Flexible Capital: Operating in the Void Between Senior Private Lending and Traditional Private Equity
From the wake of the Great Financial Crisis to the waning days of the COVID-19 pandemic, many businesses have thrived in an environment marked by low interest rates, predictable inflation and elevated consumer demand. This environment catalyzed significant deployment by the private equity industry, pushed valuation multiples up and helped companies fetch premium valuations. Today, in what some market observers are calling the “post-Goldilocks era,” certain tailwinds have shifted to headwinds.
Many companies that once had sufficient cash flow to comfortably service their debt and invest for growth may now struggle to balance these priorities and are faced with difficult decisions. In particular, certain companies acquired by private equity sponsors through highly leveraged buyouts have seen declines in their leveraged free cash flow caused by the large rise in their borrowing costs. With increasingly burdensome capital structures and imminent debt maturities, sponsors are weighing whether to (i) monetize aged positions at potentially lower valuation multiples or (ii) extend and recapitalize the debt obligations of these portfolio companies to provide additional runway. Both options have implications that warrant close consideration and create opportunities for opportunistic flexible capital.
Given compression in valuation multiples over the last two years, exiting an asset today might not achieve a sponsor’s targeted return. Even if a sponsor is willing to accept lower returns, their typical exit paths are not as readily available in the current environment, marked by a deficit of private equity dry powder versus unrealized assets, reduced sub-investment-grade debt issuance, increased anti-trust scrutiny for M&A, and soft IPO markets.
With this market backdrop in mind, private equity sponsors are more often choosing to hold their positions for longer. As such, private equity sponsors and corporate leaders face a complicated question: how can they obtain additional capital – to either delever or play offense – while minimizing dilution at a potentially depressed valuation, all while keeping control?
Enter flexible capital solutions – a range of privately negotiated liquidity solutions that can be achieved through customized mixes of debt, equity and other bespoke instruments. These solutions are increasingly sought out by companies looking to address capital structure and liquidity complexities - or to help pursue inorganic growth via M&A - and by private equity sponsors seeking to create distributions or extend hold life as they navigate a challenging monetization / exit and financing environment.
Private Equity Faces a Conundrum
Following the Great Financial Crisis, a robust fundraising environment produced a supply of dry powder in private equity funds that closely matched the unrealized value of existing sponsor-backed companies. We believe this facilitated a virtuous cycle of buying and selling of assets between various private equity sponsors at increasing multiples, often supported with higher levels of leverage. Today, the unrealized value of sponsor-backed companies dwarfs buyout dry powder by 2.5:1, meaning sponsor-to-sponsor sales are a less reliable path to monetizations.
Global Buyout Unrealized NAV Outpacing Dry Powder
The exit gridlock is evidenced by the trailing historic pacing of limited partner distributions (“DPI"), which has declined meaningfully. As an example, 2018-vintage funds are 60% behind historic levels of DPI, while 2020-vintage funds are 80% behind1. This has led sponsors to seek distribution proceeds from structured dividend recapitalizations at the investment level – oftentimes utilizing flexible capital to fund proceeds – or at the fund level (e.g., NAV loans).
Global Buyout Average Distributions to Paid-In Capital (DPI)
Separately, not only have companies become increasingly cash constrained by higher interest costs, they also need to address their looming debt maturities – such as the $235 billion of below-IG debt coming due over the next two years2. The path forward in these situations is often benefited by a flexible capital solution that reduces debt, and / or perhaps temporarily replaces cash coupons with pay-in-kind structures, to keep cash interest coverage ratios in check. These companies will typically seek a comprehensive recapitalization solution, where, as an example, (i) first lien lenders agree to an “amend-and-extend” solution, which pushes out the first lien debt maturity in connection with a partial paydown and oftentimes adjustments in coupon rate, or (ii) existing lenders are fully repaid and new secured debt is put in place at a lower quantum. In both scenarios, flexible capital can help delever balance sheets to facilitate the overall transaction and extend duration for the company, allowing the company to execute on its business plan and enhance enterprise value prior to an eventual sale.
Another important driver of flexible capital transactions has been the need for growth capital. With multiple expansion no longer a dependable value creation lever, companies must create value via strategic M&A, new products / services, or other operational initiatives, all of which can require significant investment in the business. As an example, imagine a sponsor engaging in a buy-and-build strategy, where they acquired an initial platform investment for 15x EBITDA (using 7.5x of debt and 7.5x of equity) when interest rates were low, and the sponsor planned to make “tuck-in” acquisitions at lower valuations to benefit from multiple arbitrage and synergies. A few years in, let’s assume the sponsor and management team continue to have conviction in the thesis, but the investment has not yet hit the sponsor’s targeted return, and the company now is approaching a debt maturity. With today’s higher rates, the sponsor might only get traditional debt financing up to 4x – in other words, there is a 3.5x capital need. The sponsor could (i) inject additional equity in the business, an action that the sponsor might not find appealing for return degradation reasons or feasible given their own fund dynamics, or (ii) take on flexible capital that is less dilutive than common equity and aligns with the company’s desire to keep the M&A engine turning.
Illustrative Refinancing Example in the Current Environment
Operating in the Void
Whether companies are seeking capital to pay dividends, push out maturities or invest for growth, flexible capital is increasingly becoming an attractive solution. The old parlance of investing in “good companies with bad balance sheets” is transitioning to good companies with capital needs not being met by traditional financing sources, as banks continue to largely focus on larger cap issuance and less so on the middle market. Companies seeking flexible capital also often attribute value to the partnership orientation of a counterparty, which may cause them to not always choose the “cheapest” option available. All of these factors likely strengthen the case for flexible capital and solutions-oriented partners.