Yahoo Finance Private Equity’s Latest Move to Gin Up Cash: Borrowing Against Its Stock Holdings
(Bloomberg) -- Cinven’s clients got some unwelcome news last year: the buyout firm’s financing tied to a lab-testing company wasn’t going well. Instead of getting a windfall, clients had to ante up more cash.
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It turned out Cinven had borrowed against its stake in Synlab AG, a move that typically would boost everyone’s cash distributions. Now, though, shares of the company Cinven took public in 2021 were plunging as sales of Synlab’s Covid tests faded along with the pandemic.
The price drop was so bad in February 2023 that Cinven faced a margin call — an ultimatum from lenders to put up more money for collateral or risk seeing the stock seized. Cinven, with the help of clients, had to hand over 299 million euros, or about $320 million, said people familiar with the investment.
Private equity firms have used margin loans backed by shares in companies they’ve taken public to supercharge returns for more than a decade, and to return cash to clients frustrated by the recent drought in asset sales. Industry executives estimate up to $50 billion of the debt is now outstanding.
But the risk is more than just a falling stock price. On top of the margin loans, funds have adopted more novel forms of borrowing against their holdings to free up cash for investors, adding to the proliferation of debt across private equity.
The full cost of all this debt is coming due as interest rates have drifted up. Even after an initial public offering — which clients might expect to close out a debt-heavy wager — the investors may find their stakes are still leveraged with floating-rate margin loans.
And sometimes, the loans just add new headaches.
“Any time a manager is introducing an additional layer of debt or leverage, it can create an opportunity for things to go wrong,” said Brian Dana, who leads outsourced chief investment officer services at Meketa Investment Group.
Blackstone’s Loans
Blackstone Inc., the world’s largest alternative asset manager, received a March 2022 margin call after borrowing some $860 million against its stake in dating app Bumble Inc. KKR & Co. disclosed in 2020 that some funds received margin calls after the securities that they pledged as collateral – like shares in oil pipeline company Genesis Energy LP — lost value amid the pandemic.
Blackstone took out margin loans of about $4 billion on stakes in more than half a dozen companies during 2021 and 2022, according to Bloomberg estimates. “This is a very common way to accelerate returning gains – while preserving value and potential upside – with large public positions,” said a spokesman for New York-based Blackstone.
In years when stock markets are volatile or when other holdings are hard to sell, margin loans help managers avoid taking a loss on a sale and still send cash back to investors. The clients get more spare change to re-invest with the funds — and a new round of fees flow to the managers.
The flip side is that if a stock falls far enough to trigger margin calls, the borrower winds up at the mercy of market forces that they can’t control, undercutting the idea that private equity offers shelter from the turmoil of public exchanges.
To meet the Synlab margin call, Cinven was in effect asking clients to return prior payouts from the private equity firm, which had taken Synlab public in a 2021 offering that raised 671 million euros ($813 million).
The move to recall distributions just when the investors were hungry for cash caused unrest, said one of the people familiar with the matter, who asked for anonymity to discuss the private transaction. Some clients voiced concern among acquaintances or questioned Cinven staff on whether the fund had done enough to protect their money, the person said.
Cinven has since closed out the margin loan, according to people familiar with the matter. The firm set up an entity that bought more Synlab shares, a move that supports the stock and gives the private equity firm a controlling stake so it can direct the company’s growth. It also plans to take Synlab private.
A representative for London-based Cinven declined to comment.
Useful Tool
Margin loans aren’t inherently bad. They helped build US railroads, and they’ve been used by modern swashbucklers like Elon Musk.
But they come with a stigma, too. During the Roaring Twenties, investors bought stock by paying just 10% down and borrowing the rest. When they sold en masse to meet margin calls, it fueled the crash of 1929 and left behind a high-risk taint.
Private equity began warming up to the loans some 15 years ago, as their ventures and buyouts got bigger and exit strategies became more problematic.
When buyout firms take companies public, they’re often left with capital tied up in huge piles of stock, because major shareholders typically are required to wait as long as 180 days before selling. In theory, this helps protect underwriters and new public investors from sudden declines. Even when the lockups expire, the blocks can be too big to sell quickly.
More Fees
That’s where margin loans came in. Debt was cheap in the decade after the 2008 financial crisis, which made it easy to borrow and unlock some cash. This also helped nudge up a metric used to calculate private equity portfolio returns — which in turn helped dealmakers start collecting their share of profits earlier.
If a fund is making only 7%, there’s little or nothing earned for the private equity sponsor, but at 9% the “carry” can be huge, said Richard Lichter, vice chairman at Newbury Partners, a secondary buyer of private equity stakes. “That definitely goes into the calculus” about whether to borrow.
Blackstone reaped the benefits of margin loans when it took hotel company Hilton Worldwide Holdings Inc. public in 2013, one of Blackstone’s most lucrative deals ever. After the IPO, Blackstone took out a $2.25 billion loan secured by stakes in Hilton, according to regulatory filings. Most of the money was distributed to fund investors.
This allows the firm to “have our cake and eat it too,” then-Blackstone President Tony James told investors in a 2014 earnings call, adding that Blackstone expected to use the technique again. The firm can “get some money off the table at very low cost and continue to have 100% of the upside in the stock.”
Blackstone took out at least seven margin loans in 2021 and 2022, and they all added to returns. They include borrowings against shares of Gates Industrial Corp. and Chesapeake Energy Corp.
One secured against Bumble stock helped the firm pay out twice its original invested capital on the deal by the end of 2021, said people familiar with the matter. Collectively, the initial loan-to-value ratio for the group averaged out to less than 20%, according to a spokesman.
But there was at least one notable setback. Amid a historic growth rout prompted by rising rates, Bumble’s shares plunged as much as 52% during the first quarter of 2022 — steep enough that bankers issued a margin call, the people said. The firm tapped reserves of funds that held Bumble to put up cash.
A Blackstone spokesman said it has tapped margin loans some two dozen times over the years “with virtually no issues.”
He called the loans a “low-cost tool” to enhance returns for its investors, adding that margin loans are generally used for less levered companies. The firm said it typically notifies investors when a margin loan occurs.
A more recent drawback is that the debt generally has floating interest rates, and the cost of existing margin loans has risen as the Federal Reserve pushed rates higher. Blackstone negotiated new terms on the Bumble loan late in 2023, according to people familiar with the matter — and rising rates ratcheted up the cost some four-fold, to more than 8% from an original 2%.
Most of the loan had been paid down by then, according to documents and people with knowledge of the loan, who weren’t authorized to speak publicly.
Modified Terms
Margin loans can present a test of a private equity firm’s negotiating skills when things go awry.
Shares of pipeline company Genesis Energy plunged along with oil prices when the pandemic took hold in early 2020. That also reduced the value of the preferred stock that a KKR affiliate had pledged as collateral for a margin loan several years earlier.
While KKR was able to initially modify the terms, the firm had to put in more cash as Genesis shares continued to slide, according to a person familiar with the situation. There was no default and KKR repaid the loan that March, the person said.
Investors are divided over whether the costs of the financial engineering will hurt returns over the long haul.
“As an investor in a partnership, would I be in favor of them borrowing money to get my capital back faster if that increases my return on invested capital? Sure,” said Mark Yusko, founder of Morgan Creek Capital Management, which runs money for institutional clients. But he’d “rather them leave our money invested longer and get a higher multiple of capital.”
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