The private equity business model has played a huge part in the development of private debt and been a major contributor to the asset class’s rapid rise in recent years.

Private equity thrives on leverage as the engine of its outsized returns. And although banks have pulled back from debt markets in the wake of the 2008 financial crisis, private equity’s thirst for leverage has not let up. Private debt funds have found an opportunity to step up to the plate and provide private equity houses with the debt they need to keep investing in and growing their portfolio companies.

Even as private debt has sought to diversify – through providing loans directly to companies via ‘sponsorless’ transactions, or by diversifying into market niches such as asset-based lending, real estate debt or litigation finance – private equity remains a key plank of private debt’s most popular strategy, mid-market direct lending. All the signs suggest that private debt’s fortunes will remain bound up with those of private equity funds for many years to come.

Deal data indicate the degree to which private equity and private debt funds work together. Deloitte’s Alternative Lender Deal Tracker survey shows that in the first quarter of 2019, 60 mid-market private debt deals were sponsored transactions; during the same period, just 13 – less than 20 percent – were deals without a financial sponsor. All 13 of those deals were refinancings. Clearly, private equity sponsored transactions continue to be the driving force behind the deployment of private credit in the mid-market in Europe. The more mature market in the US is believed to have more sponsorless transactions, but private equity relationships remain important for industry professionals there as well.

Tailored finance

We’ve heard a lot from the debt side about the advantages private credit brings to the private equity sector, and also about the dangers of being too reliant on these fund managers. But what do the private equity funds really think about private debt and the role it plays in financing their portfolio companies?

Silverfleet Capital, a well-established mid-market European private equity investor, provides a good example of how private debt has rapidly become an integral part of the landscape for financial sponsors. The firm’s second fund, a 2015 vintage, made 10 investments, all of which were supported by senior bank finance. However, the firm’s third fund, which launched in August 2018, has made nine investments so far of which six are supported, wholly or partially, by private debt funds. Four deals used unitranche financing, while another two feature stretched senior finance.

“For us, it’s about getting the best finance package that meets the specific needs of each company whether that is from a bank or a fund, as we consider the merits of both options on all of our deals,” says Robert Knight, a principal in Silverfleet’s London office with responsibility for the firm’s debt relationships.

Robert Knight Silverfleet Capital
Robert Knight, Silverfleet Capital

“We always look at what type of debt is appropriate for the business. We need to make sure there is sufficient flexibility to meet the needs for capex and add-on acquisitions. We also talk to the management teams to understand their preferences and sensitivities, and whether they want to continue a relationship with an incumbent lender.”

It is important for alternative debt providers to remember that it is not the type of lender that matters to a private equity fund. What does matter is how the finance options can fit into the broader growth strategy for a portfolio company. This can involve a range of decision points such as price, availability of follow-on capital and terms offered.

David Leland, managing director and head of capital markets at large-cap private equity investor BC Partners, says the financing always has to fit into the way fund managers are looking to grow the business.

“The size, scale and scope of the business all have a bearing on how we will try to finance it and the strategy for the asset also matters,” he explains. “Traditional unitranche is employed in many areas of our business. Unitranche is good for highly acquisitive transactions as we’re not reliant on having to keep going back to the market to finance add-ons.”

He gives the example of VetPartners, which the firm acquired last year: “The business is highly acquisitive and we chose Ares to finance it as we have good relationships with the team there. We’ve been able to go to them for several financing rounds as the business grows.”

Making choices

So in which situations do private equity funds tend to look for debt fund financing, and when are they more likely to go for a bank?

One historical trend that still applies is that bank finance is typically more suited to large transactions while private debt funds tend to be most active in the mid-market, though this is beginning to change. Some of the larger debt funds can write large tickets to rival the offerings of banks. However, they can also offer some distinct advantages over using a bank syndicate.

“Debt funds can have a speed and deliverability advantage as you are usually speaking directly to the decision maker and they can provide 100 percent of the debt,” explains Knight.

