Negotiating a minefield

Private equity firms launching debt arms must act very carefully to avoid conflicts of interest.

A number of medium-sized private equity firms have launched private debt businesses in recent years, as they look to expand their product suite and replicate the success of the alternative asset behemoths.

As more of them begin investing on both sides of the capital structure, a conundrum presents itself: do credit arms bankroll their firm’s own leveraged buyouts, add-on acquisitions and other transactions?

There are two schools of thought: those general partners that won’t consider using their debt capital to back their equity deals and those that will. If a firm is in the latter camp, the question is how they do so while not putting fiduciary duties to each of their limited partners in peril.

Communication with LPs must be high on the priority list. Early disclosure of plans with both debt and equity positions in the same deal, and how the GP plans to curtail conflicts of interest, is paramount. The prospect still makes the average LP uneasy though, one credit manager tells us, noting that “perception can be as bad as reality”.

Beyond getting the blessing of investors, there are challenges associated with putting the plan into practice.

If a lender housed under the same roof as a potential private equity buyer is in an auction, third-party lenders can become uncomfortable with the thought the debt investor backed by the equity buyer may end up with information that they do not have access to.

One method to avoid conflict of interest is private equity firms only allowing their related debt funds to be a passive investor. The credit group is then limited to holding 49 percent or less of the debt on buyouts or other transactions led by the private equity team.

But even holding, say, 40 percent of the debt can present challenging situations when deals go awry and the company ends up under court protection, at least for US investors. Distressed investors routinely deal with bankruptcy cases, but it’s still important for a direct lender to think how it could end up exiting a deal and protecting its downside.

To get any reorganisation plan confirmed by the court in a Chapter 11 case, half the number of claimants and two-thirds of the amount owed for any given creditor class must support the plan.

If a firm holds multiple claims in different funds – even if they have only $1 in the vehicle – and they make up a majority of creditors in a given group, they might retain a blocking position, which would put them in the driver’s seat for any negotiations.

Beyond vote-counting in bankruptcies, distressed scenarios can present information disadvantages for third-party lenders in secondary markets.

A third-party credit firm might pay more for debt on the secondary market than a private credit group that is under the same roof as the portfolio company’s private equity owner. That overpaying could be detrimental to the outside manager’s LPs because the investment could be shakier than it realises.

Information disadvantages can also arise on the front end of deals.

This should provide pause for thought for any direct lender targeting performing credit – one of the last conversations a firm wants to have with its LPs is how and why a borrower fell off the straight and narrow. Unfortunately, not every deal is a home run, so envisioning such scenarios and putting policies in place is a sensible way of preempting difficult scenarios.

After all, no fund manager wants the most difficult conversation of all: explaining retrospectively why a damaging conflict of interest arose.

Write to the author: andrew.h@peimedia.com