With the right approach, debt can form part of the solution and not the problem for private equity

“Lenders Flying Blind on Private Equity Risk” screamed the FT last week. The Sunday Times chipped in with “Private Equity Faces A Reckoning”. Both articles were reporting on the Bank of England’s recent alarmist statement regarding the private equity industry and its exposure to interest rate rises. So how worried should the private equity community really be?

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We believe that there are many reasons to be optimistic about the leverage finance market for UK private equity in the mid-market. The robustness and breadth of debt markets is proving to be a key positive in supporting private equity, we are seeing lenders:

1. Provide flexible capital for borrowers still transitioning after the post pandemic inflationary spike;
2. Enable sponsors to return cash to LPs while a valuation expectations gap exists between sellers and buyers; and
3. Improve return multiples by actively supporting buy & build strategies.

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This is a super interesting time for debt advisors as we support our sponsors across a full range of transactions, including stretched refinancing mandates, dividend recapitalisations and more mainstream buyouts. Our recent experiences demonstrate the debt markets remain in rude health and there are pockets of capital available for most reasonable borrower needs. There continues to be increased polarisation from lenders compared to pre-pandemic. This places the onus on borrowers to put in the effort to sell their credit to maximise lender traction and optimise terms. It is more important than ever to select the right advisor, who will help borrowers prepare properly before they approach the market and who will identify the right pool of lenders to approach.

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Supporting of borrowers in transition

Borrowers faced a perfect storm as they came out of the pandemic with weakened balance sheets into a low growth and high inflationary environment. Helpfully, the growth in private credit has resulted in lower levels of restructuring events compared to previous crises. We have seen private credit lenders:

1. Support their portfolio companies and behave in a largely commercially predictable manner. Subject to borrowers presenting credible business plans that demonstrate a flightpath back to normalisation and mitigating liquidity risk, we have seen direct lenders acting in a reasonable manner and utilising levers such rolling interest to support their portfolio companies.
2. Offer alternative flexible capital to refinance stretched credits. The rise of private capital has opened the door to a whole range of different products capable of pricing risk differently and offering bespoke solutions, such as transitional capital and/or integrated finance. These solutions enable borrowers to buy time to implement their plans, normalise their balance sheets and create equity value.

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Enable sponsors to return cash to LPs

The expectations gap in valuations between buyers and sellers has reduced M&A deal flow and created fewer opportunities for lenders. This has created a pent-up need to deploy capital, particularly amongst the private credit community. As a result, we have seen exceptionally strong appetite on processes for higher quality credits, and we heard of increasing unsolicited approaches to sponsors from lenders suggesting recapitalisations. Debt serviceability remains a key feature that has marginally constrained debt capacity in a higher interest rate environment. This is where the breadth of the debt market can offer solutions, as there is now more opportunity for banks and stretched senior providers to compete on leverage for stellar credits at a better price.

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Improving returns by supporting buy and build

When valuations are under pressure, there is increasing importance on how debt can support a buy and build strategy to enhance returns. Lenders like to provide follow-on capital to existing borrowers because known credits are perceived to be lower risk. If the borrower can sell the credit story regarding their acquisitive plans (e.g. demonstrating the considered nature of their strategy, their track record and the credibility of their integration plan), lenders will buy into the idea that acquiring scale will help them to de-risk their position. This means that they are increasingly open minded to ‘pre-baking’ re-leveraging into documentation. This provides more certainty regarding the availability of follow-on firepower and enables private equity to drive returns by funding bolt-on acquisitions without the need for any dilution.

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BDO Debt Advisory

Over many years BDO Debt Advisory has established a reputation for offering a differentiated approach that truly prepares credits for market, which empowers lenders to put their best foot forward. When married with our problem-solving approach, we do not need to quote the market, we drive it and create innovative debt structures that align with our clients funding objectives. With increasing polarisation in lender appetite, the importance of this approach is further elevated, as is the value that it delivers.