6 Reasons Why Private Equity Firms Are Becoming Lenders

Returns delivered by the private equity industry are declining, although the asset class still outperforms the public stock markets. Projections put buyout returns at 8.8 percent over the next 10 years, down from the actual return of 10.6 percent over the past decade, according to a recent report published by pension consultant Cliffwater.

“Leveraged loans, by and large, are cheap and a very good place to invest capital,” said David Miller, global head of credit at Credit Suisse (NYSE: CS), at a recent conference. The move to offer credit products is viewed as a relatively easy one to make for private equity firms. General partners use a lot of the same skillsets to buy a company as they do to suss out solid credit deals. Additionally, many industry professionals argue there is a greater need for more lenders as a result of traditional banks shuttering their lending arms after the financial crisis. From large to small, over the past three years, a slew of private equity firms have dipped their toes into the leveraged lending business.

Private equity firms including the Blackstone Group (NYSE: BX), KKR, the Carlyle Group (Nasdaq: CG), and Apollo (NYSE: APO) have all grown their credit business substantially over the past couple of years. Many middle-market firms have also expanded or launched credit strategies. Firms such as Thoma Bravo, Adams Street, the Sterling Group, the Riverside Co., H.I.G., BC Partners, Silver Lake, Gryphon Investments, and Francisco Partners have all launched credit arms. This has prompted more private equity firms to follow the lead of their peers and get into the lending business.

The private credit market is still in its ascendancy. There are a supply and demand imbalance that was created when the banks exited the market. That void has yet to be filled. And even though the private market has become more crowded, the supply-demand imbalance remains largely intact. The total pool of dry powder in private credit funds today is about $100 billion. That is up to two- or three-fold from 10 years ago, but there is still about $800 billion in visible forward demand with upcoming mid-market loan maturities and private equity dry powder.

In the lower middle market where Balance Point Capital plays, access to credit and equity isn’t always an easy feat, so early on in the firm’s life, the Westport, Connecticut-based firm decided that being able to provide flexible capital was the right move. The firm has the ability to provide credit and equity in a single transaction, or come in as the lender, or just invest equity.

“We can be super flexible. We found the companies in the lower middle market often don’t have access to both sides of the balance sheet and we felt like being able to offer both equity and debt was a competitive advantage,” says Justin Kaplan, a partner at Balance Point Capital, which recently closed on Balance Point Capital Partners III with $380 million. “Having the ability to customize capital options for companies in our market is a competitive advantage and at the same time, is a benefit to the entrepreneurs in our market who appreciate the flexibility.”

“Overall, the market has become more competitive and a plethora of direct lending funds have been raised over the last two years, but one of our differentiators is that direct lenders can’t speak to both credit and equity-like we can,” says Kaplan.

One example of a company taking advantage of credit opportunities is what happened at Carlyle. In the past five years, the Washington, D.C.-based firm Carlyle has formed a direct lending fund to finance sponsor-backed middle-market companies, a distressed and special situations fund to invest debt in distressed situations; an energy credit fund, and a structured loan fund. “The private credit market today appears strikingly similar to where private equity was approximately 20 years ago,” said Kewsong Lee, Carlyle co-CEO, in a recent interview with Korean Investors. “We have considerable white space to launch new products and expand investment mandates.”

The move into credit has made sense for Carlyle. “The Carlyle team has tremendous knowledge and a strong deal sourcing capability that allows the team to see a broad spectrum of investments,” says Popov. Credit Opportunities Fund, which is Carlyle’s newest fund, will allow the firm to work with businesses that are looking for capital but don’t want to sell a majority stake or necessarily work with private equity owners.