As we approach the end of 2023, the Freshfields Private Capital team took some time to pause and collect our thoughts about trends and issues for the year ahead. Here are the topics on our minds when we aren't focused on year-end closings and wrapping gifts.
AI is Coming To PE
Prognostications around artificial intelligence range from wish casting to dystopian warnings. The truth is that even those at the forefront of AI development can't be sure exactly what it will look like in the coming years. That said, it is safe to assume that if there is some way to leverage the power of AI to increase the efficiencies, and reduce the cost, of business operations – and there probably will be soon, if they aren’t here already – private capital will be at the vanguard of AI adoption, largely through the introduction of AI across their portfolio of companies. Private capital firms are well positioned for this role because many of them have the scale, know-how and internal and external resources needed to navigate the privacy, data security and other regulatory and business issues that AI presents. But cost efficiencies can come at a cost of jobs, which has long been the public relations monkey on private capital’s back.
Secondaries are Here to Stay (and Growing)
Predicting that the secondaries market will be strong in 2024 is a little like saying the sun will rise tomorrow. What is new about this success story is that there are reasons to believe that secondary transaction activity can reach even new highs in the new year. First, secondary fundraising, which has been unable to keep pace with deal flow, should get a nice boost from the recent batch of strong returns from recent vintage GP-led continuation fund transactions, which should translate into more capital being available to fund secondary deals. Second, in the context of what is still a sluggish M&A and IPO exit market, more private capital managers will likely look to secondary liquidity solutions, such as preferred equity deals and NAV loans, to manage to the DPI (distribution to paid-in capital) expectations of their investors.
Asset Management Consolidation
A combination of market factors, including a sluggish fundraising market (which itself is a product of a sluggish exit market), and mega fund managers vacuuming up available LP dry powder, has contributed to an increasingly bifurcated private capital industry: private capital managers who are big and getting bigger, on the one hand, and the rest of the private capital manager community looking for ways to grow and remain relevant, on the other. This environment has become a ripe one for private capital asset management M&A, with larger players using their substantial balance sheets and franchise resources to acquire stakes or outright control of other manager businesses. In the last twelve months, we have seen a continued flurry of manager combinations, including private equity houses acquiring secondary and infrastructure businesses and multi-channel asset managers reorganizing their product verticals so that they look at real assets on a more integrated basis. As private capital investors continue this expansion of product verticals, the universe of potential investors in any given asset is necessarily changing, bringing new competitive dynamics into a marketplace that has remained strong and is expected to get even stronger over the next year.
Private Credit Strategies and Market Participants Are Converging
Over the course of the past year, the leveraged finance market has seen the continued growth of private credit as a source of financing to fill the gap where the broadly syndicated loan (BSL) market has not been available. The private credit market now constitutes around $1.5 trillion in assets under management, which is comparable to the BSL market. While this growth has been widely reported, a more nuanced aspect of this growth is the convergence of formerly disparate private credit strategies and market participants.
For one, there has been an increase in “capital solutions” focused private credit funds moving into acquisition financing and other “performing” parts of the credit market. As the Freshfields’ Private Credit and Capital Solutions team highlighted in a recent chapter for the GRR Americas Restructuring Review, historically the private credit universe might generally be divided into two parts: (1) direct lending to performing credits where the direct lender is providing an alternative to the BSL market to support M&A and other strategic activity and (2) “bespoke” capital solutions whereby the credit fund is providing financing for companies that may be more challenging to finance in the BSL due to any number of factors, including stress in a particular industry or sector, litigation overhang and geographic issues. Credit funds lending into the latter would typically be compensated for the inherent additional risk in those types of financings, allowing them to achieve targeted returns in excess of 10% per annum. The recent rise in interest rates has brought more credit funds, which may have previously been confined to the “capital solutions” space, to participate in the “performing market”, while still achieving their targeted returns.
