Structuring deals in a bear market

Although the stock market peaked about a year ago, LPs have yet to feel the full impact on their private-equity portfolios. But surely it is only a matter of time before lower public-market multiples feed their way through into private-market valuations. For example, the FT recently ran an article with the headline “Harvard predicts looming markdowns to private fund holdings” (13/10/22).

Harvard’s endowment fell 1.8% in the past fiscal year, although it still outperformed the S&P’s 11% drop © Maddie Meyer/Getty Images

With no end to central-bank tightening in sight, LPs seeking to protect their portfolios from further market falls will naturally turn to credit. But even with the recent increases in yields, the bond market only offers investors returns that are negative in real terms. This is where private credit can help, particularly in niche strategies such as Prefequity’s that offer net returns in the mid-teens without having to take market risk.

How is this achievable? First, by targeting an underserved part of the market, in our case non-sponsored deals in strongly performing owner-managed companies. Returns in this space have not suffered anything like the compression seen, for example, in so-called direct lending funds that finance buyouts. We are therefore able to achieve attractive returns while still maintaining our preferred position as senior secured lender. Second, we aim to generate approximately two thirds of our returns from contractual interest and fees. This allows us to capture a decent return even if the company’s performance is underwhelming, by eating into the owner-manager’s equity value if necessary. Third, the balance of our return comes from an equity warrant, where we take a put option to sell the warrant back to the company at a fixed multiple of earnings once our loan has been repaid (usually after five years). The multiple on the put option is fixed according to the agreed enterprise value at the time of making the investment. So, if the market subsequently falls, we still have the right to sell back our warrant at the original multiple – insulating us and our investors from market risk.