The dearth of private equity deal-making has been a nightmare for big investment banks used to getting 20% to 30% of their total advisory revenue from the industry. But while fund managers have been starved of takeovers and public stock listings or other investment exits, banks have helped raise cash and move it around in other ways as they desperately try to keep their investors happy.
Now, central bankers in the UK and Europe are looking closer at the interconnected and opaque risks of lending to private capital funds, their investors and their managers. Globally, these debts amount to hundreds of billions of dollars of mainly bank loans on top of the trillions of dollars borrowed directly by private equity-backed businesses from banks and markets.
It is not before time. Private capital funds have always been billed as committed investors with long-term funding which never need worry about a rush of destabilizing withdrawals like banks or mutual funds do. However, the industry has ballooned into a vast institutional business focused on keeping investors, managers and even shareholders happy with regular cash flows. To satisfy these needs, managers have increasingly turned to financial engineering, which unavoidably makes funds less stable.
Regulators in the US and Europe previously tried to cut the risk of borrowing by private equity-owned companies through limits on debt-to-earnings multiples in leveraged loan markets, with only partial success. But now the Bank of England and European Central Bank are quizzing lenders about all the lending that touches private capital groups. “Vulnerabilities in the [private equity] ecosystem could amplify shocks and disrupt the stable provision of finance to the real economy,” the BOE wrote in last week’s financial stability report.
The concern is the layers of leverage that all ultimately are linked to the health of highly indebted private equity-backed companies, which are facing tough times in an era of higher interest rates. There has been “a Cambrian explosion in the variety and complexity of financing products that banks now provide to the private equity industry,” as Rebecca Jackson, an executive director at the Bank of England, said in a speech this spring.
UK banks have until the end of August to report back to the BOE about their monitoring and management of these various forms of lending following a “Dear Chief Risk Officer” letter it sent in late April.
So what are all these diverse kinds of credit and how large are they? There are three layers of borrowing: downstream, which is the classic high-risk lending to fund buyouts; midstream, which is the rapidly growing area of lending to funds; and upstream, which is lending to investors against their stakes in private capital funds.
The $2 trillion-plus leveraged loan market is well understood though not completely transparent. Private credit, or direct lending, has boomed in recent years to reach about $1.7 trillion of assets under management and is less well understood. These are the main sources of downstream lending, provided by a mix of banks, specialist funds and securitization vehicles. Banks help to finance loan securitizations as they are being built in warehouses, and they often buy some of the resulting bonds.
Next up the chain, midstream lending is where the real “Cambrian explosion” has happened in recent years, and it is much less transparent. The best-known part is subscription-line financing, which is borrowed money that private equity funds use to make investments before calling on investors to provide the capital they have committed to a fund. Through timing effects, this debt boosts reported fund returns while reducing actual cash returns. Sub-line lending volume rose to $750 billion by the end of 2022 from about $400 billion in 2017, according to an estimate from Fitch Ratings. Activity slowed last year mainly because private equity companies weren’t buying many businesses.
And they weren’t buying because they weren’t selling many either, which has fueled a boom in so-called net asset value (NAV) financing. Private equity funds borrow against the value of their portfolios of companies to either hand back cash early to investors or put more money into struggling businesses. Figures for the NAV loan market are harder to come by, but a specialist lender in the UK called 17Capital has estimated that $20 billion was loaned against portfolios worth $100 billion in 2020 and that more than $70 billion will be loaned against $360 billion next year. By 2030, it estimated more than $145 billion of loans would be made.
Banks are still the main lenders here, but 17Capital raised a near-$3 billion fund in 2022 to serve this market, while last year Apollo Global Management said it expected to lend more than $4 billion to other private equity funds.
Then there are margin loans against public stocks, a more traditional form of borrowing. When a fund sells a company in an initial public offering, it won’t typically sell all the shares in one go but will hold some public stock for months or years. There is upward of $50 billion of margin debt owed by private equity right now, according to a Bloomberg News report last month.
So, in total, that’s more than $850 billion of obscure debt to private equity funds. That’s only about 10% of buyout industry funds under management, but it’s not nothing, and it’s not evenly distributed — bigger firms use more financial engineering.
Lastly, in midstream there is borrowing by private credit funds used to boost their returns. Most private credit is loans to companies owned by private equity, so the risks are likely to be correlated. Last year, this market boomed with leveraged loan markets as good as closed after banks suffered billions of writedowns on debt they couldn’t sell in 2022. Private credit funds are usually seen as more stable than banks because they lend money that is committed for the long term by investors. But the more such funds use borrowed money themselves, the riskier they get. Analysts at JPMorgan Chase & Co. estimated earlier this year that private credit funds likely had about $1.2 trillion worth of borrowings from banks.
Upstream lending is least transparent of all, but volume probably surpasses tens of billions of dollars, perhaps even hundreds. One of the more regular types is financing used in buying stakes in private equity funds when an existing investor wants or needs to sell. Another type of upstream credit is utilized by big private capital investors, who can get loans against the value of their existing fund stakes to make investments in new private funds. Third, private equity managers themselves often borrow the money they need to make personal commitments to the funds they run alongside their investors.
Midstream and especially upstream lending might be protected somewhat by the diversity in private equity portfolios or by the broad array of other assets that big investors own. But all this lending is linked primarily to the fates of those risky, highly indebted companies at the bottom of the chain. What’s more, regulators have realized that there’s a lot more of this debt, and it’s a lot less well understood than they had thought. That alone is a reason for concern and sharper attention.
As Ms. Jackson said at the end of her speech, referencing Shakespeare: “It’s better to be three hours too soon than a minute too late.”
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