Looking for the Private Equity Lending Train Wreck in All the Wrong Places?

There’s a lot not to like about how private equity managers use debt, the degree that some commentators are pointing to private equity being on track to cause a new financial crisis. As much as we aren’t fans of private equity, we’ve explained why these concerns are overblown, particularly with regard to collateralized loan obligations. However, a new wrinkle on how private equity firms are getting to higher levels of leverage has the potential to be dangerous if it were to become widespread.

How Private Equity Wrecks Companies

The big sin is that private equity’s business model, where nearly 2/3 of revenues have nada to do with performance, so they profit whether their deals work out or not. That makes them not all that cautious in levering up companies to goose their returns, since their equation is “Heads we win, tails we win, just not as much.”

The media has finally started paying more attention to companies whose failure was largely due to private equity companies loading their acquired companies with excessive borrowings, with Toys’R’Us the poster child. Even so, the damage done is almost certainly more extensive than most would infer from reading the business press. For instance, the conventional narrative is that it is Amazon that has been the destroyer of retailers. While Amazon has been a wrecking ball in some sectors, private equity has also played a very large role. Not only would they borrow heavily against these cyclical businesses, but they would also strip them of stores they owned, selling the real estate and having the retailer lease it. That would saddle the chains with an even higher level of fixed payments, making them more vulnerable to recessions.

How Dangerous is Lending to Private Equity?

It’s not hard to see that private equity is often a hazard to the health of the companies it buys. How about to lenders, and more importantly, to the financial system? After all, bankruptcies generally result in loan restructurings, which is a polite way to say, “Agreeing to take losses.” And it would add insult to injury to have private equity looting for fun and profit wreck banks, who if they are big, would be bailed out, further confirming that private equity’s gains often come at considerable collective cost.

Simple old-fashioned lending, if done badly enough at scale, will cause financial a financial. The Latin American debt crisis and the S&L crisis involved conventional loans. The last big blow-up of private equity loans, in the late 1980s, was masked by the much larger S&L crisis, and also by the fact that Japanese and German banks were big buyers of those syndicated loans.

The 2008 crisis was different. Even though subprime loans were a significant market and did show heavy losses, the market wasn’t large enough by itself to create a near-death event for the global financial system. The financial crisis was a derivatives crisis, with side bets on subprime mortgages estimates at 4 to 6 times the value of the actual loans. On top of that, the parties on the wrong side of those wagers were overwhelmingly themselves highly leveraged, systemically important financial institutions. We explained long-form in ECONNED how a collateralized debt obligation strategy devised by the hedge fund Magnetar managed to subvert the normal arbitrage mechanisms that should have led the cost of betting against subprime to rise as more wagers were made.

Financial commentators have from time to time taken to worrying that collateralized loan obligations, which are used to package and tranche the risk of risky loans, almost entirely the “leveraged loans” used to fund private equity purchases of companies, pose similar systemic risks to CDOs. We debunked that notion in a recent post (which Nathan Tankus re-reported; both Nathan and I responded to Partnoy’s objections). There’s a lot of devil in the details in understanding why CLOs are unlikely to have amplified the risk of lending to private equity deals much if at all. From our first post this year on this topic:

Now let’s look at CLOs. They are intrinsically less risky than asset-backed-securities CDOs, which the press took to calling just “CDOs”.

Those CDOs were resecuritizations. They were created from the riskiest parts of mortgage securitizations made of risky loans, as in subprime or Alt-As. Those tranches usually represented only 3% of the entire deal. They’d be worth 100% if the losses on the subprime RMBS were 8% or less, and totally wiped out if the losses were higher than 11%. Since subprime losses averaged more like 40%, nearly all these CDOs were complete wipeouts.

By contrast CLOs are made from risky corporate loans, so-called “leveraged loans” typically made when a private equity firm is buying a portfolio company. So they are more analogous to a subprime RMBS (residential mortgage backed securitization) in terms of the risk level of the assets.1 Note that even with the high level of subprime losses, AAA tranches of RMBS lost only 0.42% on average.

