Conflicts key as managers ponder debt expansion

It’s been a long-running conversation and one that appears to have been revived in light of current market conditions: does it make sense for a private equity firm to also have a private debt arm?

The liquidity crisis brought about by the pandemic is the main reason for the question being asked once more. Many portfolios companies in need of liquidity are fundamentally good businesses with temporary cashflow issues. In an environment where sources of debt financing – especially from the banks – are more limited, does it not make sense for private equity to step forward with the needed capital? This could come either from private equity funds with a flexible mandate allowing some debt investment, or from debt-focused funds.

One of the key advantages for private equity firms is their swiftness of execution at a time when, for some imperilled companies, speed may be very much of the essence. What they also may have – and certainly in cases where they already have an equity investment – is familiarity with the company, eliminating the need for a lengthy due diligence process. The appeal of being able to easily steer such a company through its short-term difficulties appears obvious.

The problem, and what has always been at the heart of such conversations in the past, is around potential conflicts of interest. The regulatory environment appears to be becoming stricter. Even in the US, where managers have traditionally been more inclined to combine equity and debt operations than in Europe, the SEC has been taking a close look not just at the disclosure of conflicts but how firms are managing them. Aside from dealing with the regulators, GPs must ponder the potentially thorny issue of explaining why the equity and debt investments in the same asset may have very different outcomes.

Nonetheless, we do hear of more interest in migrating to the debt side of the fence – some of it coming from US houses wanting to do in Europe what they have always done in their home market, and some from traditionally cautious European GPs becoming a little more emboldened. Some, we hear from market sources, are considering upfront conversations with LPs about the conflicts and asking them whether they think the potential benefits outweigh the risks.

If a trend is to develop here, it’s likely only to be applicable to the larger investment houses with big teams where crossover of information can be avoided and genuinely independent decisions made. It would be no surprise though to see some more equity managers adding debt to the menu.