Debt financing of private equity sponsored or privately owned businesses can provide very attractive returns (mid- to high-teens) with debt risk profiles, a private equity group said.
Partners Group head of Sydney Martin Scott said the private debt market – specifically the senior secured loan and mezzanine market – had a supply-demand imbalance which offered well-capitalised investors attractive risk-adjusted returns.
However, AMP Capital head of alternatives Suzanne Tavill said it was important to segment the market by size of companies that sought debt financing.
Barwon Investment Partners portfolio manager Paul Ranocchiari said the supply demand imbalance is likely to persist over the medium term as banks remain capital constrained and the investment capacity of collateralised loan obligations (CLOs) diminishes.
While Macquarie Private Portfolio Management Head of Investments Paul Trainor agreed, he said private equity firms generally had to include a takeover premium to acquire the target company.
Partners Group’s Scott said companies seeking such finance “are not your small local start-ups. They are medium to large enterprises. An example is Quick Service Restaurant Holdings which owns the Oporto, Red Rooster and Chicken Treat quick service franchises.”
Many companies sought such financing facilities for strategic initiatives, Scott said. Contractual yields for senior debt could offer yields of BBSY (Bank Bill Swap Rate) + 500 basis points, whilst mezzanine transactions could also include a capitalised interest of about 300 to 500 basis points a year on top.
Although the high yield market was expected to play a prominent role in leveraged buyout financing in the next few years, “the volatility and availability of high yield will create challenges for many companies in need of capital”, Scott said.
AMP Capital’s Tavill said the market had to be segmented by size. Debt financing was in short supply for smaller to mid-sized companies with an EBITDA of less than US$50 million to $75 million.
“Banks are lending far less to this segment, and hedge funds and CDOs – which were relatively large providers of debt financing to this segment – are really not present in any material sense now,” she said.
“Also these companies are not of a size to tap the high yield market. So this means that it is possible to find companies with decent collateral that will pay 10 per cent on senior secured debt. If one is prepared to take on more default risk, then mezzanine can deliver returns in the mid- to high-teens.”
Barwon’s Ranocchiari said the supply demand imbalance would persist over the medium term as banks remained capital constrained and the investment capacity of collateralised loan obligations (CLOs) diminished.
Demand was expected to remain strong given impending debt maturities creating refinancing opportunities and the more than $430 billion of un-invested private equity capital that would seek financing.
“The imbalance is more acute in Europe where banks have historically provided 85 per cent of financing to corporates compared to 25 per cent in the US,” he said. “Furthermore, the US benefits from larger and deeper leveraged loan and high-yield bond markets.”
Debt financing to middle market companies was likely to yield the strongest risk-adjusted returns as the market was generally less efficient as companies were unable to access the leveraged loan and high-yield bond markets.
Furthermore, regulatory changes would mean it was more costly for banks to hold middle market loans and illiquid/below investment-grade loans. Commercial and investment banks had also increasingly focused on larger corporate borrowers.