In addition, while credit funds have dominated the private credit arena, investment banks are making a push to compete for business by either forming or expanding private credit strategies within the bank. Colloquially referred to by some in the industry as “back to lending”, doing so allows the investment banks to leverage their own client relationships and name brand appeal so as not to lose transactions to credit fund competitors. While the banks are subject to regulations, including leveraged-lending guidelines, the current lending environment in the leverage finance market is one of generally lower leverage (and larger equity checks in the context of acquisition financings). Interestingly, various lending guidelines and regulatory overlay may focus the private credit arms of banks on the par financing market, which will only add to an increasingly competitive market in that space.
Needless to say, the private credit market – both in terms of direct lending and more opportunistic capital solutions – remains a dynamic and ever-growing component of asset managers’ general private capital strategy.
“Relationship Lending” for Private Equity in a Distressed Environment
Prior to the global financial crisis (GFS), private credit funds were often seen as lenders of last resort that a private equity sponsor would only turn to should the BSL market be unavailable. Rightly or wrongly, from the borrower’s perspective there was a perception that these players acted more like vulture funds ready to spring any default into an opportunity to take the keys from the current owners. Fast forward to 2023 and credit funds increasingly are first ports of call for even the largest of private equity backed acquisitions since the private credit universe can provide certainty of pricing, speed of deal execution and an additional capital partner to support the portfolio company throughout a deal lifecycle.
Private equity sponsors and other borrowers should remain focused on their relationships with private credit lenders. While in the par performing space, providers of private credit have positioned themselves as good long-term partners to borrowers, this perception of private credit as relationship lenders may be tested once the next distress cycle and/or upcoming maturity walls hit. Anecdotally, we frequently see credit funds as (within reason) willing capital providers to help carry a relevant portfolio company through a rough patch, which is consistent with the fact credit funds generally aim to hold a credit investment through maturity and view their investment akin to the equity sponsor, albeit at a different level in the capital structure. In addition, private credit providers (including capital solutions oriented funds) are quite nimble and seek out opportunities to propose bespoke solutions across the capital structure in both the performing and stressed spaces, including debt-like preferred equity (whether for ratings purposes, to address regulatory concerns or otherwise to address leverage concerns), paid-in-kind or zero-coupon instruments (to address cash flow concerns) and other structured financial products. A number of these solutions are not available from banks or otherwise in the BSL market (whether as a result of the regulatory overlay, what CLOs behind the BSL market can hold, or otherwise), thereby adding to the attractiveness of the private credit market for private equity backed and other borrowers. Nevertheless, if there is a sustained increase in defaults and bankruptcies – which as of late there has been in the middle market - it will be interesting to monitor how private credit responds.
Acquisition Financing Sources and Structures Continue to Diversify
Rate increases and other market shifts in 2022/2023 have given rise to new players entering the acquisition financing space in a meaningful way. What used to be a playbook where everyone knew the rules and financing gaps were filled by traditional syndicated lending is now a puzzle board taking in pieces of different sizes and shapes. Credit funds, sovereign wealth, pension funds, family offices and others have stepped in to fill the financing void created by the inability to access traditional lending sources. New players have stepped in with equity and debt checks and combinations of both, resulting in more complex post-close private company capital structures than those we were accustomed to in a traditional LBO world. While this trend initially took hold in the context of smaller and middle market deals, complex debt and equity financing structures with multiple players are gaining traction in the context of larger deals and we expect that trend to continue in 2024. As a result, we expect to continue to see an increase in the complexity of post-close cap tables and investors and acquirors’ portfolios themselves will increasingly include a mosaic of different types of investments and securities.
The SEC's New Private Funds Rules May Be a Regulatory Bridge Too Far
It is no secret that the private capital sponsors are not pleased with the SEC's recently enacted New Private Funds Rules (even though the final rules were somewhat less problematic from the industry's perspective than the originally proposed rules). What is surprising is that, other than the SEC itself, there were no real constituencies that were pushing for the new rules in the first place; many institutional LPs are still shaking their heads about this rule-making exercise and are fretting about how they will manage the firehose of information that will be coming their way soon thanks to the new rules. The fate of the new rules is now before the Fifth Circuit, which will decide whether this is a case of administrative overreach. In the meantime, private capital firms and their investors are preparing themselves for the information superhighway and compliance costs that the SEC has mandated for the private funds industry.
