Investors are intensifying their scrutiny of private equity firms’ utilization of debt and intricate financial strategies to generate profits from their owned companies, emphasizing the need for transparency regarding associated costs and risks.
Private equity groups have increasingly turned to margin loans and net asset value (NAV) financing, secured against shares in their publicly listed companies or asset portfolios, as a means to enhance returns and fund investor distributions. This shift comes in response to a slowdown in deal-making opportunities for selling businesses.
However, concerns have arisen among some investors that this focus on financial engineering may overshadow the underlying performance of the companies involved. The Institutional Limited Partners Association, representing private equity investors, is actively examining these borrowing strategies and is expected to propose recommendations, urging the industry to justify these loans and disclose their associated costs and risks to investors.
Advisers working with major investors are also reviewing contracts to assess whether they can prevent firms from employing NAV loans to distribute funds to investors without their consent.
Investors have started demanding restrictions that mandate firms to seek approval for such borrowing when launching a new fund. As reported in July, private equity firms such as Vista Equity Partners, Carlyle Group, and Hg Capital have employed NAV loans to finance investor cash distributions.
Andrea Auerbach, a partner at Cambridge Associates, an advisory group for institutional private investments, expressed concerns about the potential consequences of this trend, noting that the increasing use of NAV financing may make it more challenging for investors to discern the proportion of returns derived from fund finance versus actual investment returns.
In addition to NAV loans, private equity firms are also turning to margin loans to raise capital. Notable industry players, including Blackstone, Apollo Global, Warburg Pincus, and General Atlantic, have taken out such loans in recent years. Margin loans involve pledging shares as collateral for a loan, which is distributed to investors without selling stock. While these loans can accelerate returns and offer tax advantages, they also pose risks, as a significant drop in share prices can trigger collateral calls.
Blackstone, the world’s largest private equity firm, extensively used margin loans, pledging all its shares in dating app Bumble to secure an $860 million loan from Citibank in 2021. However, after taking out the loan, Bumble’s share price dropped substantially. Other firms, like Apollo, have also employed margin loans, but concerns have arisen about their increasing use for extracting cash from investments that are difficult to sell profitably.
While margin loans have been in use within the industry for over a decade, recent trends suggest a heightened reliance on them for distributing funds to investors. Some private equity professionals have raised concerns about the risks associated with this practice, emphasizing that it may offer short-term benefits but could pose long-term challenges.