Even though there was a tidal wave of risky “leveraged loans” to fund deals at sky-high prices right before the last crisis, and a lot of them wound up in CLOs, while their value traded down afterwards there were no losses. Admittedly, the Fed dropping interest rates and manipulating long-term rates lower allowed many of the pre-crisis loans to be refied at lower rates. But the Fed didn’t engage in measure intended to rescue corporate borrowers; they were just lucky beneficiaries.

Nevertheless, CLO structures have been made more conservative since the last crisis. See here for geeky details.

That’s before getting to the fact that the CLO market is way smaller relative to GDP than subprime bonds were…and they aren’t leveraged the way CDOs were, nor are CDS used to create CLOs (this was
the case prior to the crisis….).

But Are Things Changing?

One thing that is new-ish but not really new is that a risky practice, dividend recaps, that was in vogue briefly, then discredited, is back. And of course it involves yet more debt.

A dividend recap is a particularly aggressive way for private equity to suck money out of a company. After the general partner has bought a company, they put more debt on it and dividend out the most if not all of the proceeds of the loan. Clayton & Dublier notoriously did a dividend recap of Hertz in 2006, less than a year after it acquired the company. It had a A discussion in Forbes a few years after that deal (emphasis original):

Dividend Recapitalizations Programs—An Action We Should All Fear

Dividend recapitalizations (also referred to as a “recap”) are financial events whereby existing shareholders receive dividends in excess of annual free cash flows, thereby altering the firm’s financial structure. Both the entity’s cash may be removed and substantial debt assumed in the process. Although such programs are typically associated with a private equity (PE) firm, publicly held companies may also engage in a dividend recapitalization. Since the dividend is not covered by the free cash flows, thus leveraging the financial structure, the firm’s fixed charge coverage and financial flexibility are negatively impacted….

Firms which have been through recaps, like Hertz, may not have defaulted, but have been placed in a precarious position from which they may never recover. The list includes Hexion Specialty Chemical (HXN), Burger King (BKC), KB Toys, Warner Music (WMG), Burlington Coat and countless others who have enriched their PE firms, yet in so doing have dismantled once solid, position-leading organizations.

Note that Hertz, Hexion and KB Toys did go bankrupt; Burger King and Burlington Coat are in bad shape.

Yet thanks to our super-duper low interest rates, dividend recaps are back! From the Financial Times:

So far in September, almost 24 per cent of money raised in the US loan market has been used to fund dividends to private equity owners, up from an average of less than 4 per cent over the past two years. That would be the highest proportion since the beginning of 2015, according to monthly data from S&P Global Market Intelligence.

The Financial Times editorial board even weighted in to criticize the practice:

The surge in so-called dividend recapitalisations has, rightly, rung alarm bells among finance watchers.

Even before Covid-19, companies had taken on unprecedented levels of debt. Combined with the near-total lockdowns that brought most economic activity to a halt — and with the prospect of more to come amid a resurgence of the virus — it is inevitable there will be a flood of bankruptcies.

But notice that that 24% for part of one month isn’t outside post-crisis levels. And at least historically, banks have argued that their loans to divided recaps are on average on better terms than to LBOs.

Put it another way: this trend is too new to be sounding alarms, at least for lenders. But the Financial Times is correct that these dividend recaps are creating more bankruptcy risk when the economy has become extremely fragile, and this obviously greedy action will make it politically more difficult to provide Covid-related aid to private-equity-owned companies.

What About Borrowing at the Fund Level?

But what could change this picture is leverage on leverage. Let’s turn to a section of a January 2017 article by the Financial Times’ Gillian Tett:

““Hi Gillian,” the message went. “I have been working in the leveraged credit and distressed debt sector for 20 years . . . and I have never seen anything quite like what is currently going on….”…

He then relates the case of a typical hedge fund, two times levered. That looks modest until you realise it is partly backed by fund of funds’ money (which is three times levered) and investing in deeply subordinated tranches of collateralised debt obligations, which are nine times levered. “Thus every €1m of CDO bonds [acquired] is effectively supported by less than €20,000 of end investors’ capital – a 2% price decline in the CDO paper wipes out the capital supporting it.

