PE-backed companies in need of cash

Alternative investment firms are bracing themselves for some of their private equity portfolio companies to need infusions of cash and debt workouts — or even fail.

A total of $18.9 billion worth of loans defaulted in the second quarter, compared with $10.4 billion in bonds, "reflecting an increasing number of defaulting LBOs with top-heavy debt structures," according to a Moody's Investors Service report released July 31. Defaulted loans from leveraged buyouts accounted for 81% of the total $18.9 billion in loan defaults, said Michael Simon, Moody's spokesman, in an email.

"Distressed LBOs mainly funded with leveraged loans are driving loan default rates higher than those of bonds," he said.

Portfolio companies are struggling to manage debt coming due in a world with much higher interest rates, with some lenders are backing off and private equity investors becoming choosier as to which portfolio companies will receive cash infusions, industry insiders said.

Moody's 12-month trailing speculative-grade default rate was 3.8% in June, up from 1.4% a year ago. Moody's base case default rate forecast peaks at 5.8% in the first quarter of 2024, easing to 5.2% by June of 2024, said Julia Chursin, a vice president with Moody's Investors Service, in a written statement.

Private companies form about half of Moody’s rated speculative-grade universe.

Bankruptcies of private equity-backed companies shot up to 18 in the first five months of 2023, the highest since all of 2020, PitchBook Data Inc. reported.

S&P Global Market Intelligence data currently puts the bankruptcy total at 54 U.S. portfolio companies, on track to reaching a total of 108 by year-end. This would be the highest number of private equity and venture capital portfolio company bankruptcies since at least 2010, S&P Global Market Intelligence said. (S&P counted both venture capital and private equity-backed companies through the first half of 2023.)

It’s a bleak picture for investors.

Private equity returns are expected to drop below public markets this year due to falling valuations, said another PitchBook report released July 7. Not including fees, the median private equity return for the six largest publicly traded private equity managers in the first quarter was 2.4%, compared with 7.5% for the S&P 500 index, the report said. The culprits are rising interest rates, scarce credit and slowing growth for private equity-backed companies whose upward trajectory had been supercharged by cheap debt.

Some pension funds are reporting fiscal year 2023 global equity returns that far exceeded private equity returns. Global equity, with a 14.1% net return, was the highest-performing asset class at the $468.3 billion California Public Employees’ Retirement System, Sacramento, in fiscal year 2023. Private equity, reported with a one-quarter lag, was the second to the lowest performer for the fiscal year, with a net return of -2.9%.

“Higher interest rates chews up a lot of your free cash flow and makes it harder to make investments in people and processes” at portfolio companies, said Alok Singh, New York-based co-founder, CEO and CIO of private equity firm Bridge Growth Partners. Growth is now more difficult than it was before, he said.

Brian Payne, Washington-based chief strategist of private markets and alternatives at BCA Research, also expects loan defaults of private equity-backed firms to pick up in coming quarters.

Technology companies are especially at risk, Mr. Payne said.

“From venture capital to buyout, we see those companies starting to pop,” he said. With debt being so easy to obtain, portfolio companies across sectors were leveraged up a lot, with debt being so easy, he said.
Once-hot sectors could be in for some pain.

For technology companies, it’s not just the amount of leverage burdening those companies, Mr. Payne said. The rise of artificial intelligence will make some technology obsolete, he explained.

“SaaS (software as a service) had been a defensive sector for the last 20 years,” with private equity and venture capital investors preferring SaaS companies, due to the recurring income from reoccurring subscriptions rather than the former model of selling the technology, Mr. Payne said. AI will take market share from technology companies and private equity, and other investors “will end up with much less valuable companies due to AI,” Mr. Payne said.
Health care is another sector already giving some private equity managers headaches.

PitchBook identified two health-care companies backed by KKR that filed for bankruptcy protection this year. They are GenesisCare, a Sydney-based health-care provider, an investment of KKR Core Private Equity, a long-dated private equity fund with a 15-year life, and Envision Healthcare Corp, a portfolio company of KKR Americas Fund XII, a 2017 buyout fund.

KKR executives declined comment.

Sources familiar with the matter said investments in the health-care sector were hard hit by the pandemic.

KKR wrote off Envision Healthcare Corp. and took losses in two health-care investments in its core private equity portfolio, GenesisCare and PetVet Care Centers LLC, according to KKR’s latest 10-Q filed with the SEC on Aug. 8.

GenesisCare filed for reorganization in bankruptcy in June with the goal of separating its U.S. business from its businesses in Australia, Spain and the U.K., the company said in a written statement at the time.

KKR reported in the 10-Q a since-inception net internal rate of return for KKR Americas Fund XII of 20.2% as of June 30. It also said it held $34.3 billion in assets under management in core private equity that appreciated 2% in the six months ended June 30. KKR’s $6.2 billion balance sheet investment in core private equity produced an annualized inception to date gross IRR of 20% for the firm.

Many alternative investments firms say they expect ample opportunities to invest their record-breaking amount of dry powder in new investments, estimated at $2.5 trillion worldwide, according to S&P Global Market Intelligence and Preqin data.

Blackstone Inc. alone is holding record dry powder of nearly $200 billion, according to its second-quarter earnings report.

However, Brian Dudley, Menlo Park, Calif.-based partner in growth equity at Adams Street Partners, said most of the trillions in dry powder is really “wet powder” because it will be used to prop up existing portfolio companies rather than making new investments.

“A meaningful part of the dry powder is marked for existing portfolio companies because GPs want to protect the investment they already made,” Mr. Dudley said.

What’s more, Mr. Dudley said limited partners might pressure their managers to cut capital commitments due to constraints caused by the denominator effect; meanwhile some general partners will sit out the market while they help existing portfolio companies survive.

Adams Street executives expect that demand for capital from growth companies will exceed supply, rising in late 2023 or early 2024. One reason is that growth companies reduced spending and some had also taken out lines of credit that are becoming less attractive due to rising interest rates, Mr. Dudley said. They will need to raise more capital from investors because they are running low on cash, he said.

While defaults rates are rising, this isn’t a rerun of the global financial crisis because overall companies are carrying less debt than they did back then, said Christopher G. Wright, Los Angeles-based managing director and head of private markets at credit firm Crescent Capital Group. “There’s a massive amount of equity in the companies, 30% to 40% loan to value,” Mr. Wright said.

“We haven’t seen default rates move as much as people expected one year ago, a trend that has been going on for some years now,” he said.

However, the amount of leverage that is now considered too much debt on companies is decreasing today from 18 months ago and portfolio companies are now faced with the need to reduce their first lien debt, said John A. Fekete, Los Angeles-based managing director and head of capital markets, also at Crescent Capital.

“Eighteen months ago, up to six times leverage was considered comfortable leverage,” Mr. Fekete said. “Today it is viewed as too much debt because of higher interest costs and tighter credit conditions.”

Many private credit firms expect the coming pain in private equity could produce a new investment opportunity, offering net asset value loans to private equity firms. Some private equity managers are taking out net asset value loans secured by the assets in their funds to help their portfolio companies pay down their debt, Mr. Fekete said.

“With sponsors owning a larger equity position in portfolio companies, when they refinance, they are incented to retire some of their senior debt by replacing it with a privately arranged junior debt solution,” Mr. Fekete said.