Private equity groups face investor scrutiny over tactics for returning capital

Investors are stepping up scrutiny of private equity firms’ use of debt and complex financial engineering to generate returns from companies they own, demanding disclosure about the costs and risks.

Private equity groups have been increasingly using margin loans and net asset value financing — secured against shares in their listed companies or their asset portfolios — to boost returns and fund distributions to investors, after a slowdown in dealmaking reduced their options for selling businesses on.

But some investors worry they have tilted returns too far towards financial engineering, rather than companies’ underlying performance.

The Institutional Limited Partners Association, an industry body representing private equity investors, is examining borrowing strategies and drafting detailed recommendations. These will call for the industry to provide justification for the loans and more disclosure of their costs and risks to investors, said two people familiar with the details. 

Advisers to large investors have also been checking contracts to assess whether they can stop firms from using NAV loans to return cash to investors without their consent, other people close to the situation told the Financial Times.

Investors have also begun demanding restrictions that force firms to seek approval for such borrowing when they raise a new fund, the people said. 

In July, the FT reported private equity firms including Vista Equity Partners, Carlyle Group and Hg Capital had used NAV loans to finance cash distributions to investors.

“I’ve heard a lot of reasons why [using NAV loans] has created a lot of concern,” said Andrea Auerbach, partner at Cambridge Associates, a US group that advises institutions on private investments.

“One of my concerns is that this will become a part of the fund management toolbox,” she added, noting the rise in NAV financing could make it harder for investors “to understand the percentage of the return that comes from fund finance versus the actual investment return”.

In addition to NAV loans, private equity firms are also using margin loans to raise cash. According to securities filings reviewed by the FT, many of the industry’s biggest names, including Blackstone, Apollo Global, Warburg Pincus, and General Atlantic, have taken out such loans in recent years.

A margin loan involves pledging shares to a bank as collateral for a loan. In the private equity industry, this typically amounts to 20 per cent of the total shareholding. The cash is then distributed to investors, creating an investment gain without selling stock.

Generally, private equity firms earn profits for their investors by listing or selling businesses. But this can be a slow and volatile exit pathway, while selling down shareholdings can take years and depress the price.

Margin loans can improve an investment’s internal rate of return by realising profits more quickly and can have tax benefits, said executives working on such transactions.

But they can also be risky because a large share price fall can trigger a collateral call, something buyout firms are not well set up to deal with.

Blackstone, the world’s largest private equity firm, has been a major user of margin loans in recent years. Securities filings show that in 2021, it pledged all of its shares in dating app Bumble, which it listed the same year, to secure an $860mn loan from Citibank to return capital to investors.

After Blackstone took out the loan in June 2021, Bumble’s shares dropped from nearly $60 per share to just over $30 by the end of the year, before falling further.

A disclosure this March showed Blackstone had sold millions of Bumble shares and repaid some of the loan, leaving it with outstanding borrowing from Citi of $455mn. Bumble’s stock has fallen more than 40 per cent since early March.

Other firms are common users of margin loans. Over the past six years Apollo has borrowed against shares in five companies it listed, including ADT, Rackspace, Hilton Grand Vacations, TD Synnex and OneMain Financial, according to securities filings.

Since Apollo borrowed against all of its Rackspace shares in December 2020, the software company’s stock has fallen more than 90 per cent.

Blackstone and Apollo declined to comment.

While margin loans have been used by the industry for more than a decade, bankers and lawyers who spoke to the FT said they are being used more frequently to allow firms to extract cash from investments they do not want to sell or cannot sell at a profit.

“I have seen a pick-up of margin loans over the past six months,” said one private equity adviser, adding that firms were using the loans in part for “distributions for [investors]”.

Some industry executives consider margin loans too risky. “I told our team, don’t do that,” the managing partner at one large private equity firm said. “It is a real short-term opportunity.”

Another executive said: “I don’t think it would be attractive to do this, unless you have a burning desire to return capital.”