“The degree of leverage at work . . . is quite frankly frightening,” he concludes. “Very few hedge funds I talk to have got a prayer in the next downturn. Even more worryingly, most of them don’t even expect one.”

There are more leverage on leverage approaches afoot in private equity…although most observers have been sanguine because banks are perceived to be very well secured.

In addition to borrowing at the level of the various companies that private equity funds buy, the general partners are also borrowing at the level of the fund. Howard Marks of Oaktree Capital decried the practice but it had become common in 2017 and we understand it is now widespread.

Notice the fuzziness of “We understand”? In virtually all cases, private equity limited partners don’t consent to these fund-level borrowings, nor are they told much about them. From a 2016 post:

For the last couple of years, we’ve been monitoring a troubling development in private equity, the use of “subscription line financing”. This innocuous-sounding term is for a credit line, offered by a bank, to allow general partners to borrow at the level of the investment fund. This is in addition to the considerable borrowing that already occurs in private equity, at the portfolio company level, where 70% of the purchase price typically comes from lenders.

This practice, which even major players like Bain Capital decry as dangerous, appears to have gone mainstream. As we’ll explain, these credit lines make already-exaggerated returns in private equity look more attractive than they are, not merely through the raw application of leverage but by changing how investment cash flows are reported. And they greatly increase the risk of investing in private equity during financial shocks. That risk obviates out one of the supposed advantages of private equity, that private equity appears to do well in bear markets, when in fact private equity partners are merely providing rosy portfolio values. The more general partners use these subscription lines of credit, the more private equity will amplify investor risks rather than reduce them….

Early in the life of a specific private equity fund, investors will report negative returns. This will occur in the first year or two, after the investor has incurred management fees and had some initial capital calls. Unless the general partner has an aggressive, fast strategy for monetizing the investment (say the now out-of-favor “dividend recap” in which the GP loads the acquired company with lots of debt and pays investors a large special dividend), for at least the initial year after making an acquisition, the GP is likely to report the value of the portfolio company as par value, meaning the acquisition price. So when you include the management fees and the cost of closing the deal, the limited partners’ reported returns will be negative. This pattern is called the “J curve”.

Without belaboring the topic, the subscription lines of credit are to goose reported returns by solving the J-curve problem. This sort of thing goes on even though investors in private equity are supposedly seeking to put their money to work in long-term investments, and not rely on other people’s money.

Oh, and back to why is no one is much worried about the risk to banks? Because these subscription lines are secured by the uncalled capital commitments of the limited partners! Meaning the expect deep pockets like CalPERS are on the hook to respond to capital calls, and not the private equity funds. LACERS admitted to being hit with capital calls, and its explanation suggested it was due to subscription credit lines.

But a new way of lending to private equity funds, as opposed to private equity companies, is getting starting to become popular to borrow at the fund level is a so-called NAV (Net Asset Value) credit facility.

These credit lines are designed for private equity funds where the investors subscriptions have been largely used up, so there is little or no borrowing capacity left under a subscription credit line. So these NAV lines of credit borrow against the value of the portfolio. From an overview by Mayer Brown:

Some Lenders in certain high-quality asset classes will consider NAV Credit Facilities on an unsecured basis. But while most Lenders recognize that complete security over all the Investments is commercially challenging, there is a strong preference among Lenders towards a secured facility. Thus, while NAV Credit Facilities are not typically secured by all the underlying Investments, they are often structured with a collateral package that does provide the Lender with a certain level of comfort compared to an unsecured exposure. The collateral for these Facilities varies on a case-by-case basis, often depending on the nature of the Investments the Fund holds. In many NAV Credit Facilities the collateral includes: (1) distributions and liquidation proceeds from the Fund’s Investments, (2) equity interests of holding companies through which the Fund may hold such Investments or (3) in some cases, equity interests relating to the Investments themselves….Thus, in a workout scenario, the Lender could foreclose on the equity interest collateral, and either take ownership control of the interests in the holding companies or sell such equity interests and apply the foreclosure sale proceeds to its debt.

