Capital Solutions: A Flexible Response to Private Equity’s Exit Problem

Anu Rajakumar: If you follow private credit, the headlines this year have been somewhat worrying, but there are segments of private markets where the dynamics are constructive. One example is flexible capital that sits between traditional debt and equity, designed to solve structural liquidity problems for private equity-backed companies. The setup matters. Roughly $4 trillion of equity investments are sitting inside private equity funds waiting to be sold, many acquired at high valuations during the low-rate era. But exits haven't materialized, and recently we've seen software companies are difficult to value in an AI-disruptive world, and the pressure on some managers to return capital is mounting. For providers of scaled, flexible capital, that's a favorable backdrop.

My name is Anu Rajakumar, and today I'm joined by David Lyon, managing director and head of Capital Solutions at Neuberger. David oversees approximately $10 billion in assets and deploys $2 billion to $3 billion annually, providing large-scale financing to sponsor-backed companies. David, welcome to the show.

David Lyon: Thanks for having me.

Anu Rajakumar: David, let's start with the basics. Capital Solutions or hybrid capital, this can mean different things to different people. Some people hear these words and they immediately think private credit; others might go straight to distressed investing. In your own words, how do you explain what your team actually does?

David Lyon: I'd start off by saying we are not distressed. In plain English, we provide non-traditional capital, which means we're not a loan, and we're not common equity. We have great license to be flexible in terms of how we structure these things. Generally, the security can be preferred stock, it can be structured equity, it can be a note, but it's typically done to solve a very specific need. One of those needs is not fixing a broken company. I want to be adamant about that. Lots of people have slapped the words Capital Solutions on decks, and generally, these are distressed players. I have to remind people there's no barrier to entry to distressed. If you are willing to be the last dollar of resort, you can be that dollar. Our business is much more founded on relationship, on creativity, on speed, and on quantum of capital. That's what we do in a nutshell.

Anu Rajakumar: Great. Thank you. That's a helpful framing. Now, the backdrop is noisy. There's a lot of anxiety around private credit broadly. We've seen return compression, public traded lenders under pressure, defaults ticking up. David, what's your read on all of that, and how much of it is relevant to what you do?

David Lyon: We haven't seen a massive spike in defaults. We haven't seen a real degradation of performance. What we've seen is a panic about what could happen. You've obviously seen amazing advances in AI, and it's caused people to step back and say, "Oh my God, how do these software models work? What is the revenue paradigm? Who's going to take what profit pools going forward?" People hate a vacuum. They're terrified. They don't know the answer, so in public markets, stocks are down 30%, 40% because people don't understand the enterprise value.

Now, at the end of the day, does that mean that every software company will be disintermediated by AI? No, it does not mean that. In fact, many of these AI companies are still trying to figure out their go-to markets. What's going to happen is a lot of software companies will partner with AI and go to market that way. There'll be some exciting opportunities, but right now, people don't know.

What's happened is in direct lending, which is the biggest part of private credit, is that a lot of the deals they financed were in software. Because 25% or 30% of buyout activity was in software, if you were a direct lender, that's how your book is indexed. Just to give you some comparison, the high-yield market software exposure is probably 3.5%. Syndicated loans is probably 13%. Direct lending is probably 22% to 25%. What's happened is people have posited absolute worst-case scenarios for a quarter of these books. Then, unfortunately, you have some large public lenders you referenced who got a lot of money from retail. At the end of the day, people were promised liquidity in these structures. I tell people all the time, I want to be 6ft 4, but I'm 5ft 9. No matter what I do, I'll be 5ft 9. These loans are not liquid. People all at once panicked, and it created a prisoner's dilemma, and so, "I have to submit my request. If I don't, I'll be in the back of the queue," et cetera.

The media loves that. The media has run with that and said, "Oh my God, the world is ending. The world is ending." I think I look at that backdrop, there's a lot of misapprehensions and misunderstandings. You haven't seen wide-scale defaults yet. You've actually seen some software deals that have actually failed because, frankly, they were just bad deals. They had nothing to do with AI. All of this uncertainty, the markets hate it.

Remember, if you were a retail investor and someone pitched you, "Hey, 9.5%, whenever you want your money, just ask for it, it's money markets but better," that, unfortunately, is the disconnect. These are illiquid loans in leveraged companies, and by the way, there will always be defaults. I tell people all the time, loans are not magic beans. If you're trying to get a 10%, 12% return, you're taking risk. There is no free lunch, and there will be defaults.

