Private Equity Firms Embrace Equity Financing Amid Challenging Debt Market .

Written by:  The PE Guru – Gerald Moran O’Dwyer, III – Blackmore Partners, Inc.

Private equity (PE) firms are adapting to a shifting financial landscape as they face mounting pressure to seek alternative funding options for add-on acquisitions. Concerns over rising interest rates and conservative lending standards have led to a tougher debt market, prompting PE firms to explore equity financing to support their investment strategies. 

In the past, when interest rates were low and lending criteria were lenient, PE firms enjoyed greater flexibility in funding add-ons. Utilizing existing credit facilities or layering incremental debt onto current liabilities were common practices. Debt financing was often preferred as it allowed for the maximization of returns on acquisitions, with cash on hand being the last resort.   

However, with the current market dynamics, the feasibility of relying solely on debt has diminished. Lenders’ risk aversion, coupled with existing covenants, has limited the amount of debt available to potential buyers. As a result, PE managers are seeking alternative solutions to ensure the success of their add-on acquisitions. 

According to recent data, add-on acquisitions have gained prominence in the PE landscape, accounting for a substantial 78% of total US buyouts in the first half of 2023. Nevertheless, the number of such acquisitions has seen a decline compared to the figures in 2021 and 2022. It is evident that the challenges posed by the debt market are influencing the decision-making process for PE firms. 

  To address these hurdles, many PE managers have shifted their approach to add-on financing. It has become less common to witness add-ons being fully funded with borrowed money. Instead, various financing methods are being employed, including cash from the acquirer’s balance sheet, additional equity issued by the PE owner and co-investors, or a combination of debt and equity.   

By injecting more equity into add-ons, PE managers aim to manage the capital structure of platform companies better, ensuring compliance with credit covenants. This strategic shift allows the combined business to maintain a more manageable capital structure, providing a buffer to navigate potential economic uncertainties in the future. 

In the past, a typical add-on deal might involve leverage of 6x to 8x over EBITDA with 1.5x to 2x equity, or even no equity at all. Today, PE firms are structuring similar deals with reduced leverage of 3x to 4x and allocating a larger portion to equity financing. 

Nitin Gupta, a managing partner at Flexstone Partners, highlights that private equity funds are willing to inject more equity into deals they believe to be promising or offering considerable synergies. He explains that once the bank debt market reopens and conditions improve, they may readjust the capital structure and recoup some of the invested equity. 

Despite the benefits of equity financing, there are challenges. One significant concern for acquirers is the triggering of “most favored nation” provisions (MFN) prevalent in many credit facilities. These provisions allow lenders to reprice existing debt when new loans receive higher interest margins. This has made PE firms cautious about taking on additional debt, as it could lead to higher interest costs for the entire debt facility. 

The current debt market climate also reflects lenders’ tightening grip on borrowers. In the broadly syndicated loan market, the average debt to EBITDA ratio for loans issued in Q1 2023 declined to 4.7x from the peak of 5.3x recorded in 2021. This signals a more conservative lending approach, leaving less room for additional debt. 

In conclusion, private equity firms are adapting their financing strategies to navigate the challenges of the current debt market. The increased reliance on equity financing for add-ons demonstrates their commitment to maintaining a healthy capital structure and complying with credit covenants. As market conditions evolve, these firms will continue to reassess their financing strategies to make the most of investment opportunities while managing risk effectively.