As one private equity expert pointed out:

Fur years ago, but everyone said, oh no, there’s no reason to worry about fund-level borrowing, it’s all collateralized by uncalled commitments so it’s not as bad as you think. But now it turns out that these “NAV lines” are secured by the fund’s assets and also have tighter covenants. So in a rapidly deflating asset value macro environment, it seems like this could trigger a run on the bank.

Now in reality, the damage to banks would hinge on how many NAV lines they had done, and also how much in other private equity exposure they had. Recall that even though they have often bought CLOs, banks overwhelmingly hold the AAA tranches. We’ve pointed out that these structures are more analogous to RMBS than CDOs in their risk levels, and that AAA tranches of subprime RMBS suffered only 0.42% in losses.

So unless the banks go hog wild, their exposure still seems to be not dreadful. Yes, they would be bloodied but not mortally wounded.

By contrast, private equity investors look to be setting themselves up for a world of hurt. They are exposed to subscription line capital calls. They now are also at greater risk of having their assets in mature funds takes away if NAV credit line borrowings go sour. And like CalPERS, many are or planning to invest in private debt, mainly or entirely via private equity credit funds, which invest in riskier debt exposures than banks do, so they are also exposed to credit losses on the debt side. And CalPERS, as most readers know, plans to create its own leverage on leverage by borrowing 20% across all its funds.

A wild ride is in the offing, but how wild depends on how long the private equity debt binge continues.

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9 comments

  1. vlade

    PE lending will hurt PE investors. Which is why it’s dumb that people like CalPERS still want to increase PE exposure. At the time when it’s obvious it’s gonna hurt?

    Catching falling knives and all that..

    Reply
  2. ObjectiveFunction

    OK, I’m an old fashioned country “project level” guy, so I’m going to dumb this down a lot. I have no problem with getting slapped upside the head by Much Smarter Big Picture People for missing obvious points, but I don’t think I’m alone.

    1. Finance 101 says: equity investors (shareholders) are only paid what’s left over, after all other obligations are met (well, there are management fees, cascades, etc.)

    …So back levering the fund equity means (?):
    (a) LPs* get paid the bulk of the loan proceeds, but also get lower dividends going forward, as lenders get first call on free cash; and
    (b) Because the portfolio itself is already levered, lenders at fund level are effectively subordinated; they can only claim against what the portfolio companies dividend out. So they presumably price that into the rate, or shorten the term, or require a DSCR.* All of which also hits equity returns….

    2. But I guess who really gives a toss? if after the initial restructuring (refi, asset stripping, and layoffs, etc.) you (the GP) have declared a giant special dividend that recovers the entire original equity investment, and then some.

    …In that case, every year the NAV house of cards stands before collapsing into bankruptcy is pure gravy. So hell, why not lever up the fund itself and dilute the risk across your TBTF ‘relationship’ banks? They get bonuses, join your team later, etc.

    …And if the underlying portfolio proves sturdy enough to limp along until exit, then go find that starving-for-yield g̶r̶e̶a̶t̶e̶r̶ ̶f̶o̶o̶l̶ pension fund to pay your 25% pop: beach houses for all! Bonus points for ‘hockey stick’ fantasy forward valuations, e.g. renewable/ fintech/ blockchain/ virtuesignalingmandatedwankofthemonth

    So isn’t this all basically a big bet (mostly with other people’s money) on how long the Fed keeps the punch bowl filled before it all goes to hell? A bet which has paid off in spades since 2007. So why stop now?

    3. When I read about Muddy Waters / Carson Block’s latest expose of a US-listed Chinese company, what usually seems to emerge at the heart of the scam is that the same (overvalued) collateral has been pledged a dozen times over to different counterparties, but somehow overlooked by complaisant auditors.

    Is that some of what’s happening here, or could happen once NAVs start to plunge?

    * For those who hate acronym soup: Limited Partners. General Partners. Debt Service Coverage Reserve.

