Private equity’s new financial engineering brings risks

The writer is managing partner at Thoma Bravo

After the sharp rises in US interest rates since March last year, debt is now more expensive than it’s been in more than two decades. The ensuing squeeze hasn’t just reshaped the strategic direction of private equity firms — it’s testing the industry’s relationship with risk.

Blame it on the human psyche. While today’s market conditions may be new for many, the way in which we behave under such conditions is anything but.

The foundations of behavioural economics show that people and organisations have a built-in decision bias at moments like these. As psychologists Daniel Kahneman and Amos Tversky explained in Nobel Prize-winning research, some people take more risk when facing losses to avoid even bigger losses.

Confronted with macroeconomic headwinds, an intolerant initial public offering market and lower valuations, the psychology of investors and other decision makers tends to tilt towards greater risk acceptance. So under heightened market pressures, it’s increasingly important to remind ourselves that there are no shortcuts when it comes to responsible risk strategies.

Yet signs of eroding risk discipline can be seen in the recent rise of net asset value (NAV) borrowing, so-called because of leverage of the collective valuation of a firm’s portfolio companies as collateral. Although we have not relied on such loans to date, they’re actively being used by others in our industry. In a pinch, these loans can seem like a relatively easy (albeit expensive) way to access new capital.

The newfound prominence of NAV borrowing is driven by challenging business conditions that have hamstrung private equity firms’ once-promising portfolio companies. Combined with an abating appetite for buyouts and the rising demand for liquidity among investors in funds, some may see NAV loans as a nimble stop-gap. Others may see them as financial engineering designed to cloak failing portfolio companies — simply, and perhaps dangerously, throwing good money after bad.

Whether those concerns are merited depends entirely on how the proceeds of NAV loans are deployed, and equally how that deployment is communicated to limited partners (LPs), the investors in funds. The funds can be used in a way that investors may be amenable to; say to create liquidity that in turn expedites the return of their capital in advance of pending realisations.

Likewise, in older funds NAV loans could be used to finance a performing portfolio company’s add-on acquisition. The alternative — raising incremental debt capital from the company’s existing lenders — might cause its entire facility to be repriced, something worth avoiding in today’s rate environment.

But those approaches endorsed by LPs are starkly different from using a NAV loan to recapitalise an underperforming portfolio company with “equity”, particularly when that is not clearly communicated to the business’s investors. Using money to facilitate an acquisition in a performing portfolio company isn’t the same as deploying it to prop up underperforming businesses unable to service their existing obligations, or those losing money with no path to profitability.

Critics call the prop-up approach “pray and delay”. Firms bet on a different future: either the ability to turn a company’s margins up to meet today’s demands for profitability, or the hope that an impending turn in the economic cycle will boost top-line growth and company valuations. Time will test the sustainability of defensive NAV borrowing — but if we’re truly looking at “higher for longer”, that’s quite a gamble.

As with many technologies (financial and otherwise), NAV loans themselves are neither good nor evil; that judgment should be reserved for how they’re put to use. LPs deserve to make that judgment for themselves after receiving a transparent explanation of NAV borrowing. If the money is going to be used to turn a company around, LPs should see a detailed map for the journey — and know clearly why taking leverage in this form and contributing it as equity is the preferred alternative to, say, actually calling equity from the fund and investing it.

LP transparency doubles as a hedge against short-term, reactive decision-making, thereby helping general partners — the managers of funds — stay true to investment theses. And it protects our companies, our investors and ourselves against the human behavioural inclination towards excessive risk acceptance under unexpected pressure — discipline that is more important now than ever.

Ultimately, while a NAV loan can buy time, no amount of financial engineering can impede the inevitable: those pricey loans will eventually come due, and if the businesses haven’t improved, the portfolio as a whole — and its investors — will be left holding the bag.