Private Equity Pummeled by Higher Interest Rates as Portfolio Companies and Credit Funds Struggle; Use of PIK Loans Now Recalls Late 1980s LBO Crisis

The Financial Times has published two articles, each based on reports by Moody’s of more signs of distress in private equity land in the wake of central bank interest rate increases and very low odds of interest rates going back to the old abnormal of sustained super low levels. The first analysis and related article described how more private equity portfolio companies were having their debt downgraded to levels that pointed to good odds of default, which means a bankruptcy or some other cram-down of current equity holders. The second related to the not-as-well-known world of private credit funds. In the hoary old days of private equity, Chase dominated the business of making so-called leveraged loans, which Chase then would syndicate to banks and other investors like life insurers and sovereign wealth funds. Private equity firms stepped in and started making the loans via so-called credit funds, with the investor profile resembling that of private equity investors (as in public pension funds in particular are big players).

These developments are reminiscent of the end-of-cycle phase of the LBO boom of the 1980s, which ended in a crash in LBO activity, many recent deals going belly up, and lots of debt restructurings. Oddly this big development is not much part of discussions of the end of the LBO wave or the very nasty early 1990s recession, perhaps because the S&L crisis was a headline-dominating event. But it was still serious. For instance, knock-on effects included employment in M&A falling by 75% and a severe commercial real estate recession in NYC (of major developer/owners, only Steve Ross and Trump were able to keep all of the equity in their portfolios).

It’s not clear what the systemic impact might be. In general, financial crises are the result of too much private sector debt. The private equity business is also vastly larger than then. However, by virtue of the lending bagholders having substantial non-bank representation, this trend alone probably won’t threaten the financial system. But it could, as in the early 1990s, be a nasty addition to other excessive debt woes). In general, the lack of good data, as with the subprime crisis, is frustrating. They call it “private” for a reason.

However, at this juncture, the bad outcome seems more likely to be zombification, as well as increases in underfunding at public pension funds. Remember that some of these problems are being finessed with valuation chicanery, with PE players perversely providing their own marks. However, an un-fixable problem for public pension funds will be even less cash coming out of private equity/debt investments. Public pension funds reassured themselves that private equity and debt were good long term investments. But the cash flow pattern across the industry changed even in the super-low interest rate era to private equity funds distributing more cash than enthusiast investors put in, to private equity consuming more cash than it was paying out (due in large measure to ever-rising investor commitments despite steadily falling returns, particularly post ~2006). For those who piled into credit funds (we’re looking at you, CalPERS) the PIK, as in “payment in kind,” which is finance vaporware, will lead limited partners in those funds getting less cash out than they expected.

Recall that these warnings come from Moody’s. Credit agencies are very rarely out in front of adverse developments; for instance, they usually downgrade only after Mr. Market has reduced the price of bonds to reflect newly higher investor concerns. In fairness, Moody’s in one of its reports also discussed even less transparency than before due to diminished activity by some big players (more on that soon). But we also must remember their storied history. From CNBC on Congressional testimony in 2008:

Case in point: this instant message exchange between two unidentified Standard & Poor’s officials about a mortgage-backed security deal on 4/5/2007:

Official #1: Btw (by the way) that deal is ridiculous.

Official #2: I know right…model def (definitely) does not capture half the risk.

Official #1: We should not be rating it.

Official #2: We rate every deal. It could be structured by cows and we would rate it.

Now one might wonder,”Why did these private equity masters of the universe let things get this out of hand?” Incentives, naturally. Even though private equity fund managers do make more money when their deals do well, they do extremely well even when their investments do badly. As Eileen Appelbaum and Rosemary Batt documented in their impressively researched book, Private Equity at Work, nearly 2/3 of the fees earned by private equity they collect irrespective of how their funds fare.

Now to the two stories. I find the one about PIK loans more troubling, but we’ll treat them in order. First, the tweet below provides the money chart from Private equity groups’ assets struggling under hefty debt loads, Moody’s says.

new Moody’s report on who is in trouble in PE land: pic.twitter.com/K5CnWFfsdU

— Sujeet Indap (@sindap) October 10, 2024

More detail from the article:

In a new analysis, the agency indicated that recent increases in interest rates have put the assets held by some of the world US’s fastest-growing PE groups under strain.

It said more than half of the companies in the portfolios of Platinum and Clearlake, both Los Angeles-based, are at heightened risk of default, with a rating of B3 or below.

Moody’s said the holdings of Clearlake, a co-owner of Chelsea Football Club, and Platinum had the highest leverage ratios of the firms it surveyed, while others had begun to reduce their debt loads….

The report found that overall in the two years to August, portfolio companies of the top dozen buyout groups defaulted at a rate of 14.3 per cent, a figure twice as high as that for companies not backed by private equity.

Private capital powerhouses including Apollo Global and Ares Management have had buyouts suffer. Nearly a quarter of the Apollo-owned companies that Moody’s rates have defaulted since 2022, while 47 per cent of Ares-backed companies they follow are distressed, the agency said….

Between January 2022 and August of this year, more than a third of the Platinum-owned companies rated by Moody’s underwent restructuring or a debt default. Seventeen per cent of Clearlake’s portfolio suffered the same outcome.

The newer names are not small funds. Platinum has $50 billion under management, and Clearlake, $90 billion.

The pink paper also points out that Clearlake has been an active user of a new industry gimmick designed to hide for poor performance: “continuation funds.” That is when the private equity mavens, unable to sell some companies they bought for a price they find acceptable, instead roll much of the equity stake into a new fund….and trying to get investors in the current fund to participate in the new one. Fortunately, a lot of limited partners aren’t that dumb. From a 2024 post at the Harvard Law School Forum on Corporate Governance:

Continuation funds are not an esoteric phenomenon. In the past few years, they have grown increasingly popular within the private equity space, and are now the most common type of secondary transactions led by private equity sponsors. In 2021, these transactions reached their highest volume in history, estimated at around $65 billion in deal value, representing a 750% increase since 2016. According to market experts, these funds are here to stay and to grow.

