What are the current challenges and opportunities within the PE industry?

Difficult macroeconomic conditions

In recent years, the global macroeconomic context has not been particularly favourable to companies.

The Russian invasion of Ukraine in September 2022 has further exacerbated the post-pandemic rise of inflation by increasing supply chain disruption and driving up energy prices.

In response to the increase in inflation, the main central banks raised their interest rates, leading to a contraction in consumer demand impacting the operational margins of the companies.

Moreover, as interest rates rise, companies that have benefited during more than a decade of a low interest environment struggle to meet their financial obligations under their existing debts.

The convergence of these factors creates an explosive combination, putting the companies in financial difficulties.

Needs for equity financing
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PE Firms seeking to provide financial assistance to their portfolio companies must be cautious of the different pitfalls associated with such procedure of share capital increase.

Frédéric Lemoine

Companies, particularly those backed by private equity firms (PE Firms), which heavily relied on financial leverage, find themselves in a position where they need additional financing.

Additional financing can be obtained through debt funding but also by injecting fresh equity into the company. Typically, such an injection of new equity is made through a share capital increase.

PE Firms seeking to provide financial assistance to their portfolio companies must be cautious of the different pitfalls associated with such procedure of share capital increase.

(i) Control

As larger acquisitions become more common, it is not unusual for PE Firms to collaborate with co-investors for their investments. The notion of control becomes then paramount.

Indeed, in the most common forms of companies used in Luxembourg (i.e. sociétés anonymes and sociétés à responsabilité limitée), any share capital increase will require the holding of an extraordinary general meeting of shareholders before a Luxembourg notary.

Thus, in order to avoid being blocked by recalcitrant minority investors in their attempt of refinancing, PE Firms must ensure the control of the company in terms of quorum and voting rights.

To mitigate such risk, PE firms will generally rely on the voting agreements, which are commonly found in the co-investment agreements that they entered into with their co-investors.

(ii) Preferential subscription rights

PE Firms must also consider the eventual existence of preferential subscription rights. Preferential subscription rights is an anti-dilution mechanism of protection. However, such mechanism may have two main disadvantages for PE Firms. In refinancing transactions where time may be of the essence, setting a period during which the shareholders may exercise their preferential subscription rights may cause delay in the process. In addition, PE firms may also seek to increase their participation in the company to have its full control to implement the necessary measures to turn around the business. Preferential subscription rights, by potentially preserving the status quo in terms of shareholding, may constitute a significant drawback.

(iii) Balance sheets clean up

Potential new investor(s) may be reluctant to invest in a company with a balance sheet showing important losses. Hence, it may need to proceed with a share capital reduction with the absorption of the losses before the share capital increase. Such an operation is not without risk, notably in a scenario where the share capital has been reduced to zero. Minority shareholders expropriated from their shares may initiate a legal action against the PE Firm on the grounds of an abuse of majority. Such transaction must be carefully justified from an economic point of view.

New opportunities

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As traditional banks became a bit reluctant to grant or extend credits, or tightened their conditions or required additional security, borrowers sought alternative means of borrowings.

Audrey Jarreton

The Luxembourg market continues to feel the impact of the financial crisis, especially with the increase in interest rates and inflation during 2023. Compared to other jurisdictions, mid-sized transactions (up to EUR250 million) have been less affected by the financial crisis, while large cap transactions (over EUR250 million) drastically decreased, although the market was not totally frozen.

As traditional banks became a bit reluctant to grant or extend credits, or tightened their conditions or required additional security, borrowers sought alternative means of borrowings.

Luxembourg debt funds took this opportunity to provide direct lending to borrowers and thereby position themselves in the Luxembourg market and abroad. The observed growth in debt financing during the last two years can be attributed to various factors that have collectively contributed to the utilisation of debt financing as a means to access capital for business and economic activities. Such factors include:

  • overall economic growth;
  • globalisation fostering business expansion;
  • increased entrepreneurial activities;
  • real estate development requiring substantial capital; and government stimulus programmes that may have encouraged borrowing for various purposes.

Depending on the risk appetite of their investors, debt funds may lend directly to a variety of borrowers, such as midmarket companies. They also offer more flexibility on the form and features of the loans granted, such as PIK, mezzanine, bullet loans, unitranche financing, etc. However, those financings usually come with other challenges, such as higher interest rates.

It is easy to see how private debt activity, including venture debt activity, is a natural extension of private equity. Whereas private equity funds in years past might have had a small amount of debt in a portfolio, some appear to be looking at becoming high-volume debt providers or managing a book of loans.

It is also worth noting that private equity firms are particularly relying on mezzanine debt as an asset class. For example, in August 2023, BlackRock Inc. (a renowned provider of investment management services based in the United States) completed the acquisition of Kreos Capital Group, a leading growth and venture debt financing solution provider headquartered in the UK. The specific financial terms of the acquisition were not publicly disclosed, but this strategic move by BlackRock is aimed at fortifying its global presence and capabilities as a prominent credit asset manager. Through this acquisition, BlackRock endeavours to expand its offerings, providing clients with a wider range of private market debt options and diversified investment solutions.

However, lending to the public (without collecting funds from the public) is a regulated activity supervised by the Luxembourg financial supervision authority (Commission de Surveillance du Secteur Financier – CSSF). Professionals performing lending operations engage in the business of granting loans to the public for their own account. There is an assumption that the activity is the main activity carried out by the company, and that it is performed repetitively.

There are a couple of exemptions, such as granting loans to one or several companies belonging to the same group (to which the entity concerned belongs) or lending to a targeted identifiable person (limited circle exemption). There is also a professional exemption, which excludes loans with a nominal value of at least EUR3 million and loans granted exclusively to a professional, as defined in Article L. 010-1.2 of the Consumer Code – i.e. any natural or legal person acting (including through another person acting in his/her/its own name or on his/her/its own behalf) for purposes relating to his/her/its trade, business, craft or profession.

In addition, some professionals are specifically excluded from the scope of this legislation, including UCIs, SIFs, pension funds, SICARs and other persons carrying out an activity the taking up and pursuit of which are governed by special legislation in Luxembourg.

In almost all cases, private debt funds would not fall within the scope of the professional as understood in financial sector law or would fall under an exemption accepted by the CSSF.

This article was first published by Paperjam (where you can also watch a short Q&A video).