are so closely linked. Could a crisis in the private equity sector lead to contagion in private debt? Are credit funds too close to their private equity partners? These are important questions for fund managers, investors and financial sponsors to consider.

Gauging the role of private equity in private debt deal activity can vary widely depending on the sector. Some private debt niches, like asset-based finance or aviation finance, may eschew financial sponsors entirely, and areas such as real estate or infrastructure debt might be less reliant on private equity investors than corporate lending. However, mid-market corporate lending is still very much the focal point of the private debt industry and the numbers suggest it is still heavily reliant on private equity activity to source dealflow.

Deloitte’s Alternative Lender Deal Tracker, which examines mid-market European private debt activity, consistently shows that financial sponsor-led deals make up the majority of the market. According to Deloitte’s most recent data, there were 188 mid-market European deals in the first half of 2018, but just 33 were non-sponsored, indicating that more than four-fifths of this market is still reliant on private equity for deal origination.

Too close for comfort?

The biggest risk for a private debt fund is that it can get too close and too comfortable with its private equity partners, which may lead to taking unacceptable risks in order to win business.

Abhik Das, head of private debt at Golding Capital Partners, says this can often be seen in some of the language that debt funds use.

“We sometimes see debt fund managers referring to private equity sponsors as their clients, but this is somewhat misguided,” he says. “The ultimate client is the LP. This says a lot about the relationship with private equity firms, and the risk that private debt funds may compromise on terms and other documentation points.”

One area where firms can risk becoming too dependent on private equity relationships is when those relationships are highly concentrated, where a debt fund becomes heavily reliant on a small number of private equity funds for its deal origination and may feel pressured to accept bad terms or light covenants to retain favour.

“There is a risk of concentration as we do sometimes see debt funds which only work with two or three private equity sponsors, though this does tend to be those which have a niche sector or regional focus,” Das explains. “In these cases, we will obviously try to get an even closer look at the underlying documentation for some of their transactions.”

Terms and tribulations

Stuart Fiertz, co-founder of Cheyne Capital and chairman of the Alternative Credit Council, sums up the biggest challenge for private debt funds dealing with private equity: “The dynamic of private equity firms is that they’re very good at devising term sheets that hit standards.”

He adds that the past year has been particularly challenging and warns: “In 2018 we’ve seen some of the most egregious EBITDA adjustments, intended to fool investors and give false comfort. But the loss of covenants and the loss of subordination will lead to lower recovery rates than many investors expect.”

Leverage is a crucial part of the private equity business model and the secret to the exceptional returns it can achieve. To this end, private equity fund managers have a fiduciary duty to secure terms and pricing that are ultimately beneficial to their LPs, just as a private debt fund does. This means each side has its own priorities when securing a deal, which are not always aligned and may be in direct conflict.

Das outlines some of the key areas where debt and equity providers can come into conflict, saying: “We have seen the envelope being pushed on covenants in particular, baskets, the ability to re-lever, EBITDA adjustments and many other points. This is definitely concerning.”

Private debt providers should also be wary of sponsors that are not growth focused but instead are aiming to make money from using leverage, as this could expose them to unnecessary risks. “Some private equity players do not add much value and are making returns from financial engineering,” says Jaime Prieto, founding partner of private debt manager Kartesia.

To mitigate the downsides of being too reliant on private equity sponsors, Prieto’s firm has been shifting more of its business towards non-sponsored deals. While its third fund, which closed in 2015, made around 80 percent of its deals with a private equity sponsor, its fourth fund has taken a more balanced approach with around 50 percent of deals originated without a private equity sponsor.

While there are a number of risks to consider when dealing with a private equity sponsor, there are also major advantages to doing business this way, which is why it continues to be such a popular origination channel for debt investors.

“Sponsorless allows us to get better terms but it is also a lot more work from a due diligence perspective when you don’t have a sponsor,” Prieto says.

Golding’s Das agrees. “Private equity sponsorship does have huge advantages,” he says. “The level of due diligence, governance and other matters typically meet a certain minimum standard and level of quality. In addition, every private equity-backed transaction has a built-in exit plan, which provides the private credit lender with the opportunity to exit as well.”

Working with private equity sponsors isn’t just a channel for easy origination; the other real benefits it offers in terms of professionalism have to be weighed against other potential issues – such as pressure on terms and pricing – to come to a deal which works in the best interests of the lender. While the terms may not be as good as a sponsorless deal, there are also fewer risks.

The next crisis is expected to test private equity and private debt relationships and shed light on issues around terms and pricing that may not yet be evident.

“There are some firms that are too close to private equity, and it won’t be obvious until the next crisis,” Prieto warns.

But Das believes that a credit downturn could provide the basis for strong relationships in the future. “In the event of underperformance and especially when the cycle turns, if private debt and private equity funds can mostly demonstrate that they can work together to resolve any issues in a consensual manner, that will definitely be positive for the further development of the industry. Many situations with private debt funds ‘taking the keys’ will undoubtedly be seen as more controversial for the industry.”

The argument over whether private equity is good or bad for private debt’s development will rage on, but the best advice for fund managers today is to ensure they apply their own best judgement across all their deals, sponsored or not.