Franchise expansion could be double the trouble

Private equity firms launching debt arms must act very carefully to avoid conflicts of interest, argues Andrew Hedlund

A number of medium-sized private equity firms have launched private debt arms in recent years, as they look to expand their product suite.

As more begin investing on both sides of the capital structure, a conundrum presents itself: do credit arms bankroll their firm’s own leveraged buyouts, add-on acquisitions and other transactions? Some GPs won’t consider using their debt capital to back their equity deals; others will. If a firm is in the latter camp, the question is how they do so without putting fiduciary duties to each of their LPs in peril.

Communication with LPs must be high on the priority list. Early disclosure of plans with both debt and equity positions in the same deal, and how the GP plans to curtail conflicts of interest, is paramount. The prospect still makes the average LP uneasy though, one credit manager tells us, noting that “perception can be as bad as reality”. And there are other challenges.

If a lender housed under the same roof as a potential private equity buyer is in an auction, third-party lenders can become uncomfortable with the thought that the debt investor backed by the equity buyer may end up with information that they do not have access to. One method to avoid conflict of interest is private equity firms only allowing their related debt funds to be a passive investor, limiting the credit group to 49 percent or less of the debt on buyouts or other transactions led by the private equity team.

But even holding, say, 40 percent of the debt can present challenges when deals go awry and the company ends up under court protection, at least for US investors. Owning that figure allows the firm to drive the restructuring process.  Distressed investors routinely deal with bankruptcy cases, but it’s still important for a direct lender to think how it could end up exiting a deal and protecting its downside.

A third-party credit firm might pay more for debt on the secondary market than a private credit group that is under the same roof as the portfolio company’s private equity owner. That overpaying could be detrimental to the outside manager’s LPs because the investment could be shakier than it realises.

This should provide pause for thought for any direct lender targeting performing credit – one of the last conversations a firm wants to have with its LPs is how and why a borrower fell off the straight and narrow. Unfortunately, not every deal is a home run, so envisioning such scenarios and putting policies in place is a sensible way of pre-empting difficult scenarios.

After all, no fund manager wants the most difficult conversation of all: explaining retrospectively why a damaging conflict of interest arose.