Private equity gets creative in down market

Data InsightDealspeak 5 May

Private equity gets creative in down market

The private equity industry is employing creative strategies as it grapples with some of the lowest levels of dealmaking in 13 years.

Financial sponsor activity in North America peaked in 2021 and stayed strong throughout the first half of 2022, then plummeted from last summer onwards. The 165 buyouts and 67 exits in 1Q23 – excluding a nadir following the pandemic’s start in early 2020 – were the lowest quarterly totals since 4Q09 and 1Q10 respectively, Mergermarket data shows.

The fastest rise in the cost of debt in decades, a continuing valuation gap between buyers and sellers, medium-term economic uncertainty, slowing growth, and persistently high inflation have all combined to dampen deal activity, said panelists at the Mergermarket Private Equity Forum in New York last week.

Despite the downturn, private equity has been paying rising valuation multiples for US targets, while multiples paid by strategic buyers have declined, Mergermarket data shows.

One reason for that is private equity’s flight to quality. “With higher cost of capital, returns come down. But that also puts a premium on being a better asset selector,” said Patrick Kocsi, head of co-investment for North America at Ardian. “Quality assets get a quality entry multiple in any market.”

Eventually, however, valuations are expected to drop – higher interest rates tend to suppress valuations. “People will get sick of holding on to assets, they will have to transact, people will have to deploy capital, and there will be price discovery at some point,” said Kocsi.

Continuation funds and minorities

The steep drop in public market valuations is posing problems for PE firms, who are under pressure to exit their portfolio companies so they can distribute realized profits to their investor base – or limited partners (LPs). Without such distributions, it has become harder to raise fresh capital for new PE funds.

Many have turned to continuation funds as a form of exit. Ownership of one or more portfolio companies – typically they are “trophy assets” that investors believe have far greater upside – are moved out of an older fund and placed into a new continuation vehicle. Since 2019, continuation vehicles have enjoyed compound annual growth exceeding 20%, reaching a cumulative total of USD 50bn of capital raised in 2022, according to Chrystalle Anstett, a managing director of the private funds advisory at Moelis. “They can be a very attractive option for the GP and LP community.”


Continuation funds now account for 20-30% of deals, estimated Ardian’s Kocsi, who believes it is more of a bull market phenomenon that is now slowing down.

Selling a minority equity stake has also risen in popularity. Doing so keeps existing, cheaper debt in place. It also allows PE firms to take some liquidity off the table but stay in for further potential upside with another partner.

“I expect the uptick in minority deals to continue for another couple of years,” said Andrew Farris, a managing director at Blackrock Private Equity Partners.

Private credit

Financing buyouts has also shifted. Preferred equity, earnouts and subordinated seller notes are on the rise. The private credit market – estimated at USD 1.4trn – has taken considerable market share from banks in the last year, said Matteo Zenari, head of the financial sponsor group at Intesa SanPaolo.

With debt costing 12%, up from 7.5% a year ago, that has resulted in between one to one and a half turns of less debt than a year ago and bigger equity checks, said Zenari. The USD 3.7trn in private equity dry powder will also spur deal activity.

Buyout, exit outlook

Investing in down markets leads to outsize returns. Buyouts that take place in the next one-to-three years are likely to be strong vintages, much as those done during the bear market of 2008/9 produced strong returns, according to Jeremy Knox, senior investment director of private equity at Schroders Capital.

Exits are expected to pick up once greater clarity around the Federal Reserve’s monetary policy, the US’s debt ceiling, and the presidential candidates emerges, said Sheryl Schwartz, CIO of ALTI Financial. That is unlikely to happen before September, she said. When it does, the floodgates might open. “We will see a lot of backlog of good companies that did not exit in the last 12-to-18 months,” said Luca Pietrantoni, a managing director at Intesa SanPaolo.

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