Pitchbook: Private Credit 101 – High rates, scarce exits prompt inclusion of equity warrants

Equity warrants are finding their way into private credit transactions, particularly in the lower middle market, as a way to juice returns and align interests between a borrower company and lenders, market participants say.

Although warrants have featured in deals for decades, they are by no means common in private credit transactions. Nonetheless, there has been an uptick in their use since 2022 as borrowers seek to avoid adding cash-pay interest, according to market participants.

In today’s high interest rate environment, where exits have been challenging, the feature backloads part of the lender’s return — via equity participation — at an agreed-upon exit event.

Lower spreads, complex stories

Warrants in private credit transactions typically exist in two forms: penny warrants and traditional warrants.

Penny warrants allow the lender to buy a given amount of a company’s securities at a nominal exercise price, which is usually set at a very low value (i.e. $0.01 per share). These types of warrants are more common in private credit transactions, market sources said.

Traditional warrants are calls that give investors the right — but not the obligation — to buy the underlying stock from a company at a set strike price, before a pre-determined expiration date.

By providing potential equity upside to a lender, they encourage debt providers to support a borrower’s success.

Investors often use warrants in private credit transactions where borrowers are in a high-growth phase, have some aspect of additional risk or uncertainty (i.e., high customer concentration), or need more flexibility in the structure of the deal, market sources said.

Lenders use the tool to create a bespoke, flexible solution for borrowers with a more complex story than a traditional direct lending strategy allows for. “When you have businesses with complex financing needs, warrants can be a good way to bridge the return needs of investors while creating shared success and shared outcomes, for both the lender and the borrower,” said Alexandra Jung, head of private debt at AEA Investors and Managing Partner of Amateras AEA.

Warrants can lower the cost of capital in a private credit transaction by providing lenders with potential equity upside, incentivizing them to accept a lower interest rate on the loan portion at close of a transaction.

Warrants typically account for 25- 30% of the overall return, while the yield, or contractual return, accounts for the other 75%-80%, market sources said. “By way of example, if I am aiming for a 20% total return (which is a typical return for a lower middle market deal with warrants), approximately 15% should come from the contractual yield, and the other 5% from the equity component,” said Michael Guarnieri, managing partner and co-founder of Evolution Credit Partners.

Hopes for extra return

Despite these features, warrants remain uncommon in private credit transactions, because most private equity firms or owner-founders don’t want to give up equity in their companies. However, when they are used, they are typically paired with a junior capital loan, market participants say.

“Warrants are always something that we are thinking about as we look at our toolkit, particularly in junior capital financings … still, warrants have been rare, and I’d expect them to continue to be rare,” said Haynes.

“When Amateras AEA has used warrants, it has typically been with some form of junior capital,” said Jung. “Because for junior capital, the position in the capital structure requires higher returns that reflect a hybrid equity type risk, which is higher than a typical stated coupon would be.”

Some market participants note that in today’s high interest rate environment, warrants have become a more relevant tool, especially in lower middle market transactions.

“Bluehenge has been doing warrants since forever, but not many in the last ten years,” said David Kocen, managing partner at Bluehenge Capital. “But we’ve used warrants in four to five of the first nine deals in our new fund.”

“During the bull market for credit that existed up until 2022, warrants were very rare,” said Guarnieri. “You may see them more in today’s environment, but they remain a rarity.”

“Warrants have long been a part of our tool kit, although we hadn’t used them much in the last ten years,” said Kocen. “Leading up to the middle of 2022, though, when the market softened and credit became more dear, warrants came back around. They provide that supplemental component of return that has been appropriate in this environment, but that can’t be covered with a cash or PIK yield appropriately.”

Recent warrant deals

Among recent examples of deals with a warrant component, Enthusiast Gaming received a $20 million credit facility to support growth initiatives and fund working capital. In connection with the financing, the lenders received warrants to purchase roughly 37 million shares of the company’s common stock. Lenders may also convert outstanding PIK interest into common stock.

Elsewhere, haircare company and Supercuts franchisor Regis Corp. has obtained a $130 million credit agreement to refinance debt. In connection with the financing, the lenders received warrants representing 15% of Regis’s diluted equity.

Zinc-based battery company Eos Energy Enterprises has secured $315.5 million in credit facilities to repay debt and fund growth plans. In connection with the financing, Cerberus was granted penny warrants to purchase non-voting convertible preferred stock representing between 33% and 49% of the company’s outstanding equity.

Comtech Telecommunications Corp secured $222 million in financing to refinance debt, fund working capital and for general corporate purposes. In connection with the facility, the lenders received warrants to purchase roughly 1.4 million shares of Comtech’s common stock.

Vancouver-based Conifex Timber (TSX: CFF) received a $25 million secured term loan. Proceeds will refinance debt, fund working capital and general corporate purposes. In connection with the financing, Conifex issued to PenderFund warrants to purchase 3.6 million shares of the company’s common stock.