I think historically over the last six, seven years, you had a very benign default environment, but if you look at leveraged loans, which have been around for a long time, over 30 years, defaults, depending on how you measure them, are 2.5% to 3% per annum. That's the reality. You're going to have defaults in this product, and unfortunately, and that's what the media has seized upon, redemption requests, and that's what everyone is in a frenzy about today.

Anu Rajakumar: I think there's some important distinctions that you've drawn, and I'll come back to AI in a moment because I know everyone wants to hear about that, but just a follow-on question. There's been a valuation question hanging over the entire industry, and private marks haven't followed public comps down in a lot of cases, and just curious how you think about that.

David Lyon: Yes. People are governed by incentives, and they're a pretty powerful thing. A lot of private equity owners are going to take a different view on valuations. You'll hear things, "This will grow into its value." They're not going to whipsaw marks 20%, 30%. I think eventually they all get to the right spot, but there is delayed discovery, and that's been the hallmark of private markets since inception. Also, ironically, a lot of the investors don't want volatility. The reason why they seek out private markets is they actually want to have muted volatility. These things go hand in hand. Do I think that everyone's software marks today are pitch-perfect, given what's happened in public markets? Probably not, but far be it from me to tell everyone that their books are wildly overmarked as well.

Anu Rajakumar: Yes, sure. Maybe now we'll talk about the demand side of the business because private equity sitting on roughly $4 trillion in unrealized value right now, LPs are getting increasingly impatient for distributions. How does the industry actually solve for that, and where does this hybrid capital really come in?

David Lyon: Obviously, to form the next fund, you got to get money back to commit to that fund. It's a pretty simple cycle. DPI, simply put, is the money that your manager has returned to you in the fund that you're invested in. If you look at right now, people measure basically distributions divided by how much NAV there is. When it's 25%, you can invert that and saying, "Hey, realizations are happening every four years." That's a good level. When it's 15%, you can invert that number and realize that people are holding onto things longer.

What's happened in private equity is valuations have gone up, and you're paying 16 or 17 times double secret adjusted EBITDA for an asset. That means that you've only borrowed 6 turns, and you have 10 turns of equity in this company. You're going to have to do a lot to make money. It isn't just financial leverage and flip it and make a return. You're going to have to sell things, fix things, combine with things. That takes time.

I think structurally, you're going to see that DPI problem persist because it takes time to get these things right, to earn rates of return that people think are appropriate. Then obviously, I think there was a lot of deal-making that happened in 2020, 2021. Let's just say it was a much headier environment. Rates were zero. I think people had a lot of expectations about these software assets, and valuations reflected that. I also think that you have a vintage problem and you have a bid-ask problem. To your point about valuations, it's very tough to go raise a closed-end fund if you mark it all down and the returns aren't good. This cycle feeds on itself a little bit.

Now, eventually, these things will get corrected. You will see capital leave parts of this ecosystem. If you were a middle-market PE shop and you didn't have a lot of value-add, weren't doing anything differently, and your returns reflected that, eventually, you'll have that capital leave the ecosystem. That'll be good for returns overall. I tell people over and over again, private equity's not dead. I've heard that so many times over 32 years doing this, but it is mature and it's cyclical. I think we are now recovering from the times in 2021, 2022 when things were done a lot more aggressively.

Anu Rajakumar: Yes. I think that all makes sense. Maybe now going back to the AI comments that you made earlier on today, acknowledging the uncertainty that's been created around software, services, businesses. These, of course, are core holdings for a lot of PE sponsors. Tell us a little bit more about what that looks like from where you sit, and does the volatility actually create openings for you?

David Lyon: I think if you look at software and services and add it all up, it's 45% of the US economy. Right now, in this uncertainty, a lot of people want to stick their heads in the sand and say, "AI good, AI bad. I want to just sell food or distribute pipes because those things aren't impacted by AI." The reality is that it's a lot more nuanced. It isn't just software, it's professional services. What's going to happen to accountants? What's going to happen to paralegals? What's going to happen to certain lawyers? What's going to happen to consultants? You can imagine the doomsday Death Star scenarios everyone posits.

