Private Debt financing for leveraged buyouts (LBOs)
Within private equity transactions or more general in leveraged buyouts (LBOs), different sources of debt are used as financing sources. Examples of sources of debt are given by bank debt, high-yield bonds, mezzanine, or private debt, which has gained greater importance in the years following the financial crisis. Therefore, let’s have a closer look at private debt in the context of LBOs and understand why this source of debt had such strong growth in recent years and the reasons PE funds choose it as a source of debt funding.
1. Definitions of private debt and private debt fund
Generally speaking, private debt is a form of debt that is issued to or held by privately held companies. It comes in many forms, but most commonly involves non-bank institutions making loans to other companies. A variety of investors, or private debt funds, are involved in the space. Private debt funds in particular raise capital from investors and then distribute it as loans to a wide range of companies. While a private debt fund is mainly used as an alternative to traditional bank lending, it also can provide investors with access to steady returns that occur from having private debt as a separate asset class. Private debt funds’ strategies comprise direct lending, distressed debt, mezzanine, real estate, infrastructure, and special situations funds, among others. In addition to paying back the full sum of the loan in the future, the company must also pay interest to the private debt fund. Moreover, private debt funds come in different shapes and sizes and most well-known alternative assets managers (e.g. Blackstone, KKR, Oaktree, Partners Group, or Apollo Global Management) also have private debt or credit funds.
2. Growth in recent years
As a consequence of the global financial crisis, banks have experienced stricter regulation, which in turn led to the emergence of a new credit market for non-banks. With few opportunities for high (fixed income) returns in the public markets, investors sought new strategies. Private debt funds, which act as direct lenders to medium-sized companies and as sources of credit for leveraged buyouts, promised the higher returns investors were looking for. The annual funds raised by private debt funds undermine this growth. To give you some numbers: in 2011, 140 funds were raised for a total of $61 bn. The fundraising activity peaked in 2017 during which a total of 325 funds raised around $200 bn. Since 2017, fundraising growth has slowed, but picked up again in 2021, reaching a total of almost 192bn, almost back to the value of the peak in 2017.
3. Advantages of private debt in LBOs
As mentioned above, the market was looking for a vehicle for high return within the debt market, which helped the private debt funds to raise money. Now let’s have a closer look at why private equity funds use private debt as a source to fund LBOs. Firstly, as a result of the financial crisis, the regulator wants to prevent banks from taking on larger exposures in the riskier LBO business. For example, leverage above 6x EBITDA may only be carried out with an explicit exemption from the risk premiums. It follows that debt funds are more flexible when it comes to structuring financing or dealing with covenants, allowing to have a broader range of LBOs credit funds. Secondly, private debt funds can provide funds for an LBO faster than a bank can as in the banks’ case loans take longer to be approved. This has become increasingly important in recent years, especially for mid-market LBOs as deals’ speed has become faster and quicker debt funding became necessary. Another advantage private debt funds have over high-yield bonds is that they do not require an external credit rating by a rating agency such as Moody’s or S&P.
4. Limitations of private debt in LBOs
Due to the higher risk affinity of debt funds, these are also under pressure to achieve corresponding returns and are primarily looking for loans with lower risk, for example through lower seniority. In contrast, banks do not experience such pressure and can offer also loans with lower interest rates (e.g. senior loans). This gives banks an advantage, especially in the area of low seniority and lower interest rates. Another point is that due to the size of most debt funds, private debt funds cannot fully finance mega LBOs, and especially in this area banks continue to have a clear predominance. In the meantime, numerous LBOs often involve a combination of banks and debt funds. Banks provide the lower-interest part, but are better collateralized, while debt funds take on the subordinated component.
This newsletter is fully independently produced by the members of the Nova Venture Capital and Private Equity Club. This club is run by students of the Nova School of Business and Economics.
You can directly access the sources we used:
Gunter E., Latour A. & Maguire J. (2021): Private Debt: A Lesser-Known
Corner Of Finance Finds The Spotlight. S&P Global. Retrieved from
https://www.spglobal.com/en/research-insights/featured/private-debt
Pitchbook (2021): What is private debt? Pitchbook. Retrieved from:
https://pitchbook.com/blog/what-is-private-debt
Pitchbook (2022): Global Private Debt Report. Pitchbook. Retrieved from:
https://pitchbook.com/news/reports/2021-annual-global-private-debt-
report
Lee L (2021): These Lenders Are Making A Growing Number of LBOs
Possible. Bloomberg. Retrieved from:
https://www.bloomberg.com/news/articles/2021-10-29/private-credit-
boom-is-fueling-a-growing-number-of-tech-lbos
