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Private equity firms have sharply curtailed their use of a controversial debt financing manoeuvre to return cash to investors, after institutions raised concerns about how some groups have embraced new forms of leverage to compensate for a lack of deals.
So-called net asset value loans used to pay dividends fell by about 90 per cent during the second half of last year following heightened criticism from investors, according to 17 Capital, a New York based specialist lender that has pioneered the market.
Buyout firms have increasingly added an additional layer of leverage on top of their typical deal-linked borrowing, taking on debt secured against their fund investments, with some firms relying on those funds to pay dividends to investors.
NAV loans, which are collateralised by the individual investments in a fund and can equal as much as 20 per cent of the fund’s overall value, have enabled firms to extract cash from their portfolios without having to sell assets in difficult markets.
Firms including Vista Equity Partners, HG Capital and Carlyle Group used the loans to pay dividends in 2022 and early 2023 during a marketwide slowdown in dealmaking and IPO activity.
Debt-fuelled dividends from buyout firms hit a record high in 2023, with some groups even using fund-level borrowings to inject fresh capital into ailing companies.
But the approach has proved controversial with private equity investors, because the extra debts have added new risks to their portfolios by exposing an entire fund’s investments to the possibility that just a few of its deals sour.
Although private equity funds have long loaded debt on to portfolio companies to allow them to extract dividends, payouts to shareholders funded by NAV loans are considered riskier.
Whereas traditionally each deal in a private equity fund carries its own balance sheet to stop troubles with one investment spilling over to others, net asset value loans cross-collateralise the fund’s investments.
But 17 Capital said that just 3 per cent of the industry’s $16.4bn of NAV loans was used to fund dividends in 2023, down from a quarter of the $10bn borrowed in 2022.
Pierre-Antoine de Selancy, managing partner at 17 Capital, said firms had cut back after large institutional borrowers increased pressure on firms to limit or eliminate such borrowings to pay dividends and began requiring them to seek consent.
“The power of the limited partners is crazy,” said Selancy, referring to the investors in private equity funds. “They have the power today and they are using it,” he added.
Investors in private equity funds told the Financial Times they had grown increasingly suspicious of the NAV loan-funded dividends and had devoted additional resources to understand private equity firms’ motives.
Steven Meier, chief investment officer of the New York City Retirement System said he worried some had turned to the deals because they were “desperate to appease underlying investors clamouring for more distributions and exits” and worried the deals put “excessive” debt on portfolios.
The New York pension fund had approved NAV loans in rare instances, but only when an investment firm put forward an investment opportunity it viewed as “a compelling investment option in terms of valuation,” said Meier. The fund has also rejected loans because their costs were too high, he said.
Richard Sehayek, a managing director at private credit group Ares who leads their fund finance business, said firms were primarily borrowing against their funds to finance acquisitions or pump money into existing portfolio businesses in need of fresh capital. Firms had largely stopped using it for dividends, he said.
“The noise has died down and the types of trades that are supported by LPs are much more pre-baked and determined,” Sehayek said.
“It’s never really a no [from investors to private equity firms]. More likely, they may have an objection and it’s about the sponsor managing that.”
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