In the US, some of the very large funds, notably Blackstone and Carlyle, have long been involved in investment in the debt market and both have continued to launch new collateralised loan obligations (CLO) funds. In the last couple of years, both houses have also been building up European debt teams.
In Europe, CVC is thought to be considering establishing its own CLO team, having hired a former head of leveraged finance at Deutsche Bank, and at least one other UK-based house is said to be considering a similar strategy. Meanwhile, other houses such as Alchemy have set up, or are looking into establishing, distressed debt funds.
It is not just the very large funds that are shifting their attitudes to debt, as even mid-market buyout houses generally now have in-house experts monitoring the debt market and syndication.
According to Ed Eyerman, a senior director at Fitch Ratings, among the larger funds the driver of this trend is a desire to build on their existing platforms and in some cases the aim is to create a full financial services-type firm from a private equity base.
Eyerman says: “Blackstone, for example, is pursuing multiple strategies as a financial services and investment company. It is known as a private equity house that can build companies for its LPs but also has a restructuring advisory group in the US, which is more of a classic investment banking-type business. It’s about Blackstone using its expertise and ability to raise money.”
He adds that firms like Blackstone have built up enormous expertise in investment, analysis and raising money. These are all skills that can be used in running a distressed debt fund.
“It’s about analysing businesses, looking at how much leverage they can take and how they can be improved. It’s all about asset management,” says Eyerman.
Tom Lamb, managing director at Barclays Private Equity, agrees that there are good reasons for buyout houses to get into distressed debt.
“The firms can apply their private equity skills and use distressed debt as a way of getting positions in businesses that are troubled and have an inappropriate capital structure,” he says.
But Lamb adds that he does not envisage even the larger buyout houses aiming to become a kind of one-stop shop like some of the integrated finance organisations.
Blackstone, he says, seems to be taking the diversification a step further than the rest with what looks like an entry into the corporate finance business.
“I’m not sure how that will work because they’ll be in competition with some of their introducers of business, although they’ve said the corporate finance people they’ve hired will spend much of their time with investee companies, which makes sense,” Lamb says.
He says he can understand the reasons a house like CVC is looking to develop its debt activities.
“If you’re a pretty active player, there’s a lot of debt being placed in your deals and, while you would not necessarily want to lead that debt, if you have a CDO fund or debt fund you can ensure that the bank doing the deal includes them in the syndication, which means additional income, fees and carried interest,” Lamb says.
Ian Hazelton, chief executive of debt management firm Babson Capital Europe, says the key reason for the extension into debt funds by the big players is to diversify earnings streams.
Babson Capital used to be part of Duke Street Capital and one of the issues investors in Duke Street had, says Hazelton, was the fear that the debt side would become a distraction and that management time would be taken away from investment decisions. But he says that for very large funds such as Blackstone and Carlyle that is less of an issue.
However, there is an issue over how comfortable buyout houses are at the idea of part of their debt being taken up by the debt arm of a competing buyout house and the suspicion that the rival house can therefore gain commercially sensitive information about the deal.
Hazelton says some private equity firms are concerned at this possibility but that it is hard to prevent, especially in secondary trading, and that even in syndication a bank can always front a position for a third party.
There are supposed to be Chinese walls that prevent the passing of information from debt to equity teams, but there is sometimes scepticism as to how strong these walls really are.
“Do I really want to let a competitor into a deal even if they say there are Chinese walls?” says Daljit Singh, a corporate finance partner at Berwin Leighton Paisner.
Another potential concern is a conflict of interest if a firm is both an equity investor and a debt investor in the same company, although, as Fitch’s Eyerman points out, this issue is no different than it would be for an investment bank or other financial firm.
He imagines the scenario of a buyout house owning a company through an LBO, possibly investing senior debt through a CLO and then perhaps buying bonds or bank debt through its distressed debt fund if the company gets into trouble. “In that case, you’d have the buyout house negotiating with itself,” Eyerman says.
In reality the funds are raised separately, he says, and it would be hard to imagine the buyout house favouring distressed debt investors over LPs in its private equity fund. “It’s more like an investment bank with different pools of money in different strategies and which manages conflicts as they arise,” he says.
Rabobank’s Simon Parker believes that the issue is not so much the fear that if, say, a Carlyle debt fund is taking a stake in a deal then the Carlyle equity people are staring over their shoulder and getting all the same information.
The trend is rather that buyout houses generally are more concerned about the syndication of their debt and keen to be more actively involved and monitor more closely who is buying the debt.
That is why an increasing number of buyout houses are taking the monitoring of debt syndication more seriously by using in-house experts.
“Very few houses now don’t have a dedicated partner overseeing debt arrangements,” says Parker: “Houses like CVC and Permira led the way but others were pretty quick to copy because they saw that it led to better terms.”
He adds that the growing focus on wanting to know more about the syndication is an understandable concern: “Most people don’t want to wake up one morning and find out that a hedge fund they’re not keen on or some other investor they wanted to keep out is in the deal,” says Parker.
Tom Lamb of Barclays says that this is more of an issue for the larger houses than the mid-market, where syndication may only involve a couple of organisations.
“In the larger deals the sponsor will tell the banks to give, say, five banks first refusal on syndication,” he says. One of the reasons for this could be patronage, in that by favouring certain banks in syndication the buyout house is favourably viewed by those banks when business is coming the other way.
Lamb says: “In the larger deals when you have 20 to 30 people involved in syndication you probably want to know who those people are, because if things go wrong with the investment there could be problems if you have competing agendas among those holding the debt.”
According to Berwin Leighton Paisner’s Daljit Singh, the diversification into debt funds by some of the larger houses represents a significant shift. “Private equity houses are becoming fund managers,” he says. “In the old days, they were entrepreneurial but the market has matured and become more institutional, a bit like the old merchant banks in that these houses are offering LPs a number of services.”
Singh says that some houses have always underwritten deals and then gone to the market to refinance them. “I think we’ll see more of this integrated approach, with the private equity house doing the whole deal,” he says.
Ian Hazelton of Babson agrees that significant changes in the business model of some of the larger houses are on the horizon. “These firms may look to move into other asset management activities and into building a permanent business rather than the existing partnership structures, which risk ceasing when the current partners’ careers end,” he says.
As to the longer-term influence on the debt market of these trends, while some in the lending community regard the arrival of debt funds as bringing extra pressure, not everyone is concerned.
Ian Hazelton argues that these funds are at an early stage and are not in a position to influence the market, although they may be able to cherry-pick some mezzanine financing.
Rabobank’s Simon Parker says he does not see the buyout houses branching into debt as a negative development. He says: “The way they are set up as funds makes them relatively independent entities from the equity side, so it’s just like another fund manager coming into the market and those kinds of institutional are here to stay.”
The banks cannot be like King Canute, says Parker, and try and turn back the tide of institutional money. “A lot of people whine about the institutions but I think the liquidity is helping the market develop as they bring new structures and flexibility on pricing, which is refreshing,” he says.
“More institutional money has helped the arranging banks to move away from the formulaic approach of the past and deals are now being structured to the individual requirements of each transaction. I don’t see it as private equity invading our space but as a natural development of our market.”