FSOC Targets Private Capital
Among regulatory issues facing private capital in 2024, compliance with the SEC rules (in whatever form they survive) could prove to be little more than an afterthought – at least for larger firms. In November, the Financial Stability Oversight Council released a new framework for designating nonbank financial companies as “systemically important financial institutions” or “SIFIs” and made no effort to hide that private capital firms are an intended target. Because the SIFI designation triggers Federal Reserve regulation and oversight and can lead to bank-like capital requirements, leverage limits, and investment restrictions, such a move against private capital would be a game-changer; not surprisingly, industry trade groups are preparing for a fight.
FSOC’s announcement came near the end of a year when both US regulators (Fed and SEC) and international bodies (Financial Stability Board) have said they’re looking closely at levels of bank lending to hedge and private equity funds – and may start using supervisory tools to impose limits. Even Congress has entered the fray, with Senate Banking Committee Chair Sherrod Brown recently demanding an explanation of how the Fed, OCC, and FDIC are monitoring “private credit risk to the banking sector and our financial system.” It’s too soon to tell where this all leads, but one thing is clear – the regulatory landscape for private capital looks poised to become more complicated, and potentially riskier, in the coming year.
Increased Antitrust Scrutiny of Private Equity Roll-Ups
FTC Chair Lina Khan wants to put "the market on notice that [the FTC] will scrutinize roll-up schemes," and the US antitrust agencies recently announced several such policies. Roll-up strategies can be used by any company but is often a tool in the PE toolbox.
- On December 18, the FTC and DOJ issued new merger guidelines. Guideline 8 addresses roll-up strategies, explaining that firms engaging "in an anticompetitive pattern or strategy of multiple acquisitions in the same or related business lines” may violate Section 7 of the Clayton Act.
- In November 2022, the FTC issued a policy statement describing conduct it considers an “unfair method of competition" in violation of FTC Act Section 5. The policy statement identifies roll-up transactions specifically, subjecting to Section 5 scrutiny any “series of [transactions] that tend to bring about the harms that the antitrust laws were designed to prevent, but individually may not have violated the antitrust laws.”
This policy shift is exemplified by the FTC's recent suit against PE firm Welsh, Carson, Anderson, and Stowe ("Welsh Carson") and U.S. Anesthesia Partners ("USAP"). Among other things, the FTC alleged Welsh Carson and USAP violated Clayton Act Section 7 through a string of serial acquisitions which allegedly lessened competition among anesthesiology services in Texas. The complaint also asserts that defendants’ “roll-up” strategy represented an “unfair method of competition” under Section 5 of the FTC Act. Although this challenge is pending, it is clear the US antitrust agencies are increasing their focus on PE roll-up strategies and taking a critical view toward series of PE acquisitions concentrated within a single sector or related sectors.
Antitrust Agencies' Focus on Interlocking Directorates
The FTC and DOJ similarly reinvigorated their enforcement of Clayton Act Section 8's prohibition of interlocking directorates, targeting PE fund ownership overlaps. Section 8 prohibits directors or officers from simultaneously serving "as a director or officer in any two [competing] corporations . . . so that the elimination of competition by agreement between them would constitute a violation of any of the antitrust laws[.]” Traditionally, Section 8 applied only to corporations, but in its recent suit against Quantum Energy Partners ("Quantum") and EQT Corporation ("EQT"), the FTC applied Section 8 to limited partnerships and limited liability corporations. In that case, the FTC alleged Quantum’s right to a seat on the EQT board would violate Section 8 because EQT competes directly with a Quantum portfolio company in the production and sale of natural gas. To settle the FTC's Section 8 claims and close the underlying transaction, the parties agreed to an extensive settlement, which required, among other things, for Quantum to sell its minority holding in EQT, for the parties to unwind a pre-existing joint venture, and for the parties to submit regular compliance reports. Moving forward, private equity firms can expect agencies to enforce Section 8 increasingly and should conduct regular audits of board appointments across all corporate and non-corporate relationships, including those of their portfolio companies.
