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Financing private equity deals – how are sponsors adapting to changing debt dynamics?

By on November 23, 2022 0

With debt markets tightening in response to rising interest rates and economic volatility, Ropes & Gray partners Michael Lee, David Hutchins, Patrick Dorime and myself examined how equity sponsors- investment were finding other ways to secure the debt to finance the transactions.

High-yield bond and leveraged loan issuances for buyouts and M&As in the U.S. are increasingly hard to come by, making it harder for private equity sponsors to fund transactions at the terms and leverage levels available in 2021. This contraction is largely due to equity market volatility and rising inflation. , which also contributed to a spike in borrowing costs.

While these forces have deterred many private equity borrowers from seeking new deals, some sponsors are looking for creative ways to fund deals in both mid-markets and mega-markets.

Private debt. Backed by US$1.2 trillion of dry powder (at the end of 2021), private debt funds have been a reliable source of funding during this time of uncertainty. Working with private debt managers has enabled sponsors to reduce syndication risk and provide certainty of execution.

The contraction in the syndicated loan market has been a boon for direct lenders, who are able to win more contracts at attractive prices while being selective about their commitments. In turn, sponsors are less able to rely on one or two suppliers to underwrite a deal – instead they must build a club of direct lenders for any significant commitments.

Niche products and strategies. In addition to direct lenders, sponsors are increasingly considering niche products and strategies to fund transactions, including A-term loan commitments and annual recurring revenue loans. Sponsors also use preferred stock, in-kind loans, and other junior capital options, as well as vendor debt. Some sponsors provide equity subscriptions to fund deals in advance, then return to the market after the deal to raise debt financing. Niche sources of debt are also playing an increasingly important role in refinancing the existing debt structures of holding companies.

While debt markets will likely remain tight in the near term, private equity sponsors will need to continue to find creative ways to raise funding to close deals. By adapting capital structures, exploring alternative financing sources and leveraging key relationships, PE will have options on the table to secure acquisition financing.

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The current financial landscape – with tighter liquidity and a steady decline in leveraged loan and high-yield bond issuance in the United States – has seen lenders and investors step back to assess the effects of market volatility on the quality and availability of credit. These dynamics, coupled with the rising cost of debt, are driving private equity sponsors to explore new financing structures and leverage their relationships with lenders.