Over the past few weeks, we’ve spoken a bit about the financial creativity of private equity firms. With the recent turmoil among regional banks and financials, its fun watching that creativity get put to good use. While far from new, the situations at SVB and Signature Bank kicked off a fresh round of secondary market debt purchasing. Some of this will be done by other banks and hedge funds, but the early activity has come from private equity shops where there has been an opportunity to buy the debt of owned companies for cents on the dollar. When this happens, the debt buyer can make all sorts of decisions based on what is most profitable for them. Is the equity worth more if we cancel this debt? If the answer is yes, then cancel the debt! If the debt is cheap and doesn’t take into account the true ability of the business to pay the coupons, even better! Private equity buys at a significant discount and captures more yield than the bank ever signed up for. As lovers of free money and market inefficiencies, we here at WCP love this type of move.
But the natural question is… why on earth would the banks agree to this?
There are two reasons: 1. The private equity company has better information and the benefit of control. 2. Sometimes the banks need to adjust their balance sheets for changes in asset values. Number 1 is always true because the PE companies are insiders at the companies whose debt their buying. Number 2 is not a regular occurrence but as we saw at SVB and Signature, when it happens, it happens fast and the desperation to unload those loans can lead to significant pricing opportunities.
So what’s the catch? For the most part, this is a simple arbitrage trade with relatively little risk for private equity buyers, but on the rare occasion that it goes wrong, the PE company increases its concentration risk by increasing the capital that they have contributed to the underlying company. Analysts and investors will all make the mistake of falling in love with their own idea at some point in their career. This is a bit of a twist on the classic value trap and it’s always possible when making this trade, but current market conditions could make this a very interesting strategy in the coming months.