The Rate Hike Reckoning: How Alternative Finance is Reshaping PE Investment Strategies

Cal Navatto

Last Modified : Sep 12, 2024

Fact-checked by: Bruce Sayer

The landscape of financial sponsorship is shifting significantly as private equity and venture capital (PE/VC) firms adapt to meet evolving economic dynamics and changing investor preferences. While bank lending has long been a mainstay for funding portfolio growth, a new star is rising. Specialty lenders are emerging as pivotal players, offering a compelling value proposition with fast, flexible financing solutions tailored to meet the needs and capabilities of the portfolio company.

The PE/VC industry is facing an unprecedented period. The Federal Reserve’s rapid rate hikes over the last two years, the fastest since the 1980s, have significantly impacted asset values and buyer-seller dynamics, resulting in a dramatic drop in deal activity and exit values over the past two years. The fundraising environment reflects these challenges, with limited partners (LPs) becoming more selective due to slower distributions and negative cash flows. However, sentiment among dealmakers rose in Q1 of 2024 with a growing sense that the valuation gap is resolving.

In 2023, non-bank credit funded roughly 85% of PE transactions. This blog will explore the key factors driving the surge in popularity of alternative financing solutions for financial sponsors, focusing on how rising borrowing costs are reshaping the investment landscape.

Then and Now – A Tale of Two Rates

Each investment decision involves weighing risk, return potential, liquidity considerations, and the broader economic environment. A rapid transition from historically low borrowing costs that once fueled ambitious ventures to the fastest rise in interest rates has reshaped the industry’s risk-reward calculus. What does this mean for financial sponsors looking to deploy capital effectively? Let’s explore this question with two historical examples.  

When Low Rates Spurred Direct Investment

In the years leading up to the recent rise in interest rates, the financial sponsor landscape was characterized by historically low borrowing costs. This environment presented a compelling proposition for financial sponsors. With the ability to secure loans at minimal interest rates, sponsors were often comfortable deploying a more significant portion of their capital (equity) in new ventures. The rationale was clear – the potential ROI from a successful venture far outweighed the relatively low return of savings bonds and other conservative investment options.

Imagine a scenario where a financial sponsor could earn 1.5% by investing in a bond. However, if they invest their capital in a new company with a projected 15% annual return, the potential upside is significantly higher. In this scenario, a well-researched investment aimed to add value to a company through capital injection and operational improvements has great potential for substantial returns upon exit.

The High-Rate Challenge: When Bonds Become More Appealing

Fast-forward to today’s environment of rising interest rates. The cost of borrowing has climbed significantly. Suddenly, the proposition of investing a significant amount of their own capital in new ventures becomes less appealing for financial sponsors. Why? because alternative investment options, such as high-yield bonds, now offer a more attractive risk-reward profile.

Think about it this way. If a sponsor can invest in a high-yield bond with a 5% annual return, they are less inclined to risk their capital in a new venture with a higher potential return and a greater chance of failure. The potential for a 15% ROI might justify the risk in a world of low borrowing costs. However, the equation changes when a safe 5% return is readily available.

As the lending landscape adjusts to align with changing economic conditions, financial sponsors must carefully assess risk versus return, particularly in the context of rising interest rates and financing availability. Borrowing costs and availability can significantly impact investment options differently.

Redefining how capital is deployed

The increased cost of borrowing has reshaped the investment landscape, with looming economic uncertainties adding further complexity. Strategic financing choices now carry heightened importance as financial sponsors navigate this challenging landscape.

Facing tightening credit markets, financial sponsors are increasingly turning to alternative finance solutions to meet these challenges head-on. From facilities featuring minimal loan covenants and flexible credit limits that scale with growth, to tailored solutions that adapt to unique investment needs, alternative lenders are redefining how capital is deployed.

In this dynamic landscape, financial sponsors are leveraging the value proposition of alternative finance to position themselves for sustainable growth and returns amidst economic uncertainties.

