The Private Equity industry has slowed but opportunities remain robust. 2021 was a record year for the PE industry as investment activity surpassed the trillion-dollar mark for the first time. Fast forward to now – in the first seven months of 2022, PE deal activity had kept on pace with 2021, but started feeling the effects of higher interest rates in Q3. The number of M&A, growth equity, and recap deals collectively slowed by 20.4% in Q3 year-over-year. Q3 deal volume for each market segment was below the average for each segment since 2017. Large deals averaged $314 billion in volume per quarter, but Q3’s large deal volume is 23% below average and Q3’s mega-deal volume is down 72% from the average volume per quarter. Small deals averaged $53 billion in volume per quarter and is down 13% from the average. Middle market deals averaged $202 billion in quarterly volume and Q3 is down 18% from the average to $166 billion. [i]
Inflation has hit record highs, the equity markets have been extremely volatile, and sharply rising interest rates are combining to make the investment landscape far more challenging than a year ago. As valuations decreased, the US IPO market has experienced a significant slowdown in 2022, significantly affecting the ability to finance acquisitions. Less IPOs also decreases exit opportunities for PE. Floating rates for loans on leveraged buyouts averaged 4.8% in February before doubling to 9.8% in September. A divergence in expectations between buyers and sellers is a key factor in the decline of deal activity – a common occurrence in periods of heightened volatility. For the original 70/30 LBO template of 70% debt, 30% equity – this would mean taking the equity component to 50% or more to keep interest costs controlled or finding assets at a 50% haircut to what they were once valued – sellers are resisting that for now and deal activity has declined as a result.
So how are private equity firms navigating the current economic environment? There is ample dry powder to weather a downturn, that is, money not yet spent on deals – an estimated $3.6 trillion looking to be put to work. PE deal count was running ahead of 2021’s pace through the first seven months of 2022, despite the economic headwinds, exhibiting the resiliency of the industry and the dry powder that continues to build waiting to be deployed. Deals done coming out of recessions tend to deliver strong returns – a lesson learned by both GPs and LPs in the wake of the global financial crisis. If the economy were to tip into a recession, history has taught investors to weather the storm – the impact will be on the IRR from investments made coming into the downturn, however, the IRR from investments made during recovery years has consistently outperformed the long-term averages.[ii]
Going forward, fundraising will likely revert to its historical norm as the current pace is unsustainable for LPs and GPs – the rapid deployment seen in 2021 started to squeeze LPs and their cash balances. LPs have kept up with the pace of fundraising to keep commitments thus far but fear they will not be able to keep up. Given the overcrowding in the fundraising space, large institutional allocators are prioritizing certain GPs over others, often putting longest-tenured relationships first. The larger and more established managers are likely to continue to have more success with fundraising efforts than emerging and mid-sized managers. Firms seeking new sources of fundraising have potential opportunities in retail investors, international investors, and sovereign wealth funds on the back of strong commodity and energy prices.
As previously noted, valuations decreased, or are at least dislocated – a buying opportunity for tech assets, and as such, PE firms will be able to find attractive take-private targets as public market valuations face more dislocation than private markets. IT deal value accounted for a greater portion of year-to-date 2022’s PE deal total, demonstrating that IT is much more resilient in the current economic state than other sectors. The deal environment for IT is expected to remain favorable. Smaller transactions, for example add-ons, tend to have less valuation disconnect between buyer and seller, allowing sponsors to add-onto their platform companies more easily. PE firms can average down the portfolio company’s combined multiples through the lower multiples of the smaller acquisitions. The current downturn in public markets could bolster private market add-on activity due to easier financing.[iii]
These periods of instability reduce the visibility in the overall outlook of businesses thus making deals challenging to price. It has been difficult to regain momentum in the year’s second half. The good news is that inflation-recession cycles tend to be relatively short-lived and the long-term outlook for the PE industry remains resilient. On top of that, recessionary dynamics, or a pause, generally triggers investors to deploy capital into private equity, especially in periods of US dollar strength.
[i] Emily Rouleau, (2022) “Analysis: All M&A Market Segments Saw Q2 Drop in Deal Volume” [Online]. Available: https://news.bloomberglaw.com/bloomberg-law-analysis/analysis-all-m-a-market-segments-saw-q3-drop-in-deal-volume [October 2022]
[ii] Hugh MacArthur and Brenda Rainey, (2022) “Shifting Gears: Private Equity Report Midyear 2022” [Online]. Available: https://www.bain.com/insights/shifting-gears-private-equity-report-midyear-2022/ [July, 2022].
[iii] Tim Clarke, Jinny Choi, Kyle Walters, Rebecca Springer, Ph.D; Pitchbook, (2022) “US PE Breakdown” [Online]. Available: https://files.pitchbook.com/website/files/pdf/Q3_2022_US_PE_Breakdown.pdf [Q3 2022].