An enduring relationship

Private equity sponsorship is one of the most important components of the private debt market. Without it, it’s hard to imagine the asset class could have experienced such meteoric growth as it has seen over the past decade and that we could today see fundraising numbers approaching $200 billion annually.

This is not to say private debt is completely dependent on private equity. Many specialist lenders are carving niches in areas such as asset-based lending, royalties, micro-loans and so on. But without the support of the private equity business the asset class would be a mere footnote in the history of early 21st-century finance.

Why is private debt so reliant on private equity, and is this state of affairs likely to change? The consensus is that sponsored deals continue to make up an overwhelming proportion of all deal activity. Indeed, managers are keen to boast of their diversified business model when they do less than 70 percent of their deals with private equity sponsors.

Statistics bear this out, with Deloitte’s Q3 2017 Alternative Lender Deal Tracker, which looks at mid-market private credit deals from 60 leading managers across Europe over the past five years, showing that of a total of 1,188 recorded deals since October 2012, 915 (77 percent) were sponsored.

“Because we’ve all worked in leverage finance for banks, the relationships are often the same ones we had before.”

Alastair Brown

Interestingly, while the proportion fluctuates from quarter to quarter there is no real trend away from sponsored deals, according to Deloitte. The proportion of sponsored deals in Q3 2013 was 85 percent, while in Q3 2017 it was 86 percent. So why is private equity sponsorship such a consistent part of private debt deal-doing?

“Origination is key,” says Andrew McCullagh, head of origination at London-based debt house Hayfin. “Private equity-owned businesses are great. They have good governance standards but are owned by people whose day job is aggressive financing.”

The split lives on

As for why the 80-20 split has persisted, McCullagh suggests that, because private debt is a relatively new asset class which is close to private equity in culture, private equity houses are more natural partners at this phase in the industry’s development. It’s also worth remembering that firms owned by private equity funds tend to be more highly leveraged than others, meaning they are far more likely to be supported by a private debt fund than the broader pool of companies.

The reasons for private debt’s symbiotic relationship with the private equity industry also have a lot to do with history, particularly the role of the financial crisis in 2008. When the global banking industry was forced to go cap-in-hand to national governments for a bailout, the ensuing regulatory backlash had profound effects on banks and the leveraged buyout investors that rely on them.

After 2008 banks either shed staff or left many leveraged finance professionals sitting around the office unable to lend money, many of whom decided to go and do things on their own.

One of these is Alastair Brown, who set up Shard Capital Partners last year alongside three former colleagues from CIBC Leveraged Finance and Barclays Leveraged Finance.

“Because we’ve all worked in leverage finance for banks, the relationships are often the same ones we had before,” he says.

Transfer of vital relationships and experience away from banks and into private funds has helped the private debt industry, and could hamper the banks should they look to make a comeback.

The banks’ woes can also be turned to private debt’s advantage, and Brown says one of the biggest problems with banks today is that they are not very reliable partners. “Auctions are highly competitive and private equity bidders usually need support early on in a process that can last three months from start to finish. The private equity sponsor needs a reliable debt partner, but since the financial crisis banks have become flakier in their commitment.”

Banks have faced an avalanche of regulation since the financial crisis, pushing up their cost of capital, limiting the flexibility of their terms and forcing them to invest significant resources to keep various parts of their business going, from consumer finance through to investment banking. Coupled with near-zero interest rates for the past decade it’s not hard to see why banks are struggling.

The net result of all this turmoil is that banks can appear to be highly irrational actors that constantly shift their strategies and objectives, not particularly attractive partners in an industry which values certainty.

Don’t keep your friends too close

Of course, this need for certainty goes both ways and the importance of strong relationships and understanding of the private equity business is equally valuable to private debt funds.

Francois Lacoste, partner at Idinvest, says: “We want to support companies that are well structured, and an experienced equity sponsor can help the company to become more structured and develop further.”

Debt funds also need to be wary of being over-reliant on private equity funds, according to Hayfin’s McCullagh.

“Private equity knows how to get debt funds to compete. There’s pressure to put money to work and this can lead to writing more aggressive deals. This is why we have tried to increase our in-house origination,” he says. “Lots of funds are under pressure, which will result in looser terms and more leverage, but it’s private equity that benefits.”

With increasing competition for mid-market private equity deals due to the boom in private credit fundraising activity, some investors are looking elsewhere to get a better risk-return profile. While specialist niches and non-sponsored deals have attracted some, others believe there are opportunities in less competitive segments of the private equity space.

According to Lacoste, there is a considerable difference between larger deals in the mid-market and smaller transactions, which remain highly reliant on bank finance.

“On larger transactions you have plenty of alternatives to finance your transaction and particularly in this current environment with lots of liquidity available in the market. The only way to differentiate yourself is to provide a higher level of leverage or lower pricing,” he says. “On smaller transactions you have fewer alternatives available except traditional and standard bank financings. It’s a less mature market and trust from sponsor and management is key.”

Brown agrees that smaller deals offer greater opportunities for private debt funds, and set up Shard Capital Partners to exclusively focus on smaller deals in the UK.

“If you set out your stall as competing primarily on terms and economics then it’s a race to the bottom,” he says. “Many firms are looking at sponsorless debt because of competition for sponsored deals in the UK mid-market, but we’re looking at the lower mid-market, because there were some 200 private equity deals in this segment last year but very few debt funds are active here.”

Private debt seems set to continue relying on private equity as a key source of deal origination, and given the cultural similarities it is natural that debt and equity funds will form close relationships. However, it’s important to keep in mind that they have different objectives and will necessarily come into conflict. Relying on private equity to provide a steady flow of deals should not blind investors to the risks that come with it.