Debt-for-Equity: When Credit Becomes Control

Carlyle is eyeing a debt-for-equity handover of DAINESE to HPS Investment Partners and Arcmont Asset Management. The Italian motorcycle gear company, acquired in 2022 through a €285 million debt-financed transaction, has struggled financially and recently deferred an interest payment.

This isn’t a failure story. It’s the new reality of leveraged investing in a high-rate environment.

And the firms that understand how to structure deals and manage lender relationships in this environment will have a significant advantage over those still operating with pre-2022 assumptions about credit markets.

Because when interest rates go from 0% to 5%+, everything changes. Including who ends up owning your portfolio companies.

1. The Rise of Debt-for-Equity Handovers

Debt-for-equity handovers aren’t new, but they’re becoming much more common as the combination of high interest rates and aggressive leverage catches up with PE deals from 2021-2022.

The numbers behind the trend:

• Debt-for-equity transactions up 150% in 2024 vs. 2023
• Average leverage multiples in distressed handovers: 6-8x EBITDA
• Typical recovery rates for PE equity: 10-30% of original investment
• Credit funds increasingly becoming equity owners rather than just lenders

Recent examples:

• Carlyle-DAINESE: Potential handover to HPS and Arcmont after financial struggles
• Apollo-End Clothing: Ownership shifted to Apollo after period of financial distress
• Multiple retail deals: Several fashion and retail companies handed over to credit providers

Why this is happening now:

• Interest rate shock: Companies that could service debt at 2% struggling at 7%+
• Refinancing challenges: Difficulty refinancing debt in current market conditions
• Covenant breaches: Leverage and coverage ratios triggering technical defaults
• Credit fund sophistication: Lenders better equipped to own and operate businesses

2. When Lenders Become Owners: The HPS-Arcmont Model

The potential DAINESE handover illustrates how sophisticated credit funds are positioning themselves to become equity owners when deals go sideways.

The HPS-Arcmont approach:

• Structured lending: Providing debt with equity-like upside participation
• Operational expertise: Building capabilities to own and operate businesses
• Industry focus: Developing sector expertise to evaluate and improve companies
• Exit planning: Clear strategies for monetizing equity positions

Why credit funds are winning:

• Risk management: Better at pricing and structuring credit risk than traditional lenders
• Speed: Can move faster than banks in distressed situations
• Flexibility: More creative structuring options than traditional debt providers
• Alignment: Economic incentives aligned with business success, not just debt service

The value creation opportunity:

• Operational turnaround: Applying PE-style operational improvements
• Capital structure optimization: Right-sizing debt levels for current market conditions
• Strategic repositioning: Refocusing business strategy for profitability
• Exit optionality: Multiple paths to monetize improved businesses

3. Why This Isn’t Always Bad News for PE

While debt-for-equity handovers represent a loss for PE firms, they’re not always total disasters. In some cases, they can be the best outcome for all parties.

When handovers make sense for PE:

• Limited downside: Equity already impaired, handover limits further losses
• Operational complexity: Credit funds better positioned to manage turnaround
• Capital requirements: Business needs more capital than PE firm willing to provide
• Time constraints: Fund life constraints make long-term turnaround impractical

The Carlyle-DAINESE situation:

• Timing: Deal done at peak of market in 2022 with aggressive leverage
• Market conditions: Motorcycle gear market facing post-COVID normalization
• Interest rates: Debt service burden increased significantly with rate rises
• Strategic focus: Carlyle may prefer to focus resources on other portfolio companies

Lessons for PE firms:

• Leverage discipline: More conservative leverage multiples in high-rate environment
• Covenant negotiation: Negotiating more flexible covenants and cure periods
• Lender relationships: Building relationships with sophisticated credit providers
• Downside planning: Preparing for scenarios where equity value is impaired

4. The Apollo End Clothing Precedent

Apollo’s acquisition of End Clothing after a period of financial distress provides a template for how credit-to-equity transitions can work.

The End Clothing story:

• Initial success: High-growth luxury streetwear retailer
• Financial stress: Rapid expansion and market changes created cash flow challenges
• Credit involvement: Apollo provided rescue financing as existing lenders pulled back
• Ownership transition: Apollo ultimately acquired equity control through debt conversion

Why the transition worked:

• Operational expertise: Apollo had retail and consumer brand experience
• Capital commitment: Willing to invest additional capital for turnaround
• Strategic vision: Clear plan for repositioning and growing the business
• Market timing: Acquired at attractive valuation during distressed period

The value creation plan:

• Cost structure optimization: Right-sizing operations for sustainable profitability
• Digital transformation: Investing in e-commerce and digital marketing capabilities
• Brand positioning: Refocusing on core luxury streetwear market
• International expansion: Leveraging Apollo’s global network for growth

5. Structuring Deals for the New Credit Reality

The rise of debt-for-equity handovers requires PE firms to think differently about deal structuring and lender relationships.

New structuring principles:

• Conservative leverage: Lower leverage multiples to provide cushion for rate volatility
• Flexible covenants: Negotiating covenants that provide room for operational challenges
• Lender selection: Choosing lenders who can be partners in difficult situations
• Downside protection: Structuring deals to limit downside in stress scenarios

Lender relationship management:

• Early communication: Proactive communication when challenges arise
• Transparency: Sharing detailed financial and operational information
• Collaboration: Working together on solutions rather than adversarial approaches
• Alignment: Structuring deals where lender and PE interests are aligned

The new due diligence framework:

• Stress testing: Modeling performance under various interest rate and market scenarios
• Refinancing analysis: Evaluating refinancing options and timing throughout hold period
• Covenant modeling: Understanding covenant requirements under stress scenarios
• Lender analysis: Evaluating lender sophistication and workout capabilities

Value creation planning:

• Cash flow focus: Prioritizing cash generation over growth in uncertain environment
• Operational flexibility: Building businesses that can adapt to changing market conditions
• Capital efficiency: Focusing on value creation that doesn’t require significant additional capital
• Exit planning: Preparing for multiple exit scenarios including distressed sales

The Bottom Line

Debt-for-equity handovers are becoming a normal part of the PE landscape in a high-rate environment. The firms that adapt their strategies accordingly will be better positioned to generate returns and manage downside risk.

This means:

• More conservative leverage: Lower debt multiples to provide cushion for volatility
• Better lender relationships: Working with sophisticated credit providers who can be partners
• Improved structuring: Negotiating more flexible terms and covenant packages
• Enhanced monitoring: Earlier identification and management of potential problems

The firms that continue to operate with pre-2022 assumptions about credit markets and leverage will find themselves facing more debt-for-equity situations.

The firms that adapt to the new reality will find ways to generate attractive returns while managing credit risk more effectively.

Because in today’s market, your lender might become your partner. Or your replacement.

Make sure you’re working with lenders you’d want as partners.

How are you adapting your deal structuring and lender relationships for the high-rate environment? What lessons are you learning from debt-for-equity situations? Share your insights with the VCII community.