LONDON (Reuters Breakingviews) - It’s not easy being a private equity manager. Stock prices are elevated, and debt markets are only willing to lend so much on deals, as regulators limit banks’ risk appetite. Even so, buyout firms are still finding new ways to sweeten returns.
Private equity managers typically fund purchases of companies with debt, and walk away if things go awry. Now, according to bankers, they are increasingly borrowing against their own stakes in companies, rather than loading debt onto the companies themselves.
Take an ordinary initial public offering, like Advent International and Bain Capital’s listings of Worldpay and Nets in 2015 and 2016 respectively. As with most private equity-backed IPOs, the buyout firms sold shares in the company to repay debt. The snag is that getting debt down to the roughly three times EBITDA level tolerated by public markets in Europe would mean selling a lot of stock to reduce gearing, and therefore foregoing potential upside in the share price. Instead, by taking out an extra loan against their retained shares, the private equity firms were able to bring their portfolio companies’ debt down sufficiently, and funnel money back to investors.
Such loans could pose a problem. The portfolio company’s stock might fall in value, allowing the lending banks to seize the stake and push the price lower by selling it. The fund could thus lose its investment, or have to ask investors for cash.
Buyout groups can protect themselves. One way is to borrow at a steep discount to the value of the shares - the market norm is a loan-to-value ratio of about 25 percent to 30 percent, according to market participants. The other is to create a backup line of credit that could be used to buy back the shares, at the fund level.
Still, the new kinds of leverage should give investors pause. So far the evidence is that firms are using this tool sensibly and rarely, despite the overtures of some banks. The risk is that they borrow too much, against unsuitable companies. That could endanger their investments, or force them to scramble for cash and sell other assets. The 2008 credit crisis saw leveraged funds get into trouble. With investment banks pushing these new products, managers will need to resist the urge to borrow.
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