    Reply
  3. Susan the other

    “Net Asset Value” has been so hollowed out by debt financialization it is a wonder anyone thinks there is a difference between assets and liabilities. Because there really isn’t. Any last morsel of profit earned from this boondoggle all hinges on a set up to make “limited partners” hold the bag. On “uncalled capital lines” of “net asset values” of fund of funds which have subscription lines of credit based on net asset values. Are you kidding me? Embedded debt is all there is. I’m curious to know just who the ultimate persons of interest are in any given Fund of Funds? Banks might be relatively immune from a debt implosion but the economy is not. Hence the Fed. My question is, when does this come to an end? If implosion is de-fused by the Fed, what marks the end of commerce in a valueless economy? Am I overreacting?

    Reply
    1. drumlin woodchuckles

      I am unqualified to even speculate about whether you may be overreacting or not.

      But what if you are not? Do you have a house and yard? If you do, have you turned the house and yard into a low-profile survivalist doomstead?

      Reply
  4. Chauncey Gardiner

    Thank you for this educational post. What a house of cards! And we wonder why negative real interest rates have been implemented with calls for even deeper nominal rate reductions in an effort to perpetuate the illusion. To the observation of the congressional representative from Minnesota, “It’s all about the benjamins,” I would only add that it’s also about the rate elasticity of debt service and collateral values. Unfortunately, every rate cut has been used to engineer new deals at higher levels of debt leverage with even more egregious terms, as we are seeing with the dividend recap deals and NAV deals at the fund level.

    Reply
  5. RickV

    Thank you for the insightful piece. It underscores the importance of SEC oversight (or rather lack of). These legal company robberies need to be made illegal.

    Another place to look for a train wreck is in the new SPAC market. Another enabling financial engineering devise designed to enrich rentiers at the expense of existing stakeholders including employees.

    Reply
  6. Chris Herbert

    Two words, debt deflation. One name, Michael Hudson. Hold on to your pants because just about everything else is going into the toilet.

    Reply
  7. Sound of the Suburbs

    The economics of globalisation has always had an Achilles’ heel.
    In the US, the 1920s roared with debt based consumption and speculation until it all tipped over into the debt deflation of the Great Depression. No one realised the problems that were building up in the economy as they used an economics that doesn’t look at debt, neoclassical economics.
    Not considering private debt is the Achilles’ heel of neoclassical economics.

    What could possibly go wrong?
    Hard, isn’t it?

    Reply
  8. Thor's Hammer

    The Private Equity Business Model
    “A fact-based fictional History”

    Back in Olden Times when Mitt Romney was just an ambitious 30 year old junior executive at Bill Bain’s investment shop he came to his mentor with an idea for a new business model with tremendous profit potential. The basic formulation was/is as follows:

    1- Use Bain’s access to bank lending and investors capital to create a war fund.
    2- Search out companies that were on a sound operating basis but had hopes of expanding their businesses beyond their current scope.
    3- Acquire the target businesses using borrowed funds and load them up with debt.
    4- Extract the companies lifeblood through management fees and loan origination fees.
    5- Sell off all divisions and assets of the company that have marketable value.
    6- If the company still remained economically viable, continue to run the company as an ongoing enterprise.
    7- Or if is normally the case, bankrupt the dead husk of the company and leave it blowing in the wind.

    Bill Bain’s response to Mitt: “Great idea, and I’ll let you run with it under one condition. You can’t F*** over any of my current investors or the companies they own.” This left Mitt in a quandary as he needed to raise seed money and all the really rich people he knew were contacts from his position as a junior officer with Bain Capital.

    During that era the US was heavily involved in supporting the right wing forces fighting the peasant liberation movements and leftists in Central America. Private armies and death squads were the primary tactics of the Oligarchs, but it was difficult for the CIA to provide direct support for such activities. So when Mitt contacted one of his old school chums about becoming a channel for US Central American policy it was a natural fit. Salvadorian Oligarchs and landowners provided Bain Capital with 8 million dollars in seed money to found Romney’s private equity company and became the primary investors (wherever the money came from). Salvadorian death squads continued to operate with impunity throughout that tragic and drawn out conflict. And Romney’s (death squad) private equity business model ravaged target business throughout the US long after the war in El Salvador had devolved back to the usual level of corruption and poverty.

    Reply

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