Now, I am of the belief that we're not going to lose 45 million white-collar jobs in the United States, that we're not going to put ourselves in an environment run by bots. I think there are probably limitations on what AI can do. Again, to repeat the same thing, nature abhors a vacuum. When you don't have a pattern you can cling to, investors hate it. I do believe that in next 6, 12 months, you'll start to see some patterns emerge again. How better run professional services use technology to get more business, to streamline organizations, things like that, software companies maybe going to market with AI players and figuring out how to distribute these products. I think that will all happen. I don't think it's going to be one giant disintermediation event; we're all going to be vibe coding all the software applications. I don't think that's going to happen. Again, it's going to take time. People need to see patterns. In the absence of patterns, they get very, very skittish.

We're actively evaluating all of these things. What I will tell you, and you said it earlier, marks haven't come rushing down. It's not like sponsors have taken massive marks on their book and you can provide liquidity at super cheap prices. You're going to have to do more creative things. You're going to have to structure your way through some of this. Maybe the assets are very good. Maybe the valuations aren't perfect, but they are reasonable, depending on how you look at them. There are ways to structure around that to basically create liquidity when some of these private equity firms desperately need to return money to their shareholders. Or think about simple examples where they own an asset. Maybe their equity's marked up. If they want to go buy something big with that company, they can't just use debt. They're going to need some form of equity. Very tough to write an equity check when it's marked at a 2X from a fund four years ago. That's where our capital also comes in.

It's really doing things to help companies. Again, that's also with a view to exit because that acquisition might be the final leg in the story to help them sell to whomever. That's really what our capital is around, is helping people find exit solutions. One could be, "I love this company. It's a compounder. It's one of the few assets I have that I think is going to go up reliably. Gee, I'd hate to sell all of it today." There are different solutions. You could perhaps do a continuation vehicle. You've heard a lot about those. That's a vehicle where third-party investors come in and offer existing limited partners liquidity of an equity stake, and you put that equity stake into a continuation vehicle, a separate vehicle, and existing investors can choose to sell or they can choose to roll their money in. That vehicle will also have economics associated with the private equity firm that's managing it. But again, our solution's pretty elegant. It's a bilateral negotiation. We're not selling the entire company today. We have structure around our investment. We're constructive in the boardroom. It helps them keep compounding but solves part of the DPI problem by returning money to limited partners with a friendly face.

Anu Rajakumar: You mentioned continuation vehicles as an alternative. One of the things I've heard you say in the past is that you cited the timeline difference as quite stark, a number of months versus weeks. Can you dig into that a little bit more? Is that delta really in practice, the big difference?

David Lyon: Sure. People ask me all the time, like, "Do you compete with CVs?" I say, "Not really," because if someone wants to do a CV, you know what they do? A CV. That process is generally a nine-month solicitation of your limited partners. It's a formal process where you're going out and saying, "Hey, this is the event. This is what's happening." The CV investors have specific views on when NAV is being struck, when the deal gets closed, if that NAV appreciates, what's the implied discount. That's a very different transaction from saying, "Hey, you don't have to worry about fund-level stuff, rejiggering carry, rolling carry. We are investing in a security directly into the company. It is arm's length, buyer, seller." It's just different. We can write checks of 300, 400, 500, 600 million, and do that at least in a matter of weeks if it's companies we know. It's spaces we know, and obviously, if it's management teams that we trust and have a dialogue with.

Anu Rajakumar: Absolutely. Maybe I actually want to ask you if you can give a rough sense, anonymized, of course, of businesses. We talked about software a little bit, of software companies that you feel that you have a high conviction on right now, versus others that you don't have a high conviction on.

David Lyon: Yes. I think we have eight software investments out of multiple funds. We just spent time going through them. I'll tell you the hallmarks at a high level of things that we think are more protected and things that you have to be more worried about. Obviously, data. Do you own proprietary data that AI engines don't have access to? That would be something that's very important. People also throw around system of record. Are you a place where the repository of that data, you are the system, and you don't want to basically flip a switch and rip all that out.

In general, if you are more geared towards infrastructure and parts of mission-critical applications, these are all things common sense that you think are going to be protected. On the other end of the spectrum, if you are a low-value-add coding engine and you're replicating simple human tasks, that's probably more at risk. Now, there are lots of companies the media throws around. I'm not going to use the names. For example, if you're doing help tickets, when someone calls into a system and says, "Hey," it's a bot that responds to it, "I'll log this in the queue," people are worried that that's at risk. That's easy to replicate.

