It Started With A Deal

In early March, Carlyle Group was on the brink of a takeover deal valuing healthcare software firm Cotiviti at $15 billion, a move emblematic of the audacious deals large private equity firms had been orchestrating over the past decade, fueled by a period of low interest rates. More than a dozen private lenders, including the credit divisions of Blackstone, Apollo Global, Ares, and HPS, were prepared to approve a record $5.5 billion private loan that would have given Carlyle control of Cotiviti.

  • However, the process faced unexpected delays. The primary obstacle was a surprising setback for Carlyle, one of the most influential private equity firms. They were unable to secure their approximately $3 billion equity commitment from investors.
  • The yield on the debt financing, around 12 percent at the time, threatened to overshadow the returns Carlyle was aiming for, which deterred potential investors. In response, Carlyle tried to renegotiate the $15 billion valuation, but Veritas Capital, the existing private equity owner, abandoned the sale.
  • At the time, many industry insiders viewed this as a significant setback for Carlyle, attributing it to company-specific issues or concerns about a potential banking crisis in the US.

In hindsight, this episode foreshadowed the challenges facing the private equity industry as interest rates remain higher than anticipated just 18 months ago. Cotiviti has not seen any alternative deal emerge since March, suggesting that the challenges extend beyond a single private equity firm.

Rising Interest Rates Pose Challenges for Dealmakers

The prospect of enduring higher interest rates is sending shockwaves throughout the economy, as companies of all sizes grapple with refinancing debt and governments face higher borrowing costs.

  • Private equity, which thrived during the era of low interest rates by utilizing abundant and affordable debt to acquire numerous companies, now finds itself facing a headwind rather than a tailwind.
  • Patrick Dwyer, a managing director at NewEdge Wealth, noted that much of the private equity sector's outperformance was not solely due to skill but rather the availability of cheap borrowing and liquidity.

Now, with borrowing costs rising and liquidity becoming scarcer, private equity is entering a challenging period.

A Temporary Fix

In response to the abrupt interruption in new capital inflow into their funds and the refinancing pressures on existing investments, private equity groups are resorting to various financial engineering strategies. They are increasingly leveraging the combined assets of their funds to generate the cash needed to pay dividends to investors. Some firms are shifting away from making cash interest payments, conserving cash in the short term while adding to their overall debt burden.

  • Private equity executives remain optimistic, asserting that these difficulties will be short-lived and that periods of stress often create opportunities for the best deals.
  • They argue that the unconventional financing tactics are temporary solutions in an industry that still possesses substantial uncalled investor capital, often referred to as "dry powder."

However, others see these financial engineering tactics as symptoms of a deepening crisis, as private equity's modus operandi, which thrived in a low-interest rate environment, may need to adapt to higher rates for an extended period.

Paying Interests On The Debt Load

Enterprises rated as single-B or lower confront a significant debt maturity hurdle, with approximately $200 billion due in 2024-25 and around $1.1 trillion in 2024-28. The interest coverage ratio for these companies, measuring the extent to which operating earnings cover interest payments, is anticipated to drop from 1.32 at the end of 2022 to 0.91 by December, according to Moody's, and it could decline even further. A ratio below one indicates that earnings are insufficient to cover interest costs.

  • With their financial health under pressure, many firms are turning to payment-in-kind (PIK) debt, deferring interest payments and adding them to the overall debt load to alleviate short-term cash flow constraints.
  • While this provides temporary relief, it is a costly form of borrowing that diminishes future returns for equity investors and may backfire if the company does not grow rapidly enough to cover future interest expenses.
  • This year, Platinum Equity's portfolio company, Biscuit International, issued €100 million of PIK debt at an 18 percent interest rate to address short-term balance sheet issues. In an unusual move, Platinum itself provided the financing. Solera, another Vista-owned software firm, swapped some of its existing cash-pay debt with PIK notes during the summer, according to filings with U.S. securities regulators. These deals have been characterized by some as a "Hail Mary."

However, not all private-equity-backed companies have been able to navigate the challenges posed by rising interest costs. Default are on the rise, and lenders are increasingly taking control of creditor companies at the expense of equity owners. In recent months, KKR, Bain Capital, Carlyle, and Goldman Sachs have relinquished control of businesses they supported. S&P Global predicts the U.S. default rate will rise to 4.5 percent by June next year, up from 1.7 percent at the beginning of 2023.

Financial Engineering

Before private equity firms secure new investments, investors typically expect returns from prior ventures. To fulfil these expectations, firms are increasingly turning to financial engineering and intricate fund structures.

  • Hg Capital, one of Europe's major buyout groups, has pioneered a model that other firms like EQT and Carlyle are emulating. This approach involves holding onto top-performing assets for extended periods, transferring them between funds, and generating returns for investors by selling small portions of these firms to other stakeholders.
  • Through these tactics, Hg has held Norwegian accounting software company Visma for nearly two decades, witnessing its valuation surge from about $500 million to almost $25 billion, making it one of the industry's most substantial returns.

Hg Capital has also been at the forefront of another strategy, utilizing the cash flow from their already leveraged assets to borrow additional funds to meet investor payout requirements, a practice known as net asset value financing. The firm has leveraged this form of debt to return hundreds of millions of pounds to investors, with the loans secured against assets across multiple funds.

No Liquidity

Even when private equity firms manage to list companies they own on public markets, the outcomes have been far from straightforward. Several businesses, such as Bumble, Oatly, Olaplex, Chewy, and Petco, have seen their valuations decline substantially since reaching highs in 2021, resulting in more than $50 billion in investment gains evaporating.

  • Amid a challenging exit landscape, private equity firms are exploring alternative options, including net asset value (NAV) loans, to expedite distributions, as traditional exit routes, such as selling to other companies or initial public offerings, become more complex.
  • Banks are seizing this opportunity, pitching NAV loans to investment firms struggling to sell their portfolio companies.

However, this type of borrowing has grown more expensive and has attracted increased investor scrutiny due to the risk that sound assets within a portfolio, pledged as collateral, may need to be sold to repay the loans. Firms are also turning to other forms of borrowing, such as swaps, margin loans, and structured equity sales, to generate cash for dividends.


Please note that Benchmark does not produce investment advice in any form. Our articles are not research reports and are not intended to serve as the basis for any investment decision. All investments involve risk and the past performance of a security or financial product does not guarantee future returns. Investors have to conduct their own research before conducting any transaction. There is always the risk of losing parts or all of your money when you invest in securities or other financial products.


Photo by João Barbosa / Unsplash.