Written By Dom Sorbara and Fatima Kawar

In recent years, the landscape of mergers and acquisitions (M&A) financing in private equity (PE) has experienced significant changes. Rising costs of debt and fluctuating availability have compelled PE firms to reassess their financing strategies.

High Cost of Debt Leads to More Equity-Focused PE Transactions

The Canadian PE market has mirrored global trends, with rising interest rates and higher debt costs influencing financing strategies. Traditionally, debt played a significant role in Canadian PE transactions. However, as borrowing costs have increased, there has been a notable shift towards equity. The average equity portion in Canadian PE transactions increased from 50 percent in 2022 to 53 percent in early 2023, reflecting a move towards more equity-weighted capital structures in response to the expensive debt landscape.¹ Similarly, in North America and Europe, equity as a percentage of deal value increased to approximately 56 percent in 2023, up from a 10-year average of approximately 46 percent.² This shift indicates a broader trend towards financing strategies seeking to mitigate the risks associated with high leverage.

Refreshed Competition in the Leveraged Loan Market

In addition to higher costs, the availability of debt has also been constrained. The syndicated loan market, which has traditionally been a major source of financing for PE deals, experienced significant disruptions throughout 2022 and early 2023. This led to a noticeable decline in the volume of loans to PE borrowers, from a peak of $573.5 billion in 2021 to just $191.4 billion in 2022.³ This trend continued into 2023, but private credit (i.e., non-bank financing) began to fill the void left by traditional lenders, creating fresh competition between syndicated bank loans and private credit firms. As a result, the percentage of PE buyout transactions using private credit increased from around 41 percent in 2021 to approximately 67 percent in the first half of 2023.⁴

In 2024, this shift has persisted. However, recent developments indicate a more nuanced picture. The spread being charged to PE borrowers on new issue Term B loans has decreased by 105 basis points over the past year, reflecting a slight easing in borrowing costs.⁵ While PE deal activity saw a 12 percent increase in the first half of 2024 compared to the same period in 2023, PE deal activity as a percentage of all M&A value remains well below its prior peak in 2022.⁶

The reduced interest rates have indeed sparked a significant wave of refinancing and repricing activity. The increased refinancing activity is aimed at replacing higher-cost debt with more favorable terms, extending the maturity of obligations, and improving liquidity. However, the overall market conditions, including the still relatively high cost of debt and ongoing economic uncertainties, have continued to constrain a full recovery in PE deal activity. As a result, while there is some optimism in the market, the pace of deal-making remains tempered by these broader economic factors.

Impact on M&A Activity and Exit Strategies

The general rise in the cost of debt and reduced availability of bank financing have significantly impacted M&A activity and exit strategies in PE as well. Traditionally, PE funds, and specifically leveraged buyout funds (LBO funds), have relied heavily on leverage to finance acquisitions and boost returns. However, with the increased cost of debt, it has become less economical to load portfolio companies with substantial debt, which has decreased the overall volume and value of M&A transactions.

The scarcity of affordable debt has led to a slowdown in exit activity. PE firms are finding it difficult to offload their portfolio companies at desirable valuations, partly because potential buyers face similar challenges in securing financing. This has led to longer holding periods for assets, as firms delay exits in the hope that market conditions will improve.

The increased cost and limited availability of debt have forced PE firms to rethink their approach to M&A and exits, focusing more on strategic refinancing and alternative liquidity solutions to navigate a challenging financial landscape.

Alternative Liquidity Solutions

Market conditions have led to an increased use of alternative liquidity solutions in the US, such as net asset value (NAV) loans, ManCo loans and GP-led secondary transactions—a trend that is slowly finding its way into the Canadian market as well. These tools offer additional liquidity to PE funds and provide greater flexibility in managing portfolio companies.⁷ In particular, NAV loans have become an essential tool for PE firms navigating the current environment, offering a means to leverage portfolio assets for liquidity without the need for immediate asset sales.

NAV loans are a type of financing secured by the overall value of a PE fund's portfolio, rather than by individual assets or portfolio companies. These loans are diligence-intensive, requiring a review of the fund, its partners, and a deep dive into the portfolio. Consents and step-in rights are addressed by structuring the borrower above the portfolio investments and covenants typically govern asset eligibility.

NAV loans allow PE funds to leverage the collective value of their holdings to raise capital, which can be used for additional investments, addressing liquidity needs, or supporting existing portfolio companies. NAV loans are particularly useful for funds nearing the end of their lifecycle or those with illiquid assets needing to distribute returns to investors without a complete sale.

Generally, investors view NAV loans as a flexible financing option, provided that borrowers remain within leverage limits and manage expenses. A notable example of this trend is Blackstone's initiative to secure a $1 billion NAV loan with assets from its $18 billion flagship fund. Blackstone's investors have even encouraged the firm to explore the tool of NAV loans as part of its overall financing strategy.⁸

Similarly, to lessen its dependence on banks, Apollo Global Management also issued a $1 billion NAV loan to Warburg Pincus.⁹ Apollo is at the forefront of this trend, where insurers are increasingly involved in lending to PE funds using NAV loans. This trend is furthered by US banks facing stricter capital requirements and becoming more selective in their lending. Insurance companies bridge the gap as they operate under different capital rules and seek high yield investments. Insurers such as Pacific Life, Allianz Life, and Protective Life are also now involved in providing NAV loans.

The current economic environment, marked by market and interest rate volatility, has enhanced the attractiveness of NAV loans for both lenders and borrowers. Borrowers seek flexible financing options that do not require asset sales at depressed prices, while lenders can benefit from the secured nature of these loans, which offer a more predictable risk-return profile. This alignment of interests makes NAV loans a valuable tool given current market conditions. NAV financing is expected to increase sixfold by 2030, potentially reaching a total market size of $600 billion, and become more prevalent in the Canadian market as it becomes more commonplace south of the border.¹⁰ 

To discuss these issues further, please contact Dom Sorbara.

The authors are grateful for the assistance of Benjamin Mogil, summer law student, in connection with the preparation of this article.

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