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Can someone explain in simple terms what this article was saying? I tried, and thought I knew, and began to realize how little I knew about anything the further

Can someone explain in simple terms what this article was saying? I tried, and thought I knew, and began to realize how little I knew about anything the further I read.

fakedang 3y ago
PE firms are using non traditional collateral for getting financing for their acquisitions, since on hand cash is at its lowest in many years. Traditionally, PE firms would obtain cheap financing from a bank or another finance provider to carry out a leveraged buyout - the PE firm pays a small percent of the acquisition cost using cash, the banks cover the rest, while interest payments to the bank are covered by cash flows of the acquisition target. But with the higher cost of financing that is available for traditional collateral like the acquisition firm, the PE firms have had to resort to providing collateral using other sources, such as the cash flows of the PE management company itself, or the equity returns of the acquisition target. This could be the fees that are paid to the PE firms themselves to manage the money - it would have been very taboo to expose the management company to risk like that, but now PE firms don't care. Interest rates are skyhigh, around 20%, which is actually high for corporate, and usually the rate for consumer loans. So yeah, PE is changing quite significantly, and the old model of doing business won't work.
skybrian 3y ago
Private equity firms need money and lenders are charging them very high interest rates with more strings attached. (There's more than that, but I'm not an expert either.)
nocoiner 3y ago
The article is describing debt incurred in connection with private equity investments at two separate and distinct levels of the overall private equity fund structure. I’m trying to keep this simple and straightforward, but assume some knowledge of corporate finance - apologies if I’ve missed the mark and have either undersimplified or oversimplified. A private equity fund is an entity - usually a limited partnership - that is created by a “sponsor” (called a “manco” in that article for “management company”) and raises money from outside investors. The sponsor manages the fund and the investments it makes using that raised capital (and in exchange for various management fees paid by the fund to the sponsor). Note that, for a variety of reasons, those investments usually take the form of an investor (limited partner) agreeing to contribute cash up to a designated amount - but not upfront. Instead, the investor funds that agreement to invest cash in the fund when the sponsor asks for a portion of it to be sent to the fund so the fund can make an investment. It’s been standard practice for a while for a private equity fund to borrow money secured by its assets, which are generally a combination of the ownership interests in the companies it has invested in and its right to cause its limited partners to contribute additional capital to the partnership. By using proceeds funded from debt, the fund can improve the way that its returns to its equity investors are measured, which results in the sponsor receiving enhanced incentive economics. The main new development reported by this article is that private equity sponsors are now pursuing debt at the sponsor level that is secured by the sponsor’s incentive economics mentioned above as well as any management fees paid to the sponsors by the funds that it manages. This doesn’t mean that the companies that private equity invests in are more indebted or more likely to collapse due to leverage - instead, the article is reporting that the overall structure of a private equity investment (an operating company owned by a fund that is managed by a sponsor) is seeing additional levels of debt at the top level of that corporate structure.
- jalapenos 3y ago
  What do you think this indicates economically / business cycle wise?
- probablypower 3y ago
  This is great, thank you (not OP). Is it more reasonable to understand this as: a. Private Equity is running out of cheap sources of money, so it is resorting to risky high interest sources. b. Private Equity sees a lot of present opportunity and are willing to take on even high interest debt because there are clear opportunities for higher interest returns. c. Private Equity got into the pantry and their risk appetite is all messed up and self-destructive ?
  - nocoiner 3y ago
    My guess is mostly b, though some of a - see below. One thing that I didn’t really get into is that this isn’t really indicative of a shortage of third party investor capital and a necessity to raise third-party capital on punitive terms. To oversimplify slightly, assume that every investment is funded by 60% debt, 39% equity from limited partners and 1% from the private equity sponsor - that 1% representing their common equity participation in the deal (which they’re putting up both because they presumably think it is a good opportunity to invest their personal money as well as to demonstrate alignment with their limited partners). This article is describing how that 1% is getting funded. So instead of coming out of their personal checking accounts, the private equity investment professionals are getting a private capital provider to lend it instead at credit card rates. So this article probably indicates that deals are in a bit of a lull right now (no exit proceeds from prior investments to fund new investments) and traditional banks have tightened up lending. A few years ago, traditional banks were making similar loans to sponsors at low, low single-digit interest rates (think SVB and their personal loan product portfolio), so now instead the sponsors are having to tap private credit providers, who are going to insist on a much higher rate of return.
zubairq 3y ago
I think what this article is saying is that there are so many companies that are run badly and whose costs have run out of control, that outside investors (PE companies in this case) see that they can run them much more efficiently (ie: much lower costs) and so it is worth their while to borrow the money to finance the purchase of these companies, even at high interest rates Not sure why I was downvoted so much for this comment. The parent poster asked to have the article explained. I did my best to explain the article. I didn’t say I thought that PE firms doing this was a good or bad idea. If you have a better explanation of the article then please comment yourself. I am here to learn from you too
chewz 3y ago
It says between the lines that some PE investors are getting worried about high valuations vs the real value of underlying assets and slowly start withdrawing money. Which is smart as markets come to the realization that PE's had been creating wealth by trading assets among themselves at articficial, ever higher valuations and now - with higher cost of money - could face reality check. Slowly first then suddenly. For example I have purchased a dog for a million dollars last year and today I have exchanged that with PE for two cats valued at milion dollars each. So we both now have on our books assets that are valued at two million dollars. Which is great only as long as there is someone who wants to buy my cats and PE's dog at four million dollars next year. --- > This complicates true price discovery. Public markets, while not flawless, tend to be a stricter test of fair valuations. The private equity industry deserves credit for finding continuous ways to bypass the issue and keep their fee stream running. Private equity: financial engineering prevents valuation check - https://www.ft.com/content/d6891146-f8ff-4c26-83e3-739e7793d0e4 https://www.ft.com/content/d6891146-f8ff-4c26-83e3-739e7793d... > The firms that used the era of cheap money to become the new financial titans are wrestling with rising interest costs > “Many of the reasons these guys outperformed had nothing to do with skill,” says Patrick Dwyer, a managing director at NewEdge Wealth, an advisory firm whose clients invest in private equity funds. “Borrowing costs were cheap and the liquidity was there. Now, it’s not there,” he adds. “Private equity is going to have a really hard time for a while . . . The wind is blowing in your face today, not at your back.” Private equity: higher rates start to pummel dealmakers - https://www.ft.com/content/8b4a5df6-7f6d-480f-8d20-55793854c37e https://www.ft.com/content/8b4a5df6-7f6d-480f-8d20-55793854c...