Think about something easy to replicate, that is not super mission-critical, where there's no data barrier to it. Those things, the question is, "Where do the profit pools go?"

David Lyon: Unless people have a very clear incentive to rip something out and vibe code it themselves, it's not going to happen. That's kind of a broad brush to think about it. They're not all the same. They're not all the same.

Anu Rajakumar: I think you've said a few times quite clearly there's lots of situations where you and your team can, I think, genuinely add value. We talked about why distressed capital is no barrier to entry, et cetera. I guess one other question is, are there situations where you can flip it the other way, where LPs in the underlying PE funds push back on a sponsor taking hybrid capital? Do they worry that it signals that something is wrong? How do you handle any potentially negative perceptions?

David Lyon: Again, whenever you're doing something just to show DPI for the sake of showing DPI, and the security is non-economic, and it's really painful to investors, I think we would all push back against that. Right? At the end of the day, it has to be a fair cost of capital. People ask me all the time, "Well, David, if these companies are big and they're healthy, why would they pay you 17%? Doesn't make any sense."

I explain it this way. Let's say their debt is 8%, their senior debt, and they say their equity returns 25%. You're somewhere in the middle of that. We're really not a replacement for debt. These companies borrow quite efficiently, up to six times EBITDA. We're a replacement for equity that we put in debt clothing. That's how I think about it. That's why we get the rate of return, is that we are basically not really a pure play comped debt provider—we're doing something unusual, something bespoke—but because of the need for our capital, we're allowed to put bells and whistles on it: minimum returns. Structural seniority.

I tell people, and I don't mean to be too colloquial, but everyone always pitches downside protection. The reality is, if you're junior capital and something really bad happens, it's not good. What we really do is we hedge against valuation risk, so we're not first-dollar equities. For example, if you were in a software company that was trading at 21 times and now the markets think it's worth 15, my security doesn't bear that pain. I'm typically at eight or nine times in the structure, and I have a structured minimum return.

Now, you can ask the question, does the company get sold, and what's the enterprise value that covers it, but if you think there is coverage, we don't have that real equity valuation paradigm risk that you do in common. Now, also our instruments, depending on how we structure them, some have limited upside. Some actually have convertibility, which is great. You get minimum, multiple, and the ups, whatever's bigger. That's the rule for our capital and that's why we get paid.

Anu Rajakumar: I also want to touch on another phenomenon in the industry, which is the consolidation story that's playing out. Does that wave of consolidation create more distressed situations, and does that tempt you at all?

David Lyon: Distressed, I will say everyone loves dislocation. I love dislocation. Think about eight days during COVID when everyone decided we were going to be in our pajamas and live in caves for the rest of our lives, and every company that was trading at par, the loan traded at 75 cents literally two days later. That's great. If you have capital, then, and you can watch people being irrational and risk-averse, and you could scoop it up, that's awesome. That's not really distressed. It's markets are dislocated, and you have capital. I think everyone likes that.

The problem is you can't pitch that strategy because no one knows when the next window of dislocation is going to occur. It's embarrassing looking your investors in the eye and saying, "One day, this will be good to do, but not today." I've done that, and you feel silly. I think that's always tempting. Having the ability to pivot when there are things in more liquid markets that are trading off, that's interesting.

I will tell you, in my experience, if a company's bad and the industry's bad, you can buy things cheaply, but is it cheap enough? If you think that there's a DPI or liquidity problem in private equity, imagine buying something that stinks, having to fix the capital structure, having to fix the company, and then try to get out of it. That's going to be an eternity. Tempted by distress, rarely, classic distress, you always want to be on the lookout for dislocation, so when markets start to panic like this, with AI, with people in BDCs, yes, there are things that we look for. Even today, I wouldn't tell you there's an unbelievable opportunity set in liquid markets where I'm like, "This is all mispriced," because that's just not the case.

Anu Rajakumar: No, that makes sense. Okay, last question for you, David, and it's the one I always like to end with for practitioners who are actually in the market. How does the opportunity set evolve from here? If you're sitting across the table from an investor evaluating the space, what would you want them to be focused on?

David Lyon: A couple of things. I want their manager to be forthright about expected returns. Too many people I see in these hybrid funds promise 18%, 19%, 20% net, and I'm like, "Guys, you charge fee and carry. That means you're doing 25% gross." Private equity rarely does that, so if you're generating returns like that, you're taking massive equity risk. You're probably taking types of industry and concentration risk, which are very different from saying, "No, no, no, I'm downside protected. Downside protected."

