In 2022 and 2023, rising interest rates caused a tremendous disruption to the private equity industry, which had become accustomed to a historically low interest rate environment in the previous decade. Higher interest rates have increased the cost of debt, which, in turn, affects the overall valuation of target companies. This has caused valuations to fall and forced a stalemate in some industries where sellers await a stabilization and return to previous valuations.
Notwithstanding these headwinds, the PE industry still has a historic amount of committed capital sitting on the sidelines (aka “dry powder”), which is pushing private equity firms to innovate and adapt their deal structures so they can still get deals done outside of the classic leveraged buyout model. These factors are impacting M&A activity across all industries and environments both within the private equity industry itself and the broader M&A market generally.
As a first order of business, once interest rates began to rise, private equity executives turned much of their attention to its current portfolio. Buyouts executed in 2021 were completed at historically high multiples and with historically low interest rates. As a result, balance sheets have required maintenance and equity support to ensure compliance with these prior covenants in existing agreements and to manage through some turbulence as private equity firms recalibrate their investment theses.
Acquirers have also been hesitant to take on additional debt due to concerns about triggering "most favored nation" (MFN) provisions, common in existing credit facilities. These clauses allow lenders to reprice existing debt if new loans receive higher interest rates. With rising interest rates, even a small increase in debt for an add-on to an existing private equity platform could lead existing lenders to amend and increase interest costs for the entire debt facility.
The term "dry powder" refers to the pool of capital that private equity firms have raised but not yet deployed into investments. In recent years, the accumulation of substantial dry powder has emerged as a prominent and resilient tailwind for the private equity industry. In the current environment, this reservoir of untapped capital provides private equity firms with strategic flexibility, enabling them to capitalize on market opportunities and weather economic uncertainties, even in the face of tremendous uncertainty across multiple industries.
During periods of uncertainty, having readily available capital provides a buffer against adverse conditions, allowing firms to support their existing portfolio companies, weather economic downturns, and position themselves for a robust recovery. This defensive aspect of dry powder is crucial for maintaining stability and resilience in the face of unforeseen challenges.
In addition to its strategic advantages, the presence of substantial dry powder has broader implications for the private equity ecosystem. It instills confidence among limited partners, such as pension funds and institutional investors, who entrust capital to private equity firms for investment. The confidence derived from a robust reserve of dry powder enhances the fundraising capabilities of private equity firms, allowing them to attract and secure commitments from investors seeking exposure to alternative asset classes.
While this tailwind has kept industry experts confident, firms still need to justify the existence of that dry powder, and that has been another theme of 2023. With these levels of undeployed capital, no firm can justify to its limited partners that the best strategy is to sit on the sidelines for a year or more. Therefore, we have continued to see activity in the lower middle market, where the stakes are not as high for repeat players and we have seen the emergence (or re-emergence) of more creative deal structures outside of the classic leveraged buyout.
The private equity industry has long been built around the classic sponsor-led leveraged buyout structure. In these transactions, sponsors identify targets or a series of targets and acquire the targets at an attractive private market multiple, with a mix of equity (often in the form of committed capital from their limited partners) and debt. By using debt aggressively, sponsors are able to juice up their returns to their equity investors when they exit their platforms (typically on a three- to five-year timeline). The expectation is that, through strategic management and operational improvements, the acquired company's value will trade at a higher multiple, providing outsized returns for equity investors once the debt has been repaid.
Largely because of today’s current interest rate environment and the unique mix of headwinds and tailwinds, we expect the following trends from 2023 will persist in 2024:
1. Continued Strength of the Middle Market
As many commentators have noted, there has not been much drop-off in transaction volume in the middle market, despite a significant drop-off in the broader market, specifically in private equity exits. The reason is fairly straightforward – the sellers in that market are typically founders who do not have as much skin in the game as the repeat players who are on both sides of the transaction when it comes to private equity exits. When the founder of a company takes a discounted valuation (as compared to 2021 highs), that is certainly costly to them, but it pales in comparison to the discounts a repeat player would have to take if they were to mark down their entire portfolio of companies in similar industries. We expect that will persist in 2024, with the ultimate question being whether there is a pickup in private equity exits as market conditions settle for more historic norms.
2. Room for Strategics to Make Deals
Historically less reliant on debt and more conservative on valuation, strategic acquirers have found themselves presented with a unique and advantageous landscape for deal-making. The upward trajectory of interest rates has induced a re-evaluation of asset pricing, prompting a shift in market dynamics. As private equity firms face increased borrowing costs, their capacity to out-bid strategics has been tempered. This has paved the way for strategic acquirers, often armed with more resilient balance sheets and a long-term vision, to seize enhanced opportunities in the market. The confluence of these factors has not only altered the competitive dynamics of deal-making but has also allowed strategic acquirers to capitalize on more favorable valuations, thereby positioning them to navigate a landscape marked by shifting financial tides. While many expect a pick-up in private equity activity in 2024, the interest rate environment (to the extent it persists) should keep the playing field leveled as compared to the environment back in 2021.
3. Increased Earn-Outs and Other Deferred Consideration
Earnouts create a performance-contingent structure where a portion of the purchase price is based on the target company achieving predetermined milestones or financial targets. Deferred compensation structures, including earnouts, offer flexibility in deal valuation. Parties can adapt to changing market conditions and better reflect the true value of the target company over time. These arrangements have increased in the current environment as a way to bridge the gap on valuation between buyers and sellers. We would expect this to persist even as activity increases because that pickup will still require some kind of valuation bridge from the historically high multiples of 2021 to the current environment.
4. Stock-for-Stock Transactions and Other Unique Structures
Finally, there has been a discernible uptick in stock-for-stock transactions and other unique deal structures that do not require debt financing. As interest rates have experienced fluctuations and borrowing costs have become less predictable, companies engaging in mergers and acquisitions have sought alternatives to traditional debt-heavy structures. Stock-for-stock transactions, where the acquiring company exchanges its equity for that of the target, offer an appealing avenue in this context. These transactions provide a means for companies to get deals done for their limited partners without burdening themselves with additional debt, offering a more sustainable and less financially leveraged approach. This strategic shift not only reflects a response to the current economic environment but also underscores a preference for transactions that enhance financial flexibility and minimize exposure to the uncertainties associated with debt financing.
The private equity landscape is continually evolving, driven by external factors such as interest rates. The challenges posed by rising interest rates in 2022 and 2023 have prompted private equity firms to re-evaluate and adapt their deal structures. As the private equity community continues to respond to the challenges presented by rising interest rates, it is essential for industry participants to stay attuned to these evolving deal structures. Flexibility, innovation, and a keen understanding of the shifting economic landscape will be critical for private equity firms seeking successful transactions in the coming years.
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