The future of private debt: Hybrid strategies

In August 2017, TLC Marketing Worldwide, a 400-strong multi- national promotional agency for global consumer brands, received its own tender loving financial care from specialist debt provider Prefequity.

“TLC is a very good example of the kind of company we support,” says Theo Dickens, managing partner of London-based Prefequity. “It’s owned by two founder- managers who need fresh capital to fund growth, but are reluctant to give up a lot of equity and control to a private equity firm.” Prefequity’s investments are typically structured as secured bullet loans – loans that are not amortising – with equity warrants accounting for a relatively small minority of the borrower’s equity. Dickens characterises his firm’s approach as “private debt investment with a private equity hat on”.

“We originate and structure an eventual exit. But the risk-reward for the management team is different from private equity. If they are as successful as they usually think they’ll be, they won’t have to give up as much value in the equity when we exit.”

Hybrid debt-equity structures are becoming increasingly popular, say market observers. Some of these deals come in the form of preferred equity, so-called because the company must pay a divi- dend on it before paying any dividends to anyone else. But, as with other forms of subordinated capital, the investment is only recoverable on liquidation after obligations on all other bonds are paid out. Another growing instrument is the payment-in-kind loan, a bullet structure that also includes warrants.

Kenneth Borton, London-based man- aging director at WhiteHorse Capital, the private lending arm of HIG Capital, thinks European deals using PIK loans are often favoured because they are better understood by credit funds and can have better contractual terms, such as share pledges and covenants. The growing interest in these hybrid debt-equity structures reflects the need of funds to generate returns.

“Many senior debt funds were set up in Europe a few years ago, aiming for annual returns of 10 percent,” says Romain Cattet, partner at London-based debt advisory firm Marlborough Partners. But because senior debt spreads have come down and are still falling, managers must be creative to reach that 10 percent. One way they can boost returns, says Cattet, is through structures such as PIK loans. A handful of firms are now carving a niche for themselves – going down the same road as Prefequity.

“You should still be able to target 15 percent for hybrid strategies,” says Naveed Chaudhry, partner and head of alternatives and fixed income at London-based wealth manager Stanhope Capital. But, he warns, even here returns have been compressed by the large amount of private debt capital circulating. He adds that while “it only makes sense for us at 15 percent”, returns for some hybrid strategies are only 12 percent. 

FEAR OF THE NEW?

The relative newness of these strategies also presents problems for limited partners. Chaudhry thinks the number of managers with sufficient track record and expertise in hybrid debt is limited.

“If you have a team that is beginning to look at a hybrid area, the chances are there isn’t much of a history there, in which case it becomes so much harder for us to allocate to because of the lack of information,” says Jonathan Bell, Stanhope’s chief investment officer.

Jeffrey Griffiths, principal in the London office of Campbell Lutyens & Co, the private equity advisory firm, thinks that there is some investor interest in hybrid strategies – both in the US and, to a lesser extent, in Europe – “but it’s not likely to approach the levels we saw before the financial crisis because some investors had a negative experience with these strategies then”.

Despite these potential obstacles, the merit of hybrid structures lies in the diversification they offer both investors and borrowers.

“[The European private debt market] started with a small number of non-bank lenders, and has quickly grown into a vast array of different types of credit fund. Each fund manager has a slightly different investment rationale, policy or experience, and each is willing to play at different parts of the capital structure,” says Tim Nicholson, director, debt advisory and corporate finance, at KPMG in London.

This is mirrored by the companies that need the finance. Nicholson gives an example. “If you are the shareholder of a fast-growing business, and you have identified a growth opportunity in a new market which you think can give you a 30 percent-plus return on equity, you may not want to give up too much of your own equity or control to do this,” he says.

“A solution might be a hybrid financing instrument that sets the cost of capital below equity returns but with a combination of contractual return – typically through a mix of cash paid and rolled up interest to deliver mid-teen annualised returns – and a small share in any potential upside, often through warrants.” 

In other words, hybrid structures are not seen as an instrument designed merely to benefit investors, but a genuine solution to companies in need of innovative debt solutions.