Choose Private Debt Over Private Equity

Posted on: September 9th, 2021


Private equity funds have become a major force in the middle market over the past 30 years, as they have adopted valued added business models that create strategic value in their investee companies.  Private equity, as the bottom layer in the capital stack, takes significant risk of loss, resulting in its need to charge a high return.

Private Equity Returns

Private equity returns range from 16% to 25% per annum in the lower end of the middle market. They achieve these returns through taking an ownership position ranging from 65% to 85% of the company. So, while private equity unlocks your ability to sell your company, it is highly dilutive in terms of equity ownership. A conundrum arises for many middle market companies when they consider private equity to grow as opposed to sell. The reality is that most middle market business owners want to expand rather than sell and are not interested in giving up 75% of their shares to bring in private equity capital to do so.

For decades, as private equity has expanded, it has continually heralded its ability to help business owners scale up faster. Many business owners struggle to raise enough capital on their own to scale-up faster and become desperate for funding solutions. The best move for companies in need of scale-up capital is to ditch private equity and switch to a private debt solution such as direct lending or a mezzanine debt loan. These types of lenders can fund deep into the capital structure and fill the growth needs of most scaling companies. They can fund acquisitions, new products, and regional expansion at a cost ranging from 6% to 12% per annum, depending on the risk of your deal.

Some private debt lenders may require additional return enhancement to the extent they are taking raw equity risk. This is usually no more than an extra 2% to 3% per annum when they do. These lenders, particularly mezzanine debt lenders, are highly flexible and can design a bespoke facility to create maximum value. Mezzanine debt lenders usually lend at a debt multiple of 3.5 times to 4.0 times adjusted EBITDA. So, while they cannot stretch as far as a private equity firm, they can usually provide a great deal of capital bandwidth for finance hungry companies with long growth runways. Private debt is less expensive than private equity, less dilutive and provides a high level of financial flexibility.