Nov 21, 2023

The year 2021 was a golden period for entrepreneurs, families and management teams. Cheap capital, lovely terms and private equity funds fighting to add equity into their business created an ideal environment for those looking to sell their companies. But while PE firms competed to offer sellers higher valuations for relatively less of an equity slice, an overinflated valuation market was brewing. Then interest rates suddenly rose. With capital no longer cheap, deal doers have not been prepared to pay those lofty valuations anymore. Now, not only can PE investors deliver less exciting exit multiples, but many can’t sell their assets without taking a massive haircut. A slow exit market means LPs can’t recycle money into new funds, leading to fewer PE firms offering capital for new deals, further deflating prices. At the same time, GPs have accumulated dry powder, which has gone into supporting portfolio companies that raised at elevated valuations. So, with equity capital drying up, creditworthy entrepreneurs have turned to debt capital to fill the void in supply. But even here, more traditional debt sources like banks have been retrenching – a trend only exacerbated during macro turbulence. However, one US-exported financial instrument may have the solution. Alternative capital’s alternative Hybrid capital has become an increasingly appealing option for companies seeking a more bespoke alternative to traditional private equity or homogenous direct lending options. It is often a blend of senior debt capital and another tranche of capital – whether it be convertible loan notes, structured equity, or even vanilla equity in partnership with an incoming equity investor – which ranks as junior to this debt. The lines between the asset classes are fine. Firstly, most debt funds wait for opportunities to leverage a sponsor’s returns, thereby avoiding advisers or sourcing directly. Meanwhile, investors with hybrid strategies do not do sponsor-backed deals; they are the sponsor. Secondly, with leverage, a portfolio company’s cashflow is used to pay down the debt with interest over about a four-year period. Many hybrid strategies, on the other hand, like to see profits reinvested so that the business is worth more. For example, instead of sucking cash out, Soho Square Capital, an investment firm that blends a debt product with a minority equity product, only has a preference on the return waterfall. But while hybrid capital has both downside credit protection – through seniority in the capital structure, security, covenants and maturity date – and equity protection, it does not necessarily invest equal amounts of money between equity and credit. More than 90% of the money deployed by Metric Capital Partners, a London-based private capital investor specialising in creative financing solutions, has been in credit form, generating an approximate IRR of 25% unlevered. Roughly half of the firm’s overall IRR comes from a contracted return through the obligation of the portfolio company. The other 12.5% comes from its equity exposure, which is granted at nil cost as it is attached to the provision of its credit. Elaborating on Metric Capital’s risk-adjusted return profile, John Sinik, managing partner at the firm, says: “We're looking at an exit right now in which we're going to make a 3x multiple of money, which is great for Metric. From the standpoint of the counterparty with whom we did the transaction, if they had transacted with private equity, the PE firm may have made 3.5x. The difference in the 3x we are making versus the 3.5x a PE firm would have made is for the benefit of the business owners.” Indeed, hybrid strategies provide a way for business owners to efficiently raise money in a low valuation environment, with many of them sensitive to diluting control of their company by way of voracious PE firms or trade buyers acquiring excessive amounts of equity. For some companies raising at the growth stage, for example, every percentage dilution could personally cost the owner €1m at exit, occasionally leading to a more expensive toll than the higher cost of interest stemming from debt. Stephen Edwards, co-managing partner at Soho Square Capital, argues that entrepreneurs do not mind ranking behind the hybrid capital investor and foregoing some equity, on the condition that they keep control and flexibility over their cashflow. If the business can become worth say £200m in four years, why would you want to sell now? Our capital enables you to de-risk now but hold the business longer and benefit from that value growth The co-managing partner adds that having an institutional investment partner onboard, in Soho Square, provides the portfolio company with access to further capital and gets them ready for a bigger exit in three to five years. “If the business can become worth say £200m in four years, why would you want to sell now? Our capital enables you to de-risk now but hold the business longer and benefit from that value growth. It avoids founders selling out too early,” Edwards rationalises. Outlining his perspective on hybrid capital’s benefits, Hemal Fraser‑Rawal, general partner at White Star Capital, which announced the first close of its Structured Growth Capital Fund I in September, says: “They are raising from an investor that will intimately understand their business and can quickly provide further cashflow to continue