March 2, 2021

Private equity’s risky cheap debt move

There are not many winners from Covid-19. The pandemic has wreaked havoc with most companies’ balance sheets and upset business plans everywhere. Yet for one group of investors, there is a silver lining in the cloud that is coronavirus. Private equity groups are taking advantage of soaring demand for corporate debt by loading the companies they own with even more borrowing and using the fresh loans to pay themselves big dividends.

By the middle of this month, almost 24 per cent of money raised in the US loan market had been used to fund dividends to private equity owners. This was up from an average of less than 4 per cent over the past two years. The surge in so-called dividend recapitalisations has, rightly, rung alarm bells among finance watchers.

Even before Covid-19, companies had taken on unprecedented levels of debt. Combined with the near-total lockdowns that brought most economic activity to a halt — and with the prospect of more to come amid a resurgence of the virus — it is inevitable there will be a flood of bankruptcies.

Private equity is not to blame for the current economic environment. Central banks around the world, led by the US Federal Reserve, have helped to create the benign credit conditions by pushing interest rates to historic low levels. It was the correct policy response, an attempt to lessen what is becoming a severe downturn and to enable hard-hit companies to raise cash cheaply to survive. Yet like all sweeping policy tools, it has brought with it unintended consequences.

Private equity’s rush to carry out dividend recapitalisations does not break rules, but that does not make it any more palatable. Loading up companies with borrowing at a time of peak economic uncertainty allows private equity groups to de-risk their own exposure by taking cash out of the business. But the higher risk of defaults has consequences for stakeholders beyond the private equity owners.

Investors have already raised concerns about loose documentation underpinning some of the loans, offering little protection should a company end up in trouble. The trend towards looser bond and loan covenants had started long before coronavirus and the rise in corporate indebtedness was already triggering unease among regulators. The pandemic presents an opportunity for regulators to improve lending standards.

Private equity too, must accept the consequences of its actions. The industry’s power and influence has grown enormously amid a huge shift of investor money away from public markets. This is only likely to grow; recent figures show the industry has unspent cash totalling almost $2.5tn. More power demands greater responsibility.

Proposals in the US to allow ordinary savers to invest in private equity funds through their employer-sponsored retirement accounts potentially opens up a huge new growth area, making the need for greater transparency even more imperative. The industry demands high fees from pensions funds and other investors for what it claims is better management but there is much that remains opaque. One of its preferred performance indicators, the internal rate of return, can be too easily exaggerated to demonstrate success. Investors deserve to know how private equity groups genuinely create value.

Today’s crisis is so severe there will be a need for private capital, both in the short term to keep vital companies afloat and longer term to invest in new growth industries. Private equity has a role to play in any economic recovery; it should not waste its chance to show it can be a responsible investor.

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