Can someone explain in simple terms what this article was saying? I tried, and thought I knew, and began to realize how little I knew about anything the further I read.

fakedang 3y ago

PE firms are using non traditional collateral for getting financing for their acquisitions, since on hand cash is at its lowest in many years. Traditionally, PE firms would obtain cheap financing from a bank or another finance provider to carry out a leveraged buyout - the PE firm pays a small percent of the acquisition cost using cash, the banks cover the rest, while interest payments to the bank are covered by cash flows of the acquisition target. But with the higher cost of financing that is available for traditional collateral like the acquisition firm, the PE firms have had to resort to providing collateral using other sources, such as the cash flows of the PE management company itself, or the equity returns of the acquisition target. This could be the fees that are paid to the PE firms themselves to manage the money - it would have been very taboo to expose the management company to risk like that, but now PE firms don't care. Interest rates are skyhigh, around 20%, which is actually high for corporate, and usually the rate for consumer loans. So yeah, PE is changing quite significantly, and the old model of doing business won't work.

skybrian 3y ago

Private equity firms need money and lenders are charging them very high interest rates with more strings attached. (There's more than that, but I'm not an expert either.)

nocoiner 3y ago

The article is describing debt incurred in connection with private equity investments at two separate and distinct levels of the overall private equity fund structure. I’m trying to keep this simple and straightforward, but assume some knowledge of corporate finance - apologies if I’ve missed the mark and have either undersimplified or oversimplified. A private equity fund is an entity - usually a limited partnership - that is created by a “sponsor” (called a “manco” in that article for “management company”) and raises money from outside investors. The sponsor manages the fund and the investments it makes using that raised capital (and in exchange for various management fees paid by the fund to the sponsor). Note that, for a variety of reasons, those investments usually take the form of an investor (limited partner) agreeing to contribute cash up to a designated amount - but not upfront. Instead, the investor funds that agreement to invest cash in the fund when the sponsor asks for a portion of it to be sent to the fund so the fund can make an investment. It’s been standard practice for a while for a private equity fund to borrow money secured by its assets, which are generally a combination of the ownership interests in the companies it has invested in and its right to cause its limited partners to contribute additional capital to the partnership. By using proceeds funded from debt, the fund can improve the way that its returns to its equity investors are measured, which results in the sponsor receiving enhanced incentive economics. The main new development reported by this article is that private equity sponsors are now pursuing debt at the sponsor level that is secured by the sponsor’s incentive economics mentioned above as well as any management fees paid to the sponsors by the funds that it manages. This doesn’t mean that the companies that private equity invests in are more indebted or more likely to collapse due to leverage - instead, the article is reporting that the overall structure of a private equity investment (an operating company owned by a fund that is managed by a sponsor) is seeing additional levels of debt at the top level of that corporate structure.

