Private equity firms that have for years capitalized on the regulatory woes of banks by becoming lenders to risky leveraged buyouts are doing less business just as higher interest rates have made that practice more lucrative.
Buyout firms with direct lending businesses, such as Blue Owl Capital Inc, Blackstone Inc and Apollo Global Management Inc, disbursed a total of $151.3 billion in 2022 for so-called middle-market deals -- midsized acquisitions by private equity firms -- according to financial data provider Refinitiv.
That was 23% less than the $195.7 billion lent out in 2021, but still 41% higher than in 2020. The amount of loans disbursed by direct lenders so far in 2023 has not shown any pickup, the Refinitiv data shows.
Seven private credit executives interviewed by Reuters attributed the drop to fewer companies knocking on the door of direct-lending private equity firms, with the financing turning more expensive, and the lenders becoming more-risk averse amid concerns about a potential economic slowdown.
Limited bank financing for leveraged buyouts is dissuading many potential borrowers from pursuing deals in the first place and, as a result, fewer of them are knocking on the door of private equity firms as lenders, the executives added.
"There's less mergers and acquisition activity in the market because there's limited public financing," said Marc Lipschultz, co-president and co-founder of Blue Owl Capital Inc.
The total value of leveraged buyouts in the United States fell 32% year-on-year to $345.6 billion in 2022, down from $507.6 billion in the previous year, according to Refinitiv.
Also weighing on deal volumes is the cost of borrowing from private equity firms. Such a loan has always been more expensive than a traditional bank loan, yet dealmakers still opted for it when banks faced regulatory constraints in saddling a company with a lot of debt.
The cost of this loan has recently soared amid higher interest rates. A $1 billion loan from a private equity firm for a company rated non-investment grade - or junk - now averages an interest rate of up to 12%, up from around 7.5% average in 2021, one of the executives interviewed by Reuters said. This has dampened demand for loans from private equity firms.
Milwood Hobbs, head of North American private credit sourcing at Oaktree Capital, said some borrowers are opting to delay refinancing and repaying their outstanding loans because of the higher costs of a new financing. This has restricted the ability of some direct lenders to replenish their capital so they can finance new deals, Hobbs added. "It's been taking more lenders and more time to club up a deal," he said.
For their part, private equity firms have also become more risk-averse when it comes to lending, as the economic slowdown and sticky price inflation erode the credit worthiness of some borrowers.
"The slowdown [in direct lending] is due to uncertainty about the economic outlook and interest rates, the continued disparity on valuation expectations and some seasonal factors, rather than a lack of debt capital available,” said Kipp deVeer, head of credit at Ares Management Corp.
Debt funds launches hit
The drop in direct lending business has spilled over into fundraising for vehicles that provide the pools of capital for the loans. U.S. private debt funds raised $216.2 billion in 2022, down 6% from the year before, according to data provider Preqin.
To be sure, major deals using private equity firms as lenders are still getting done as banks have continued their retrenchment from risky debt. In 2022, direct lenders backed Vista Equity Partners in its $8.4 billion acquisition of U.S. tax accounting software company Avalara Inc as well as its takeover of cybersecurity firm Knowbe4 Inc for $4.6 billion. Thoma Bravo's deal to acquire Ping Identity, a cybersecurity firm, for $2.8 billion was also financed exclusively by private credit firms.
"The absolute number of direct lending loans has come down but our market share in the financing market has gone up," Lipschultz said.
