Private Equity Turns to Left-Field Finance to Get Deals Done

As firms try to break the M&A logjam, appetite is growing for quirky junior financing such as preferred equity, PIK debt and mezzanine loans.

(Bloomberg) — Private equity firms are turning to a new weapon to help them get their buyouts over the line: less-than-conventional funding.

M&A activity has slumped this year in part because spiraling interest rates have made traditional PE investors nervous about leveraged acquisitions. Buyout firms are increasingly using expensive subordinated debt — also known as junior financing — to help fill funding gaps and get deals done.

HPS Investment Partners provided $600 million of preferred equity, which sits below other debt in the queue for repayment, to support GTCR’s recent purchase of a majority stake in Worldpay Inc., according to people close to the matter who asked not to be identified because the talks are private. The funding came on top of a $9.4 billion debt package backing the deal.

HPS also provided up to €300m ($324 million) of payment-in-kind (PIK) debt — which defers interest payments for a period of time — as part of a €1.5 billion debt financing of One Rock Capital Partners’ buyout of packaging material maker Constantia Flexibles GmbH, the same people said.

HPS and One Rock were not immediately available for comment. GTCR declined to comment.

“From larger companies to those in the lower-mid market, there are many more discussions about junior financing — whether that’s HoldCo PIK, mezzanine or preferred equity,” says Alex Griffith, a partner at law firm Proskauer Rose. “HoldCo PIK used to just be an additional slug of money up front to get a deal over the line. Now, people are realizing it solves many different issues.”

In Australia, Ares Management Corp. led a group of lenders financing TPG Inc.’s acquisition of funeral-home operator InvoCare Ltd. The A$800 million ($514 million) of debt included a small PIK feature, according to a previous Bloomberg News report.

Opportunity Knocks

Junior financing is becoming popular, too, for specialist lenders attracted by returns that can run as high as 15% or so. Oaktree Capital Management, alongside its dedicated mezzanine funds, is looking to raise more than $18 billion for what would be the largest private credit fund. It will pursue opportunistic investments. HPS recently closed a junior debt fund with $17 billion of capital available.

Read more: Oaktree Targets Record Private Debt Fund of Over $18 Billion

These funds want to take advantage of the wariness of traditional buyout investors, such as investment banks, who are still more risk averse after Russia’s invasion of Ukraine and the subsequent bout of high inflation and soaring borrowing costs.

“For lenders, it’s riskier and you’re not secured in the same way as a senior creditor, but you can generate much higher returns,” says Aymen Mahmoud, co-head of the finance, restructuring and special situations group in London for law firm McDermott Will & Emery. “A $250m PIK instrument, which compounds at market rates would be worth 50% more in principal within five years.”

PIK debt typically pays about 125-150 basis points above senior debt and preferred equity pays around the mid-teens on average, according to several bankers. For buyout firms, that may be a price worth paying if it lets a deal go ahead in a moribund M&A market.

Traditional lenders have been lowering the amount of leverage — the debt a company has versus its earnings — that they’re prepared to provide for buyouts. At the same time, the large limited partners that usually co-invest alongside private equity firms have become less willing as the M&A slump means they’ve been getting less cash back from previous bets.

Subordinated debt can also be used by private equity firms to refinance the existing borrowings of portfolio companies. Higher rates and lower earnings threaten to make it impossible for some businesses to keep paying interest on the same amount of debt, but PIK lets them delay repayments so it doesn’t immediately strain cash flow.

“It’s all economics,” says Mahmoud. “If the numbers work for junior financing when the private equity firm models it, it can be helpful as even this expensive debt is cheaper than equity. But it only really exists as an option for high-quality credits where extending leverage makes sense.”

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