jalapenos 3y ago
What do you think this indicates economically / business cycle wise?
probablypower 3y ago
This is great, thank you (not OP). Is it more reasonable to understand this as: a. Private Equity is running out of cheap sources of money, so it is resorting to risky high interest sources. b. Private Equity sees a lot of present opportunity and are willing to take on even high interest debt because there are clear opportunities for higher interest returns. c. Private Equity got into the pantry and their risk appetite is all messed up and self-destructive ?
- nocoiner 3y ago
  My guess is mostly b, though some of a - see below. One thing that I didn’t really get into is that this isn’t really indicative of a shortage of third party investor capital and a necessity to raise third-party capital on punitive terms. To oversimplify slightly, assume that every investment is funded by 60% debt, 39% equity from limited partners and 1% from the private equity sponsor - that 1% representing their common equity participation in the deal (which they’re putting up both because they presumably think it is a good opportunity to invest their personal money as well as to demonstrate alignment with their limited partners). This article is describing how that 1% is getting funded. So instead of coming out of their personal checking accounts, the private equity investment professionals are getting a private capital provider to lend it instead at credit card rates. So this article probably indicates that deals are in a bit of a lull right now (no exit proceeds from prior investments to fund new investments) and traditional banks have tightened up lending. A few years ago, traditional banks were making similar loans to sponsors at low, low single-digit interest rates (think SVB and their personal loan product portfolio), so now instead the sponsors are having to tap private credit providers, who are going to insist on a much higher rate of return.

zubairq 3y ago

I think what this article is saying is that there are so many companies that are run badly and whose costs have run out of control, that outside investors (PE companies in this case) see that they can run them much more efficiently (ie: much lower costs) and so it is worth their while to borrow the money to finance the purchase of these companies, even at high interest rates Not sure why I was downvoted so much for this comment. The parent poster asked to have the article explained. I did my best to explain the article. I didn’t say I thought that PE firms doing this was a good or bad idea. If you have a better explanation of the article then please comment yourself. I am here to learn from you too

chewz 3y ago

It says between the lines that some PE investors are getting worried about high valuations vs the real value of underlying assets and slowly start withdrawing money. Which is smart as markets come to the realization that PE's had been creating wealth by trading assets among themselves at articficial, ever higher valuations and now - with higher cost of money - could face reality check. Slowly first then suddenly. For example I have purchased a dog for a million dollars last year and today I have exchanged that with PE for two cats valued at milion dollars each. So we both now have on our books assets that are valued at two million dollars. Which is great only as long as there is someone who wants to buy my cats and PE's dog at four million dollars next year. --- > This complicates true price discovery. Public markets, while not flawless, tend to be a stricter test of fair valuations. The private equity industry deserves credit for finding continuous ways to bypass the issue and keep their fee stream running. Private equity: financial engineering prevents valuation check - https://www.ft.com/content/d6891146-f8ff-4c26-83e3-739e7793d0e4 https://www.ft.com/content/d6891146-f8ff-4c26-83e3-739e7793d... > The firms that used the era of cheap money to become the new financial titans are wrestling with rising interest costs > “Many of the reasons these guys outperformed had nothing to do with skill,” says Patrick Dwyer, a managing director at NewEdge Wealth, an advisory firm whose clients invest in private equity funds. “Borrowing costs were cheap and the liquidity was there. Now, it’s not there,” he adds. “Private equity is going to have a really hard time for a while . . . The wind is blowing in your face today, not at your back.” Private equity: higher rates start to pummel dealmakers - https://www.ft.com/content/8b4a5df6-7f6d-480f-8d20-55793854c37e https://www.ft.com/content/8b4a5df6-7f6d-480f-8d20-55793854c...