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Private equity faces painful choices over distressed assets

PE firms will need to decide how to prop up struggling investments or if they may be better off giving them up altogether.

Challenging economic conditions and higher interest rates are a surefire recipe for a heavy debt burden. While we don’t yet see a tsunami of PE-backed companies in dire straits, pressure is building and funds will need to make tricky decisions to meet their loan obligations.

Several major PE firms including Bain Capital, The Carlyle Group and KKR have ceded struggling assets to creditors or have been in talks about doing so, the Financial Times reported in August. Others have been seeking out financing from private credit or have utilized potentially risky NAV loans—a line of credit secured against the value of all their investments—to keep individual portfolio companies afloat.

Creditors too are coming under pressure as years of covenant-lite lending—comprising loans with fewer protections for lenders and fewer restrictions on borrowers—appear to be coming home to roost, for at least some loans.

Cov-lite debt has accounted for the majority of new institutional issuance in the European leveraged loan markets since 2015, according to PitchBook LCD data, representing 97% of such issuance last year. In the US, the majority of leveraged loans have been cov-lite since 2013, reaching 93% of institutional issuance last year.

 

In the post-crisis period, private credit has accounted for a greater share of the market for leveraged finance, and although the majority of this lending remains covenanted, cov-lite private credit does exist. During the boom period a couple of years ago, in particular, it became more prevalent.

“Almost all private credit deals are floating rate, and for a lot of highly levered companies their cash flow coverage is no longer comfortably covering their interest payments, so they are having to borrow more on revolving credit facilities or use liquidity to make interest payments. This is a challenging situation which can become a crisis,” said Bill Derrough, global co-head of capital structure advisory at investment bank Moelis. He added that this is especially the case when there are no maintenance covenants and management is unfamiliar with a rising rate environment.

Covenants have often been regarded as an early warning system, helping lenders to recognize potential financial difficulties before they become too serious and giving them time to call the borrower to the table to discuss possible solutions.

“Now when lenders get a phone call to say that there’s a problem, it’s often a really big problem, like a ‘we’re going to run out of money’ level of problem or a company has a maturity coming up that they can’t deal with,” Derrough said. “It was far rarer for that to be the first signal of a problem in the old days.”

Creditors on the receiving end of such a phone call will most likely want to know whether a PE firm is willing to put any more of its own capital into the ailing company before they’ll even consider providing any new financing.

For sponsors that are weighing up whether they could be throwing good money after bad, it is crucial to be clear on where the value breaks in the company—for example, how much debt is it carrying and whether there is still any value in the equity.

“In situations where there are question marks as to how much value remains in the equity, the sponsor may sit tight to see how it pans out, and potentially hand over the keys to its lenders if there is a default,” said Matthew Czyzyk, a partner in law firm Ropes and Gray‘s restructuring group in London.

Ceding ownership

Handing over the keys to creditors via a debt-for-equity swap may seem unpalatable, but if a portfolio company is really struggling, it could be the best option for a sponsor, suggested Manuel Martínez-Fidalgo, co-head of financial restructuring for EMEA and Asia at investment bank Houlihan Lokey.

“If it’s clear the company is not performing and you are not willing to invest more capital into it, handing over the keys can be the best outcome. Particularly versus pushing it to the point where creditors take the ownership through an enforcement,” Martínez-Fidalgo said. “There is less noise, less effort devoted to aggressive negotiations between the two parties, less reputational impact and you will be leaving the company in a better condition.”

It also enables PE firms to focus their efforts on companies that are performing well, he added.

But what about the creditors who are taking on struggling companies and may not have the desire or ability to run them? For the vast majority of lenders who won’t have a mandate from their investors to be so hands-on, taking over a company could be a real headache.

It is a scenario lenders need to become more comfortable with, said Moelis’ Derrough. “One of the first things lenders in a leveraged finance transaction should ask is, Am I prepared to own the asset? Because that’s a genuine possibility. Even though a lot of lenders have not had to experience that for a very long time.”

He added: “In the current climate, lenders need to have a game plan in place vis-à-vis taking ownership of companies. It’s more than just recruiting some new people onto the board, it’s thinking and acting like an owner. And some private lenders are not currently set up to effectively manage companies.” Although big firms operating multiple strategies—for example, with a PE arm alongside a private credit arm—are likely to be in a better position.

The current market could also be a busy period for focused distressed lenders, who may proactively seek to take over the positions of other creditors in a struggling company. However, distressed debt PE is arguably becoming a more niche and specialist space.

“As larger funds expand their franchises and adopt a multistrategy approach, we are seeing fewer of the big names actively engage in the distressed space as it doesn’t sit well with their broader franchise,” said Czyzyk. “Old school distressed lender tactics can be quite aggressive and if you have a broader private equity and/or private credit franchise, and you’re trying to persuade companies to engage with you rather than other investors, you want to be viewed as a collaborative partner.”

Private credit lifeline

Private credit may come to the rescue for some portfolio companies struggling to refinance.

“Some private credit funds are more willing to be exposed to that risk for the right premium than the publicly traded leveraged loan market,” said Ambarish Dash, a partner in the banking and finance practice at Herbert Smith Freehills.

NAV loans are another option reportedly being used by some PE firms—secured against the value of their wider portfolio—to pay down the debts of individual portfolio companies. This enables them to secure more attractive borrowing options for the portfolio company. It’s a novel and potentially risky practice.

In an example of both emerging practices, Vista Equity Partners-backed Finastra recently secured a $5.3 billion refinancing package from private credit lenders, including a record-breaking $4.8 billion unitranche loan. Finastra saw rating downgrades earlier in the year and it had been facing potentially difficult negotiations with existing creditors over maturing debts. As part of the deal, Vista Equity Partners reportedly invested an additional $1 billion into Finastra using a NAV loan to help raise the capital.

Featured image by Wong Yu Liang/Getty Images

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    About Marie Kemplay
    Marie Kemplay is a senior reporter for PitchBook based in London, covering private equity and funds. She was previously an editor within FT Specialist focused on investment banking and financial regulation. Marie is a graduate of the University of London, with a bachelor’s degree in journalism and contemporary history, and a master’s in 20th century British history.
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