fuelling their growth, helping the founders to continue to build equity value.” The general partner notes that many businesses are taking on hybrid capital now to raise equity again when the macro environment has settled down: “Companies always want to increase their valuations in some way, and they do that by growing their business by taking an initial tranche of less dilutive capital to fund this initial phase of growth. Then they can take equity in addition from the hybrid capital provider, which allows them to turbocharge that growth ahead of raising a fresh round of external equity.” He adds: “It’s also a validation point for future equity investors who can place some reliance on the fact that an experienced institutional lender has the conviction to invest in the business above their original senior loan.” All weather The ability to lever companies to the extent that was seen in a 0% interest rate environment does not exist in today’s market, which bodes well for hybrid strategies. “The LBO math isn’t working and that's great for us,” says Metric Capital’s Sinik. “It is not good for sponsors because their debt servicing costs too much, and it's not good for private debt providers that want to do sponsor-backed deals as the volumes are significantly lower.” Soho Square’s Edwards agrees, noticing that potential portfolio companies are more keen for his firm’s offering now. “The relative attractiveness, say, of a private equity exit for some of these founders is more cyclical. In 2021 and 2022, the market was extremely positive, so high quality companies will have attracted high valuations to exit fully,” he says. “Whereas now, we're going back to a more normal world where there is a real cost of capital and the exuberance has gone out of the market. So, against that backdrop, our structures are attractive alternatives to full exits using external leverage where the multiples have fallen and debt is harder to raise.” With that said, proponents of the strategy go on to assert that it is ‘all weather’, providing steady returns amid buoyant or difficult market conditions. “Things will come around in swings and roundabouts because markets always operate in cycles. With a hybrid approach, you're trying to solve the problem of cyclicality. It doesn't matter what cycle you're in – a combination of someone wanting to take debt and equity will always be beneficial to both companies and investors alike,” says White Star’s Fraser‑Rawal. People understand debt, they understand private equity, but hybrid strategies like ours are not as well understood. But that is changing as advisers are finding this a useful alternative Sinik believes Metric Capital has already proven that the strategy is all weather, using its fund Metric Capital Partners III to illustrate his case: “We deployed it at peak liquidity, when there was too much money in the market and too many people chasing too few deals. And yet, we still managed to do all of our deals outside of an auction process. Now, we are tracking to a 25% gross IRR and 2.3-2.4x multiple on invested capital, even though we deployed that money during a period when there was too much froth in the market.” Further defending the sturdiness of hybrid capital, he adds: “We started in 2011 with our first fund when the European sovereign credit crisis was in full swing. Even when people were questioning the existence of the European Union, we made great returns. Fast forward to 2018-2019 when there was too much money in the market, we made great returns.” PE’s future? So, why haven’t hybrid strategies dominated private capital? Edwards says the biggest challenge is education. “People understand debt, they understand private equity, but hybrid strategies like ours are not as well understood. But that is changing as advisers are finding this a useful alternative and a way to help unlock different types of deals in the current market.” Through education, Fraser‑Rawal has observed a gradual shift in attitude and risk perception from LPs that had traditional allocations to just debt or equity: “They’re starting to say, ‘Hang on a second, by allocating from either the debt or equity buckets we have and backing an all-weather hybrid strategy, we can yield high returns irrespective of the overall economic cycle we are in.’ They realise it doesn't necessarily need to come from one bucket or two; it can come from either and they can benefit from the best of both types of strategy via one fund.” While a greater number of hybrid funds would help the education piece, Sinik warns that firms looking to pivot into the specialised model face high barriers to entry, only made harder to execute if a firm does not have a first-mover advantage in the asset class. Foremost, deep networks are required to source opportunities directly, which debt funds typically can’t do. Then you need a track record in the space to convince LPs to back you. To support the strategy shift, equity-based GPs might need new investors, who are likely to be debt LPs looking at senior and performing credit. If you do reach critical mass, you’ve got to develop the infrastructure to have skilled people on the ground across Europe. “Having the expertise to structure deals the way we structure them – with both credit and equity characteristics – requires decades of experience. If you get it wrong, you may never be able to raise another fund,” Sinik cautions.