I think it's important to be very sober about expected returns, especially if you're dealing with higher-quality assets. The reality is, I think we can generate people returns that are compelling, but it's not unrealistic.

That's number one. What is expectation? Generally, our job is to compound capital. We're trying to get a multiple of money in what we do. The one thing that I've always talked about is, especially in private markets, IRR is the most meaningless number in the history of meaningless numbers. It's easy to manipulate. The fallacy, it is that it assumes that you're reinvesting at the same rate of return. We can flip Microsoft for $2 and basically assume we do it every single day, but that's the fallacy of IRR. We're really trying to compound capital, and over a reasonable window to generate a reasonable return. I think that's number one, which is what are people pitching, what is a pitch, and what's economically feasible.

I think the other thing is, obviously, people love themes. People love big picture themes, and they think that a rising tide will lift all boats. Yes, the DPI problem in private equity is real. The $4 trillion is real. I think also that we have really carved out a unique sourcing mousetrap for ourselves. It's taken us five, six years to really build that up. I think being able to speak for large quantums of capital, like $500, $600, $700, $800 million, there are many people that can do a $30 million transaction. There are hundreds of people, very few at real scale. I think that's what differentiates us, is that we're very sober about expected returns. We're targeting high-quality things, and we are one of the few very scaled players that can provide that capital.

Those are all, I think, if your eyes wide open about what it is and what you're trying to do--

We also do it in a reasonably diversified fashion. We're not making five bets. When we have a pool of capital, it's 30. You can withstand tail risk. I tell people, "I don't care how smart you are, how diligent you are, there's always going to be left-tail events. Things are always going to go wrong," and you have to set up your book that way. In terms of, we don't leverage our books, but if you use leverage, what kind of diversification do you have in your portfolio? All those types of things. Those are things I would look for in terms of providers of this capital.

Anu Rajakumar: Excellent. Thank you very much. I can't let you go without a very quick bonus question. I'd love to know, David, what's the best thing that you've learned on the job in the last three months?

David Lyon: I don't know if it's last three months, but again, I will tell you, having done this for a very long time, you're always learning. You always have to, every single morning, treat it with humility. Even in the last three months, we've had a situation that had gone the wrong way. You want to beat yourself up over it, beat yourself up for it, but I think you're always going to learn. No matter how many years you've done this, the reason why it provides me passion and I love it, is that you learn something new. I'm not going to say that three months specifically, but even over the course, every single day, if I can learn something new or something surprised me a little bit, that to me is why I come to work, because I do love investing and I do learning, even about human behavior or about how people respond, like, "Does this current private credit panic surprise me?" No, not at all. I've seen every single wave of this, but it's just how you deal with people.

I think the other little learning I would take away is I've found with investors and with management teams, honesty is always the best policy. Being transparent. When people are surprised and lose trust in you as a manager, that's the worst possible thing. I think the one thing that the last three months always reinforces is just tell the truth.

Anu Rajakumar: Yes. Absolutely. I think that's a great way to end the episode. Thank you so much. David, you kicked off this episode saying very clearly that what you do is not about fixing a broken company. This is not about distressed investing, which you said has no barrier to entry. What you talked about, this is not a replacement for debt. It's more of an equity investment in debt clothing. I like that you've said with bells and whistles. I think what really stood out to me is that this is an asset class that was almost designed for the current environment with PE sponsors sitting on trillions in unrealized value. The disruptions to LPs that we discussed today, exits taking longer than anticipated, that pressure has to go somewhere. With rates no longer on a clear downward path, that incentive for sponsors to find creative solutions isn't going to go away anytime soon.

I think as we think about wrapping up this episode, the real question for investors isn't, "Is private credit safe?" It's really, "Do you understand exactly what you own, and is the return and the risk worthwhile?" It sounds like, from what we've discussed today, with hybrid capital done well, my guess is that your answer would be a resounding yes.

David Lyon: I hope so.

Anu Rajakumar: Great. Well, thank you so much for being here, David. Appreciate your time.

David Lyon: I appreciate. Thank you.

Anu Rajakumar: To our listeners, if you've enjoyed what you've heard today on Disruptive Forces, you can subscribe to the show from wherever you listen to your podcasts, or you can visit our website at nb.com/disruptiveforces, where you can find previous episodes, as well as more information about our firm and offerings.