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Hedge funds are challenging private equity firms over restrictions that dictate who can lend to or buy the debt of buyout-backed companies, weighing legal action to capitalise on a surge in corporate distress.
Private equity portfolio companies can be particularly exposed to interest rate rises because of buyout firms’ reliance on debt to buy businesses. The firms draw up “whitelists” of approved lenders to stop potentially troublesome credit investors from using a position in the companies’ debt to steer the business’s strategy.
Although whitelists have been a feature of the buyout market for the past decade, the system is increasingly being tested as higher interest rates cause lenders to retrench, leaving companies searching for new sources of finance.
Law firm Pallas, which counts some of the hedge fund industry’s best-known names among its clients, told the Financial Times that it was exploring a legal challenge to the practice.
“The use of whitelists, which prevent financial institutions who are not listed from acquiring the debt, damages market liquidity and often results in a sponsor-friendly restructuring instead of one that is in the best interests of the company,” said Natasha Harrison, managing partner at Pallas.
Many large private equity firms use whitelists. The system not only helps them to prevent combative investors from buying the debt of their portfolio companies if they get into difficulty, but also to cement relationships with friendly lenders.
“Certain firms have reputations for being more litigious, being more activist and a lot of private equity don’t want to deal with those kinds of investors,” said Randy Raisman, managing director at Marathon Asset Management, which is on many whitelists.
But companies need to refinance more than $1tn of debt in the coming four years, according to figures from rating agency Moody’s, at a time when interest rate rises have made borrowing more expensive.
Some whitelisted lenders have been reluctant to lend more to troubled companies when their investment is already under pressure. Without existing lenders putting in new cash, portfolio companies need their private equity sponsors to permit them to take money from new sources.
“The problem becomes that you need new money and the sponsor does not want to give up [some or all of their ownership in the company] and the company is paralysed for a longer period,” a hedge fund executive said.
Last year KKR-backed cancer treatment provider GenesisCare was unable to borrow the money it needed from existing lenders, chief executive David Young told a US court, in part because of a restrictive whitelist. It was ultimately able to raise $200mn after the whitelist was expanded, according to Young.
Investors at another KKR-backed company, Unilever’s former spreads business Upfield, were unable to sell their debt to willing buyers in 2022 because of KKR’s whitelist, according to one creditor. KKR expanded the list in 2023 because Upfield needed to extend the maturities on its debt and the company managed to push out the repayment date for billions of dollars of loans.
KKR declined to comment.
As many private credit groups rely on buyout shops for business — the bulk of their lending is often to finance private equity deals — they may have an incentive to avoid rocking the boat even if a company’s strategy is failing.
“How are you going to negotiate with a sponsor during a debt restructuring knowing that you will go to the naughty list if you don’t roll over and play dead,” said Allan Schweitzer, portfolio manager at credit hedge fund Beach Point.
Some industry figures suggest that the system should be modified. One compromise would be to make it easier for lenders who are not on the whitelist to get involved earlier in the refinancing process, for example if there were a credit downgrade or a drop in the company’s earnings.
“There could be a middle road where PE firms still keep the whitelists in place but there are more triggers that allow for opening the whitelists than there are now,” said Eric Larsson, portfolio manager for Alcentra’s special situations funds.