Despite their surging popularity among private equity sponsors, continuation funds face unusual investor resistance. The Chief Information Officer of Europe’s largest asset manager went so far as to claim that certain parts of the private equity industry look like “Ponzi schemes” because of their “circular” structure, tossing assets back and forth. Another leading pension fund executive warned that private equity groups are increasingly selling their companies to themselves on a scale that is not “good business for their business”.

However, despite largely rejecting the continuation fund scheme, many private equity investors have still enabled private equity games-playing via their enthusiasm for credit funds. Later in the first Financial Times article:

The fast-growing market for private credit has impeded rating agencies’ task, since such loans are more difficult to track than more traditional forms of borrowing….

Private credit can “mask some issues” in a private equity firm’s portfolio, Julia Chursin, vice-president at Moody’s, said in an interview. “There could be some opaque credit risk which is absorbed by the private credit sector, although they claim they only pick good ones.”

The second article, Corporate debts mount as credit funds let borrowers defer payments, focuses on the use of payment in kind securities in restructuring debts. Let us not kid ourselves, the borrower would presumably default ex the use of the PIK instruments. From the story:

A growing list of cash-strapped companies have turned to their lenders at private credit funds for relief in recent months, seeking to conserve capital by delaying payments on their debt.

The rate at which companies are opting to increase their principal balance instead of paying cash, known as “payment-in-kind” or PIK, edged higher during the second quarter, according to a recent report from rating agency Moody’s. These types of loans have a catch: while they provide temporary relief, they often come with a higher interest rate on a mounting debt load as the deferred payments pile up…..

The growth in these types of loans is one signal of stress in corporate America even as the broader economy expands, particularly for businesses that were leveraged to the hilt by their private equity owners and are now struggling with those interest burdens.

Reading the Financial Times’ comments on this piece, I was surprised at the lack of historical memory. In the 1980s LBO wave took a big hit with the 1987 crash.¹ But it came back through late 1989. The collapse of a UAL buyout and the failure of First Boston to find lenders to take it out of its bridge loan to Ohio Mattress marked the end of that era.²

But during that interim phase, valuations remained elevated when the stock market rebounded but lenders had gotten wary. And it was not due just to the stock market swan dive but also that the better big deals had largely all been done. So quite a few of these deals achieved the needed level of leverage without appearing to overburden the company on a current cash flow basis by using PIK securities, often PIK preferreds.³

Back to the Financial Times:

Moody’s estimated that 7.4 per cent of the income reported by private credit funds was in the form of PIK during the most recent quarter. Analysts at Bank of America pegged the figure at 9 per cent and said its analysis showed that these funds had gone one step further: 17 per cent of the loans they hold give the borrower an option to pay at least part of their interest with more debt going forward, even if they are not doing so now.

And it is not just investors in the funds who can feel the pinch of not getting cash flow they expected. The use of PIK is rising to a level where some of the funds themselves are coming short:

While PIK income is counted as income each quarter, the funds do not receive cash payments until the loan is refinanced or matures. That can create a liquidity crunch for funds, which are required to pay out 90 per cent of their income to investors, even when they have not received cash on those debts.

Looks like some of the limited investors forgot the cardinal rule, that a guarantee is only as good as the party giving it.

Moody’s, in classic whistling by the graveyard mode, pretends that its sightings are not as bad as one might surmise:

PIK is not always a worrying sign, said Clay Montgomery, a Moody’s analyst. Some funds offer PIK to allow healthy businesses to direct their cash towards expansion plans. But it can be difficult for investors to discern when PIK is being extended to give a lifeline during a time of financial stress, or ambition.

For investors, understanding the difference is crucial. Lenders said that if built into a loan at the start, PIK did not indicate stress. Ares said that more than 90 per cent of second quarter PIK income at one of its funds was structured at the start of the investment. Blue Owl said more than 90 per cent of the loans in its technology fund that can defer payment were structured that way from the start.

Again, anyone old enough to remember the late-in-cycle 1980s LBO deals will laugh out loud at “PIKs as part of the original financing = benign” claim.

We’ll see in due course whether the damage wind up being patchy or pervasive. But in a nominally strong economy, this development is plenty worrisome even before getting to a recession or big economic shock. Stay tuned.

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¹ The Brady Commission report found that a Reagan era effort to curb highly leveraged transactions by taxing them at a higher rate (as I recall, by disallowing the deductability of debt beyond a certain gearing level) was one of the causes of the swoon. Goldman Sachs had reported (IIRC as of August 1987) that 3/4 of the hefty runup in stock prices that year was due to buyout transactions.

² That deal came to be known as the Burning Bed. By a weird happenstance of history, I was waiting to meet a Gibbons Green partner when he raced in and proudly announced, “We just won the bid on Ohio Mattress.”

³ The infamous Campeau deal featured PIK preferred. To get an idea of what some later thought about it: THE BIGGEST LOONIEST DEAL EVER It brought the excessive Eighties to an absurdly fitting end. Robert Campeau’s history of nervous breakdowns and volatile behavior was well known to the lenders who financed his ill-conceived takeover binge. So why did they give him all that money? from CNN Money. Campeau was a personal sore point. I was getting yelled at at Sumitomo: “Why aren’t you making $500 million in fees like our lending team just did on the Campeau deal?” Sumitomo lost boatloads more than that, and pretty soon too.