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Private equity firms made poor bets in the decade leading up to the 2022-2023 Federal Reserve tightening cycle. So why do creditors seem so eager to let the Masters of the Universe off the hook? A Moody’s research report showed last week that PE-backed companies have defaulted at a 15 per cent rate in the past two years. That is twice the proportion of companies that are not owned by a financial sponsor firm. The differential should not be surprising given the elevated leverage in PE transactions.
But “default” increasingly does not mean “bankruptcy”. Rather the rating agency contends that so-called “distressed exchanges” counts — where lenders or bondholders swap into new paper at a discount to 100 cents on the dollar — are a blight.
In such deals, the private equity firm keeps its existing equity stake (and sometimes puts in more cash) and hopes the business turns around with the breathing room, instead of simply letting creditors foreclose and wipe out the existing equity. It is just one of many financial engineering techniques LBO specialists are deploying to juice their returns or at least delay realising losses. It is only, too, a short-term fix: Moody’s found these exchanges mostly fail to prevent subsequent defaults.
Moody’s data confirms that two Los Angeles-based upstarts, Clearlake Capital and Platinum Equity, have among the most troubled portfolios. Both have come of age in the past 15 years and were aggressive on deploying capital, paying big prices and using heavy leverage. Each now manages at least $50bn.
Besides the likes of distressed exchanges, PE firms have turned to debt-fuelled dividends, continuation vehicles and net asset value loans to extract cash in roundabout ways. These manoeuvres, however, have required the willingness of the fixed income community, including private credit firms, to go along with them. They have been willing to extend more debt because elevated interest rates have allowed them to earn 10 to 15 per cent yields, at least for a few years, without having to take over and manage companies.
The problem, as Moody’s notes, is that in many instances creative financings are simply creating Frankenstein capital structures to unwind later. Both Clearlake and Platinum each have such reckonings right now to deal with.
The private assets merry-go-round spins onward as institutional investors still continue to allocate to private equity, private debt and everything in between. Valuations and business models will remain artificially propped up. That might be good news for asset managers collecting fees. But it is not healthy for the underlying economy when capital is misallocated in this way.