Among those we spoke to, the ability to make concrete and rapid decisions was consistently highlighted as a key advantage of going to a private debt fund over using a bank. It’s easy to see why. Banks are large organisations with long chains of decision-makers, and the people selling their products are not the ones responsible for underwriting decisions. Furthermore, they are constrained by an ever-growing array of regulation. By contrast, debt funds typically have small deal teams where both origination and underwriting take place in close proximity or are handled by the same individuals, and where there are few constraints on how much is lent or how the debt is structured.

Speed of execution was one of the most impressive aspects for first-time private debt user Christian Bettinger, principal at Munich-based private equity investor Paragon Partners. The firm recently completed a management buyout of German opticians chain Pro Optik with a unitranche facility provided by CVC Credit Partners, marking the first time the fund manager had used a non-bank lender to finance a transaction.

“The speed we saw from CVC was five times faster than we would get a commitment from a bank,” says Bettinger. “They had a good understanding of the deal and the package was very customised. This is all useful when you’re working on a deal which has time sensitivity.”

For Paragon, the ability to develop a deeper understanding of the portfolio company was integral to getting the Pro Optik deal done, because securing bank finance for high street retailers is challenging in the current environment.

“Banks are unwilling to finance deals in the retail space, but an opticians chain is very different from a fashion retailer,”  says Bettinger. “Banks view them both as being in the same retail category, but private debt was more willing to develop an understanding of this business.”

Another area where private debt can be advantageous for private equity investors is the control of information. Knight gives an example: “During our recent investment in CARE Fertility we front-ran the process and did it with a fund providing a stretched senior package. It would have been very hard to do this with a club of three or four senior banks due to the higher risk of a leak from using multiple parties.”

This could also be helpful in cases where companies get into distress. Syndicated bank finance means it is inevitable that a portfolio company’s financial problems will become public knowledge, which could exacerbate the situation. But with a private debt fund loan it is in the interests of both parties to operate more discreetly.

The price is right

It’s not just the ability to execute reliably that can be attractive to private equity players. The most important aspects of any loan are the price and terms. Private debt had historically been significantly more expensive than using banks. However, falling prices mean more private equity firms are now willing to consider private credit. This was certainly a factor in getting Paragon to engage with debt funds. “The pricing has really come down with the introduction of first-out structures, and a blended senior and unitranche structure can cost less than 5 percent,” Bettinger says.

Knight agrees that pricing has gotten better: “One downside of private debt is that it’s more expensive, though we’ve seen funds reducing their pricing recently to compete with the banks. First-out super senior structures can be great because we can get a blended rate down to around 6 percent. Similarly, stretched senior can give us many of the benefits of unitranche, particularly in terms of flexibility, with pricing in the 5 percent area.”

He adds that competition from debt funds has also led banks that are still actively lending in the market to improve their terms and make their own offerings more competitive, thereby creating a healthier environment.

Leland states that both funds and banks are converging, but believes it is funds that have relaxed their documentation most heavily. “Terms across both private debt and bank lending have become a bit more commoditised recently,” he says. “The documents were tighter among the private lenders in the past but they’re more relaxed now.”

Relaxed terms are certainly good for the borrower. However, this is one area of which private debt funds need to be mindful, as it could directly impact their own returns in the future.

One advisor to the private equity sector, who wished to remain anonymous, told PDI: “I went to a private equity fund’s investor conference where LPs were told the fund manager likes private debt funds because it feels it can exert a lot of pressure on those guys to agree to its terms – terms that a bank would never agree to.”

As the global economy begins to turn, covenants and other terms will come into sharp focus. Debt funds need to remember that the main reason the private equity industry uses their product is to enhance its own returns and minimise its downside.

Although it is still possible for both equity and debt fund managers to work together to straighten out a distressed portfolio company, each will ultimately be pursuing different objectives. It pays to remember that the ultimate client for private debt funds, as with private equity funds, is the fund LP. And when decisions are made, the LP should always take precedence over the sponsor.