The Dark Art of Leverage

There’s been a years-long lull in the ability of private equity sponsors to comfortably sell assets. It means that investors in buyout firms have been increasingly impatient for their money back from deals.

As Citigroup’s Richard Zogheb puts it: “The pressure on sponsors to monetize is huge.”

The industry has turned to a longtime friend: Leverage. Private equity firms have been tapping debt markets to borrow money against assets to return that borrowed money to investors in the form of a dividend. It’s largely seen as a bridge, a way to return some funds while waiting for an exit opportunity that they believe will be more lucrative in the future. This type of borrowing is reaching record levels, my colleague John Sage and I reported this week.

With the prospect of interest rate cuts this year, investors are flocking to buy risky debt such as this.

“There’s a huge appetite for credit right now,” Chris Bonner, head of US leveraged finance capital markets at Goldman Sachs Group Inc., said in an interview. “Issuers wake up and say if there’s all this demand, they say, what do I do with that?”

There’s always a catch: If the market turns south, or portfolio companies simply don’t grow into the added leverage burdens, then the whole plan doesn’t really work.

There’s also some skepticism that private equity firms will eventually be able to capture top dollar for the assets as they look to exit. There’s a “valuation reset” needed for more exits to transpire, according to Sarah Samuels, head of investment manager research at NEPC, a limited partner consulting firm.

“When it comes time to sell, if those private equity sponsors want to sell, there’s a valuation drop, and buyers and sellers are not yet able to meet on price,” she said in a Bloomberg Television interview this week. “The big money — endowments, pension funds, sovereign wealth funds — are not getting capital back from the private investments that they’ve made that they’ve expected, and they’ve modeled out.”

She said one reason investors are antsy is they want to be able to get back some funds to recycle into new, more promising investments. “It’s buyouts with a value orientation. We don’t want to see buyouts generating value only through add-ons and high use of leverage; we want earnings growth and multiple expansion,” she said.

There’s also a concern that with the cost of debt rising, it’s going to eat into profitability. Every dollar you’re spending on interest is another dollar that isn’t going down to the bottom line. All in all, private equity investors are starting to prepare themselves for lower returns ahead.

So as you can see, leverage is a double-edged sword. There’s also a huge debate among investors on whether more leverage in this higher-rate environment is worth the risk for the extra returns.

As for the private equity-fueled debt deals themselves, KKR is one big credit firm that would consider lending money toward them. “I don’t get too spooked by the increase in PE transactions taking capital back,” Chris Sheldon, a partner at KKR, said in a Bloomberg Television interview this week. They’re limiting such debt investments to companies they know with a long, promising track record.

“I think you have to just be wary, it’s about the right ones, leaning in, and avoiding the mistakes,” he said. “Right now, it’s about keeping it simple, not reaching for return or yield, understanding the businesses you’re lending to, picking up the right sectors.”

Investors are paying more attention to the leverage being toppled onto businesses, particularly private equity-backed ones where debt has long been a key feature.

Elsewhere in the debt world, investors in Europe, in particular, are looking for private credit funds that don’t rely too heavily on leverage to boost returns. They’re concerned that elevated interest rates will create an undue burden on firms that are using borrowed funds.

When interest rates were near zero for almost a decade, managers got used to tapping debt markets. It’s a different calculus now — and there’s a sense that some people may have gone overboard.

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AND IT'S FINALLY HERE!!! At the center of your financial universe: Bloomberg Invest is days away. I've spent 3-5 days a week for a full year helping plan this baby, and it's looking really good. In the largest event yet, you have exclusive interviews from Todd Boehly, Cliff Asness, Boaz Weinstein in the midst of his heated battle with BlackRock, Ares CEO Mike Arougheti, Apollo's John Zito, TCW's Katie Koch, Oaktree's Rob O'Leary, PJT's Paul Taubman, Gary Gensler and many more. I'm looking forward to David Rubenstein's interview with Coatue's Philippe Laffont.

And on Thursday, I'll be interviewing Marathon's Bruce Richards at the 2024 Restructuring Symposium held at NYU's Stern School of Business, my own alma mater. Come join if you can, and all the details in next week's letter.