Tags: buyout | fund | investor | debt

Biggest Buyout-Fund Investors Borrow Heavily to Boost Returns

Wednesday, 10 September 2014 10:41 AM

Some of the world’s biggest investors in leveraged-buyout funds are themselves using unprecedented levels of debt to boost returns.

“Leverage is a double-edged sword,” said Oliver Gottschalg, a professor at French business school HEC Paris. “It can boost the performance on the upside and rapidly eat into capital on the downside. The more leverage you apply, the more extreme the outcome will be for the investor.”

Ardian, Coller Capital Ltd. and Blackstone Group LP all bought stakes in private-equity funds this year, using financing from firms including Bank of America Corp. and Lloyds Banking Group Plc to fund as much as half the purchase price, people with knowledge of the matter said. Investors are poised to buy $30 billion of fund stakes this year, according to Evercore Partners Inc., twice the amount in 2007, before the credit crisis.

Borrowing lets the investors get cash upfront from their holdings, rather than wait for assets in a fund to be sold, or helps them fund new investments without having to ask their backers for money immediately. For banks, the loans can produce higher returns relative to loans to companies of a similar credit quality, said Bill Murphy, a managing director at advisory firm Cogent Partners LP.

The number of banks willing to provide funding has more than tripled in recent years. Bank of America, JPMorgan Chase & Co. and Nomura Holdings Inc. have joined smaller lenders such as Lloyds, Natixis and Royal Bank of Scotland Group Plc that have traditionally served the market, according to four bankers who work in the industry and who asked not to be identified because they weren’t authorized to speak publicly.

Pressure Mounting

“There’s pressure on buyers to generate returns and pressure on banks to put money out of the door,” said Cogent’s Murphy, who’s based in New York.

Spokesmen at Bank of America, JPMorgan, Nomura, Natixis, Lloyds and Citigroup declined to comment, as did executives at Coller and Blackstone.

Bank of America, based in Charlotte, North Carolina, was one of a group of banks that in March participated in a $1.03 billion loan facility for Lexington Partners Inc., which buys interests in private-equity funds.

The four-year arrangement gives Lexington the ability to buy stakes in funds without immediately having to seek money from its investors, according to a person with knowledge of the transaction. By delaying the request for cash from its backers, Lexington can improve its internal rate of return, a performance gauge that factors into account how long a firm takes to return money. A spokesman for the firm declined to comment on its use of debt.

Returns Envied

“People have envied the returns of select buyers who were earlier adopters of using leverage,” Phil Tsai, global head of secondary-market advisory at UBS AG in New York, said in an interview. “Banks are building their practices in response to demand and are trying to find new ways to make money.”

Demand from private-equity investors is driving an expansion of banks’ existing lending to hedge funds and mutual funds, according to bankers.

“Prior to the financial crisis, we were lending primarily against hedge-fund shares and mutual funds” said Ram Rao, a managing director at Macquarie Group Ltd.’s fund-management arm in New York. “About three years ago, we saw there was an opportunity and a huge unmet financing need for purchases of private-equity fund stakes.”

With more banks driving down the cost of borrowing, investors are loading up with debt. Loans now account for about 40 percent of the purchase price in transactions of more than $500 million, up from about 25 percent before the crisis, said Nicolas Lanel, managing director and European head of private capital advisory at Evercore in London.

Additional Money

In addition, more funds are being raised to buy other investors’ commitments to private-equity funds. Such secondaries funds have amassed $15 billion this year, adding to last year’s $21 billion, according to data provider Preqin Ltd.

The combination is driving up prices investors are paying. Before the crisis, sellers typically sold their holdings in funds at about 20 percent less than their face value, according to investors and bankers who arrange the deals. Today, those stakes are changing hands at face value, they said.

“While these structures are relatively new and have spread relatively fast, they are not the product of some form of irrational exuberance: Enough were structured pre-crisis and have shown their resilience,” Lanel said. “For buyers that are large and sophisticated enough to meticulously analyze the risks of the portfolios they acquire, they may make eminent sense.”

‘Perfectly Reasonable’

When applied to holdings that are diversified, generating cash and include companies that have themselves reduced their borrowing, the approach is “perfectly reasonable,” Lanel said.

If an investor buys a portfolio of leveraged-buyout funds at face value, using debt to fund about 40 percent of the purchase price, the return could be more than 1.6 times the original investment, compared with 1.3 without, said Thomas Liaudet, a partner in London at Campbell Lutyens, which advises investors on secondary transactions.

“The increase in returns is largely a result of the increase in leverage being put into transactions,” he said.

Ardian, a private-equity investor that was until last year part of French insurer Axa SA, agreed in January to buy stakes in more than 300 funds from Stamford, Connecticut-based GE Capital in a deal valued at $1.3 billion.

The acquisition was financed with a $600 million loan arranged by Natixis, equivalent to 45 percent of the purchase price, two people with knowledge of the transaction said. The loan was provided at a cost of 250 basis points more than dollar libor, the rate that London-based banks say they pay for three- month loans in dollars. The market average is about 350 basis points, the people said.

Improving Returns

Ardian has used leverage, or debt, since 2000, according to Benoit Verbrugghe, managing partner and head of its U.S. division. The decision to borrow is always based on returns without leverage, with debt only used to “improve returns” once the deal is signed, he said by telephone. He declined to comment on the GE deal. Ned Reynolds, a spokesman at GE Capital, declined to comment.

Ardian should be able to add debt to the funds it acquired because they are older and contain more companies closer to the point of being sold, said Gottschalg.

Investors also are using so-called dividend recapitalizations to boost returns from holdings they’ve previously acquired. In such transactions, the investor borrows money secured by the proceeds of future company sales from the portfolio. If the private-equity firm can’t sell the assets, the loan isn’t repaid and the lender can seize the investor’s holding.

Volcker Rule

That would allow banks to hold private-equity investments without violating the Volcker Rule, which seeks to restrict banks from holding stakes in hedge funds and buyout funds.

“The Volcker Rule recognizes that as part of their normal lending business banks can lend against these types of assets,” said Edward Sopher, a partner at Gibson Dunn & Crutcher LLP in New York. “If banks end up foreclosing on the assets, the regulators give them time to sell, in the same way as other foreclosed assets.”

Secondaries funds typically promise backers a faster but lower return on their investment than buyout funds. Like all private-equity funds, they measure profit using the internal rate of return, which takes into account how quickly money is returned relative to the original investment.

Coller Fund

Coller’s 2006 fund was producing an 8.9 percent net internal rate of return as of March 31, according to data compiled by the Oregon Public Employees’ Retirement Fund, one of its backers. That compares with an industry median of 6.3 percent, according to data by Preqin. A pool raised by Lexington in 2005 was producing a 7.5 percent IRR as of Dec. 31, according to the New Mexico Educational Retirement Board, more than the 6.3 percent median for that year’s funds.

Coller and Lexington, like any other investor in the industry, aren’t required to disclose to what extent they are using debt to produce returns under the European Union’s Alternative Investment Fund Managers Directive, legislation aimed at boosting transparency in the industry.

So far, few deals have resulted in losses because the purchaser is given so much information about past performance and many of the companies in the funds are ready for sale, according to investors.

“Lenders have gotten increasingly comfortable with the risk profile,” said UBS’s Tsai. “Not having seen these loans blow up before also helps.”

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Some of the world's biggest investors in leveraged-buyout funds are themselves using unprecedented levels of debt to boost returns.
buyout, fund, investor, debt
Wednesday, 10 September 2014 10:41 AM
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