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The writer is a bond portfolio manager at Barksdale Investment Management and co-author of ‘Undiversified: The Big Gender Short in Investment Management’
Private equity was a bright spot in institutional investors’ portfolios last year. The asset class held up much better than public stocks, which were whipsawed by rising rates.
Sure, the valuations put on private equity portfolios might be suspect, or at least lagging, given a disconnect with moves in public markets. But many investors value private equity’s insulation from volatility and the herd mentality seen on public markets.
However, private equity’s reliance on the public credit markets should have been an Achilles heel in 2022. While the equity ownership of a leveraged buyout (LBO) target is, definitionally, private, the debt has traditionally been provided by public credit markets that have the capacity to underwrite large purchase prices. Ever since Barbarians at the Gate, the iconic book about the RJR Nabisco LBO in the 1980s, the terms “junk bonds” and “LBO” have gone hand in hand.
As the credit markets sold off last fall, there was a lot of news on so-called hung bridges — that is, committed financings for LBOs that end up lodging on banks’ balance sheets rather than being syndicated due to market or corporate turmoil.
Right in the headlines were the banks that lent $12.7bn to Elon Musk for his $44bn Twitter takeover but subsequently were unable to sell much of the debt, and are sitting on big paper losses. Likewise, the sale of corporate bonds to fund the $16.5bn leveraged buyout of software company Citrix was described as “bloodbath” for the lenders by one banker involved in the deal.
Yet the amount of hung bridge debt is a fraction of what it was in 2007, tens rather than hundreds of billions, even though LBOs topped $200bn in 2022 — the highest volume in a decade other than record-setting 2021.
How did the banks dodge the bullets of the last LBO cycle? The short answer: regulators tied their hands after the financial crisis. As banks retreated from aggressive LBO commitments private credit is stepping into the breach — a parallel to the “privatisation” of equity markets. This has come amid increasing demand from institutional investors for uncorrelated “diversifiers” in their portfolios.
While LBO financing capacity in the public credit markets evaporated in the second half of 2022, private credit continued to underwrite deals. JPMorgan estimates the size of this private market at $1.2tn, close to that of the high-yield bond market. And unlike high-yield bonds, private credit is a growth area.
High-yield bonds owe their existence to LBOs, and vice versa, but increasingly they are going their separate ways. Today only about 15 per cent of the high-yield bond market (under $200bn) is LBO-related debt. The syndicated loan market continues to be a more hospitable home for LBO debt, accounting for 44 per cent of the institutional loan base, according to JPMorgan. But even this steady source of financing is being pushed aside by private credit.
Private credit is a catch-all term for a large range of lending, including LBOs. As a high-yield bond investor, I’ve been sceptical of this opaque asset class; from the outside it seems like a hodgepodge of idiosyncratic deals, ranging from securitisation of country music royalties to complex “unitranche” lending.
Increasingly it’s the domain of big names such as Apollo, Blackstone, Ares, and KKR. While private credit has focused on smaller LBOs to date, it seems like a logical next step for managers to team up more for “club deals”. Today a $10bn LBO would likely still have to come to the public loan and bond markets. Before long, all but the very largest LBOs might tap the private credit market.
What is gained, and lost, in the creeping privatisation of LBO debt? For high-yield bond investors, it’s a mixed blessing. We miss out on deals. They are sometimes too small for us but they also might be higher-risk investments than our market wants to underwrite.
For private equity sponsors that manage funds, this growing market can only help deal flow. For institutional investors, it offers higher yields and less volatility than public credit. And for corporate America? More hostile bids, more levered balance sheets, more opportunity to operate in the shadow with less disclosure requirements.
Private equity sponsors frequently make the argument that public market exposure and disclosure compromises the competitive positioning of companies and prevent them from making big, strategic decisions. But if greater transparency in corporate America benefits everyone, the transition of the debt component of LBOs to private markets is a step in the wrong direction.
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