Investment group TPG is in the midst of raising its latest Asia fund. But this one has a new kind of financing arrangement that reflects the pressure private equity houses have come under to boost their returns in a low interest rate environment.

Rather than insisting investors write cheques on the first day of the fund, TPG plans to use cheap bank loans to make investments and then ask its clients for money.

This seemingly technical practice has the effect of inflating returns when measured as a function of time because investors’ money is put to work for a shorter period. That improves the fund’s reported performance and means investors receive their cash back sooner.

TPG is not alone. Although Warburg Pincus has so far resisted, executives at Blackstone, Carlyle and KKR among others say their funds have begun relying on borrowed money at the beginning of their lives to varying degrees.

“It has become a kind of arms race,” says the founder of one private equity group which has chosen not to do so. But he notes the decision has put pressure on his company: “Not to do it is like showing up at a gunfight with a knife.”

This practice is one of many reasons that private equity groups have been among the biggest beneficiaries of a decade of dovish monetary policy. Their business model relies heavily on cheap debt, while their promise of high returns attracts ever more money from investors frustrated with the low yields on offer elsewhere. And years of rising stock markets and equity valuation have made it easy for PE groups to cash out of their corporate investments through public listings.

As long as it is not taken to extreme, there is little harm in this sort of financial engineering, practitioners insist. For example, TPG is telling investors that it will borrow a conservative 20 to 30 per cent of the value of the total amount it raises. Meanwhile, banks such as Wells Fargo have been more than willing to loan money to funds that can provide written commitments from pension funds, sovereign wealth funds or rich families as collateral.

But there are risks involved when funds buy companies using debt and collect the cash from investors later. When the environment changes, deals can go bad and the squabbles begin.

Look at what happened when Houston-based private equity fund EnerVest, which focuses on energy, ran into difficulty last July. The fund had used borrowed money alongside the capital commitments of its investors so EnerVest could put more money to work. But unfortunately the revenues of the energy companies it invested in dried up as oil prices fell. When the cash flow could no longer cover the repayment of the debt, EnerVest’s investors were not happy having to write cheques to creditors on transactions that had already turned sour. The original loans are now in the hands of the credit resolution groups at the banks involved. Calls to EnerVest for comment were not returned. Wells Fargo, which led the financing, declined to comment.

“EnerVest was the worst case,” says the head of one large private equity group. “They were well respected but the cycle turned so fast and the decline in the value of the investments was so fast.”

The last time investment firms engaged in comparable kinds of funding arrangements was almost two decades ago during the tech bubble. At that time, PE group Hicks Muse took out a bridge loan from its banks to buy several companies until it could raise enough money from investors. But the value of the investments dropped before the money was raised, leaving Hicks on the hook.

Many PE houses started using credit to tide themselves over while waiting for investors to respond to cash calls. But they expanded from 90-day bridging loans to longer borrowing periods, executives at the buyout groups say. Some PE firms now use these credit lines for a year or more.

Investor groups, such as the Institutional Limited Partners Association, are growing concerned. They recommend capping the credit lines at six months and are pushing for better disclosure of the use of borrowed money.

Some private equity houses agree. “There should be consistent and transparent reporting to investors so that they understand exactly how a manager is operating a fund and how its returns are generated,” says Thomas Mayrhofer, chief financial officer for the Carlyle Group’s corporate private equity segment.

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