The risky move from cheap debt to private equity
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There aren’t many Covid-19 winners. The pandemic has wreaked havoc on the balance sheets of most businesses and upended business plans everywhere. Yet for a group of investors, there is a silver lining in the cloud which is the coronavirus. Private equity groups are taking advantage of the growing demand for corporate debt by charging the companies they own with even larger loans and using the new loans to pay themselves off big dividends.
As of mid-month, nearly 24% of funds raised in the US loan market had been used to fund dividends to private equity owners. This is an increase from an average of less than 4% over the past two years. The surge in so-called dividend recapitalizations has rightly sounded the alarm among financial observers.
Even before Covid-19, companies had taken on unprecedented levels of debt. Combined with the near-total lockdowns that have shut down most economic activity – and the prospect of more to come amid a resurgence of the virus – it’s inevitable that there will be a flood of bankruptcies.
Private equity is not to blame for the current economic environment. Central banks around the world, led by the US Federal Reserve, have helped create favorable credit conditions by pushing interest rates to historically low levels. It was the right policy response, an attempt to alleviate what is becoming a severe recession and allow hard-hit businesses to raise money cheaply to survive. Yet, like all large-scale political tools, it has had unintended consequences.
Private equity’s rush to do dividend recapitalizations doesn’t break the rules, but it doesn’t make it more palatable. Loading companies with debt in times of peak economic uncertainty allows private equity groups to reduce the risk of their own exposure by withdrawing liquidity from the company. But the higher risk of default has implications for stakeholders beyond private equity owners.
Investors have previously raised concerns about the loose documentation underlying some of the loans, offering little protection if a business were to find itself in trouble. The trend towards more flexible obligations and loan commitments had started long before the coronavirus and the rise in corporate debt was already triggering discomfort among regulators. The pandemic offers regulators an opportunity to improve lending standards.
Private equity, too, must accept the consequences of its actions. The power and influence of the industry has grown dramatically amid a huge transfer of money from public market investors. This is only likely to grow; recent figures show the industry has unspent cash totaling nearly $ 2.5 billion. More power requires greater responsibility.
Proposals in the United States to allow ordinary savers to invest in private equity funds through their employer-sponsored retirement accounts, potentially open up a huge new area of growth, making the need for greater transparency even more imperative. The industry is charging high fees from pension funds and other investors for what it claims to be better management, but there are a lot of things that go wrong. remains opaque. One of his favorite performance indicators, the internal rate of return, can be too easily exaggerated to demonstrate success. Investors deserve to know how private equity groups actually create value.
The current crisis is so severe that there will be a need for private capital, both in the short term to keep vital businesses afloat and in the longer term to invest in new growing industries. Private equity has a role to play in any economic recovery; he should not miss his chance to show that he can be a responsible investor.