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The article is describing debt incurred in connection with private equity investments at two separate and distinct levels of the overall private equity fund str

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.

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.