The Value Proposition of Alternative Finance

The enhanced value proposition of alternative finance lies in its customization, flexibility, and speed. Customizable terms can be aligned to the portfolio company’s needs and ability to pay. Minimal covenants and accelerated speed of funding streamlines funding to increase agility and quick response to growth opportunities. This agility allows them to cater to a broader range of financing needs to fund deals that might not fit neatly within traditional risk parameters. In an era of low fundraising from traditional sources, alternative lenders provide accessible funding options with flexible and tailored terms to better meet PE/VC needs as investment conditions change.

Beyond Borrowing Costs: Advantages of Alternative Finance

While the lure of flexible structures and tailored solutions result in more accessible financing options, they are not the sole factors propelling the rise of alternative finance in the world of financial sponsors. Several other advantages come into play:

• Speed and Flexibility: Alternative lenders often boast faster approval times and greater flexibility in structuring loan terms than traditional banks. This allows sponsors to move quickly on deals and tailor financing solutions to specific investment needs.
• Focus on Specialized Sectors: Many alternative lenders specialize in specific industries or asset classes. This deep understanding allows them to offer tailored financing solutions and potentially lower interest rates than a conventional bank.
• Focus on Innovation: Alternative financing platforms are often at the forefront of innovation, utilizing data analytics and technology to streamline the lending process and assess risk profiles effectively.

The Road Ahead: Embracing Innovation in a Shifting Landscape

When interest rates go up, multiples tend to come down, and good assets tend to become available at a discount. Likewise, as large companies look to shed non-core business lines to pay down debt that has become more expensive, more corporate carveouts are expected. These scenarios create potential opportunities for PE/VC firms with access to capital.

Financial sponsors who can adapt to the evolving financial landscape and embrace a broader range of financing options will be best positioned to take advantage. In a strict credit environment, alternative finance solutions, such as asset-based lending and invoice factoring, are likely to play an increasingly vital role in the investment strategies of financial sponsors. Leveraging these fast, flexible financing options empowers financial sponsors to increase portfolio values through mergers and acquisitions, making companies more efficient, helping them expand into new lines of business or geographies, or hiring talented teams.

Staying informed about the latest trends, understanding the advantages of alternative financing, and building relationships with traditional and alternative lenders will be vital for navigating this dynamic and evolving financial environment.

Conclusion

The evolving financial landscape, marked by high borrowing costs and economic uncertainties, is compelling financial sponsors to reevaluate their funding strategies. As interest rates remain elevated, alternative finance solutions are gaining prominence for their flexibility, tailored terms, and ability to meet unique investment needs. Speed, specialization, and innovative approaches further underscore the value proposition of alternative lenders in supporting strategic growth and maximizing returns amidst fluctuating market conditions.

While the PE/VC industry has demonstrated resilience through previous crises, the current landscape demands innovative strategies in value creation, portfolio management, and investor relations. Embracing a diversified approach to financing will be pivotal for financial sponsors aiming to capitalize on emerging opportunities and navigate the complexities of today’s investment environment effectively.

Contact us today to request a free financing consultation and see what we can do for your business.

Key Takeaways

• Rapid rate hikes over the last two years have significantly impacted asset values and buyer-seller dynamics, resulting in a dramatic drop in deal activity and exit values.
• Strategic financing choices now carry heightened importance as financial sponsors navigate this challenging landscape, with non-bank credit funding roughly 85% of PE transactions.
• Alternative lenders provide accessible funding options with flexible and tailored terms to better meet PE/VC needs as investment conditions change. Financial sponsors who can adapt to the evolving financial landscape and embrace a broader range of financing options will be best positioned to support strategic growth and maximize returns amidst fluctuating market conditions.

Cal Navatto

As a trusted financial advisor to private equity groups, middle-market executive teams and corporate restructuring professionals for more than 30 years, Cal is adept at originating, structuring and negotiating asset-based lending and invoice factoring credit facilities for businesses across the US.

Prior to joining eCapital, Cal held the position of Vice President - CIT/Commercial Services Group, a subsidiary of First Citizen's Bank. He has also served as Senior Vice President, Finance at UMB Bank and NewStar Business Credit and Vice President, Business Development at First Capital.

Cal received his Bachelor of Arts in Economics from Montclair State University.