Leverage concerns subside

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While the coronavirus pandemic continues to upend norms across the industry, CFOs appear quite comfortable about one private equity fundamental: leverage. Nearly two-thirds of respondents to the Private Funds CFO Insights Survey 2021 report their funds use it. But when asked if growth of the leveraged loan market is cause for alarm, most seem to answer with a shrug (56 percent neither agree nor disagree). Last year, 44 percent displayed this ambivalence, while almost half agreed it was a concern. This year, only a fifth voiced any clear unease.

This may seem nonchalant, given the specter of the 2008-09 financial crisis still hangs over the industry. However, GPs appear to have learned significant lessons from that event. “In the US, we’ve had a decade during which there has been little stress on the lending market, except for oil and gas,” says Joshua Cherry-Seto, managing director, chief financial officer and chief compliance officer at Blue Wolf Capital Partners. And GPs are confident they can manage any bumps. “Much of GP expertise pre-dates the turbulent credit markets of 2008. Managers have experience of navigating through [those challenging conditions] and identifying opportunities.”

According to Cherry-Seto, most GPs have been “fairly conservative over the past few years as they expected the [credit] market to turn.” Blue Wolf does not highly leverage its investments, he notes, which is in tune with much of the mid-market that focuses not on financial engineering but on making operational improvements. “Leverage is more of a concern for LPs invested in large-levered buyout shops where debt multiples run high. Middle market firms often leverage below 50 percent at acquisition,” Cherry-Seto says.

More firms are dipping their toes in the leverage loan market, but “the important difference from the past is that you won’t see funds leveraging up multiple times to equity,” says Fred Steinberg, managing director for North America at Sanne Group. “It’ll be less than 1:1. People are borrowing where it makes sense and in more digestible levels than in the past to better manage the risk.

“You won’t see the same leverage among emerging managers investing in venture capital where there already is enough risk in the assets. You’ll see leverage in investments with more stable fundamentals.”

The survey bears this out. An overwhelming majority (87 percent) are not considering revising the terms of their equity fund to employ greater leverage. Furthermore, two-thirds of CFOs have no plans to increase leverage to finance new dealmaking, more than three-quarters are not planning to deploy greater leverage to support existing portfolio companies, and only 16 percent will use increased leverage to fund the GP commitment.

Reviewing covenants

In the meantime, as back office leaders grapple with the impact of the pandemic, their attention has turned to their existing financing arrangements. They report that banks have been receptive to requests to renegotiate terms to head off potential covenant breaches.

“We worked closely with our banking relationships to ensure our portfolio companies had adequate liquidity and covenant flexibility to navigate through the covid period,” says Shant Mardirossian, partner and chief operating officer at Kohlberg & Company. In this regard, “relationships matter a great deal. We’ve also financed three new deals during this time, an indication that the capital markets are still strong.”

Another CFO puts it bluntly: during the pandemic, “the banks have been good to us.”