By Jon Sindreu
While sometimes useful, financial innovation has a way of creating conflicts of interest. Private markets are now a key testing ground for this.
Borrowing through what is known as "net asset value financing" has become popular among private-equity fund managers, who have been going through a rough patch since central banks started pushing up interest rates at breakneck speed. It allows them to borrow money using their portfolios as collateral. NAV loans experienced a 30% compound annual growth between 2019 and 2023, hedge-fund administrator Citco estimates, benefiting specialist lenders such as Dawson Partners and 17Capital, which is majority-owned by Oaktree Capital Management.
These loans usually pay an interest rate of above 10% and, while subordinated to the debt of the companies in the private-equity portfolio, have relatively safe loan-to-value ratios of between 10% and 25%. According to the Fund Finance Association, it is a market that amounted to about $100 billion in 2022, but is poised to reach $600 billion by 2030.
Of course, adding debt to the already indebted business of private equity is always a risk. Still, absent a big-risk event like a recession, lenders are set to win big.
The interests of those who borrow, however, might not be equally well-served.
In private equity, a general partner, or GP, creates a fund by raising money from institutional investors and spends a few years building up a portfolio of companies. Typically, the purchases are done with debt loaded onto the books of the acquired companies. After about five to seven years of attempting to make the firms more profitable, the GP typically proceeds to sell them at a higher price, either to public investors, a corporation or another private-equity firm.
The problem is that these exit deals are harder when interest rates are volatile. And so, over the past two years, private-debt markets -- once confined to financing takeovers of middle-market companies, but which have expanded everywhere -- have become an obvious way to kick the can down the road.
In some cases, it has been the individual companies in the portfolio that have issued more debt. In others, GPs have used NAV loans to borrow against their portfolios. Roughly 80% of the money raised this way has been used to help the companies in those portfolios, the FFA said, for example by financing small acquisitions.
This runs counter to one reason why private equity became popular in the first place, though. Before the likes of KKR and Blackstone sparked the buyout boom of the 1980s, a common way to build a portfolio of investible private businesses was for a listed holding company to acquire them. Berkshire Hathaway, once a textile manufacturer, became just that under Warren Buffett, as did old cigar maker DWG -- today's Wendy's -- under Victor Posner and later Nelson Peltz. But conglomerates started to underperform, and investors saw the advantage in having every company they owned insulated from the other.
By taking up debt at the fund level, one bad apple can once again affect the others.
But the largest concerns affect the other 20% of NAV loans. GPs have used them to send cash to their clients without having to sell assets at an inconvenient time.
Do end-investors even need the money? A big chunk of them, including many pension funds, already own large coffers of safe, liquid assets they can use as collateral to borrow at a rate that is in the low single digits.
"One of our GPs is behaving badly, using NAV financing to send back money while portfolio risk increases. I have to pay 14% interest for this money," said Eric Deram, who invests in private-equity funds on behalf of institutional investors at Flexstone Partners, owned by Natixis Investment Managers.
While some investors are actually liquidity-strapped, there are other ways to help them, such as rolling over the assets into "continuation funds," which have also become popular of late.
Critics say that GPs have a big incentive to borrow and send back the cash. Doing so artificially boosts near-term returns, and can entice existing investors to pile into the next shiny fund that the private-equity firm is trying to raise, which is essential to grow faster and lay a claim to an even larger pool of fees.
Indeed, a recent survey by advisory firm Rede Partners found that 59% of end-investors believe that their GPs aren't providing enough information about NAV facilities. Advisory committees are often not consulted, they complain. Yet, the survey also shows that 61% of investors aren't deterred from investing in a fund if it uses NAV loans.
To be sure, the practice of funding distributions this way has eased following a 2023 craze, and works differently depending on whether repaid loans are "recalled" or not.
17Capital managing partner and co-founder Augustin Duhamel, underscores that the market is slowly learning to properly use this product, which wasn't foreseen when most existing funds were created.
Nevertheless, some investors warn that their GPs remain overly eager to borrow even as rates come down and exits improve -- in the third quarter, they were the highest since 2021, according to PitchBook figures. Flexstone's Deram said that he faces big difficulties in introducing legal language that limits NAV loans in new funds he is involved in.
In private equity, the fine print is getting finer.
Write to Jon Sindreu at jon.sindreu@wsj.com
(END) Dow Jones Newswires
November 29, 2024 07:00 ET (12:00 GMT)
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