Exit market conditions present headwinds for debt funds
Weaker exit market conditions are creating headwinds for debt funds collateralized by private equity, according to Fitch Ratings.
The ratings agency said that the most robust transactions are those with lower loan-to-values, stronger debt amortization schedules, longer maturities and more diversified asset portfolios.
“The performance of debt instruments collateralized by private equity fund holdings is directly linked to underlying fund performance, including distributions and valuations,” said Fitch analysts.
“Distributions generate cash flow to service debt obligations, and are driven primarily by exit activity and, to a lesser extent, periodic dividends.
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“Valuation changes impact the degree of collateral backing the debt, as well as transaction amortization triggers. Higher valuations can also point to higher future distributions when assets are eventually sold.”
Since the second quarter of 2022, short-term private equity returns have “significantly reduced” due to weaker distributions and slower valuation growth, Fitch added.
Furthermore, higher short-term interest rates have reduced the volume of highly leveraged buyouts, with higher long-term rates pressuring discounted cash flow valuations.
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“We expect a gradual narrowing of the expectations gap due to ongoing high levels of uninvested committed capital in new funds and increasing need for managers to exit assets to generate liquidity for LPs in seasoned funds,” added the Fitch analysts.
“Notwithstanding this, lower valuation multiples and higher interest rates will remain a drag on returns and distributions for funds that purchased assets during more buoyant market conditions.
“This in turn represents a credit headwind for more aggressively structured debt instruments collateralized by private equity fund holdings.”
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