5 insights into a changing landscape
1. Realism returns to the private equity market
A tougher fundraising environment, coupled with lower exit valuations, is restricting the flow of deals and lengthening completion times. Subsequently, we're seeing a greater sense of deal-making realism setting in.
Our latest Private Equity Trends report found that while 24% of General Partners (GPs) predict improved returns in the next two years, 47% expect a decline.
In this challenging environment where fundraising expectations are more realistic, GPs are taking extra steps in their pre-deal preparation.
There's been a surge in creative thinking around deal structuring, from using continuation vehicles on the one hand to selling minority stakes on the other. This reset in expectations is evident in the increased desire from both buyers and sellers to find mutually acceptable terms and pricing.
The increased realism also means GP appetites for deals are relatively low, while they wait out current macroeconomic uncertainties.
For example, high debt servicing costs have curtailed GPs' abilities to pay the eye-watering prices that we saw back in 2022.
This has hit valuations, with 41% of GPs expecting a decrease of 10%.
However, we don't expect there to be any further sharp declines. In fact, valuations could increase during the second half of 2024. So the way forward for many GPs, at least for now, is through more conservative valuations that keep the business wheels turning.
2. Private Equity Managers should get creative
The more realistic and conservative outlook within the industry is resulting in sales processes breaking down more frequently. In our report, 66% of GPs noted an increase in broken deals across the last 12 months.
High interest rates and inflation are putting off buyers, with many happy to sit tight and wait things out. But, the rise in failed auctions is causing a backlog of exits. And that's a problem that affects both sides. GPs can't sell, which limits distributions back to Listed Partners (LPs) and this, in turn, restricts the amount of money they have to invest in new funds.
On top of this, there's also been a slowdown in UK and European IPOs.
Without either of these traditional exit methods, GPs are having to think more creatively.
One way to tackle the backlog is by raising finance through NAV credit facilities. But that's expensive.
In today's conditions, an alternate approach for GPs is to hold onto their assets for longer, giving them more time to grow successfully before they're sold. This has led to an increase in GP-led secondaries and continuation vehicle financing.
3. The new normal of longer fundraising timelines
Before the return of realism, private equity markets saw several years of supercharged investment activity.
During that period, fundraising could be completed in just a few months, meaning many investors over-allocated funds to private equity to boost their returns.
That situation was unsustainable for the market, but a new normal has since emerged, characterised by longer fundraising periods and a slowdown in exits.
However, these longer timelines could prove difficult for some GPs, especially those who've invested but can't exit. With their money tied up in existing funds and the return to a more normal fundraising cycle, the availability of dry powder for future investments could be limited.
44% of respondents to our survey said they had less than 25% of dry powder available in their current funds.
4. Fresh thinking on transaction structures
Longer fundraising timelines and higher interest rates mean private equity managers are taking a closer look at their transaction structures.
45% of our survey respondents said leverage multiples were more than one times EBITDA lower compared to a year ago. That's a meaningful reduction which has a significant detrimental impact on valuations.
56% of respondents also reported fewer active lenders compared to a year ago and 54% said senior debt and term loan A finance were their most used structures in the last 12 months.
This tells us borrower preferences are moving away from unitranche financing to more cost-effective and lower risk bank and senior debt lending.
Until interest rates start coming back down, we expect this trend of senior lenders providing lower leverage structures to persist.
Notably, there's also been a surge in interest in asset-backed lending, which offers enhanced flexibility and significant cost savings for those asset-rich borrowers.
5. The lending and pricing squeeze
GPs have confirmed that over the previous year, lending terms have become more restrictive, and this includes both pricing and conditions.
This tighter market and a more cautious approach to risk is pushing private equity managers to think more creatively.
One emerging trend among lenders is a renewed focus on the cash generation capabilities of the businesses they lend to. This can include the requirement for an additional debt service covenant or a contractual requirement for mandatory hedging against interest rate rises.
When rates were low, hedging wasn't always front of mind in transaction structuring, but with borrowing cost peaking it's a sensible tool for downside risk management.
With interest rates expected to fall in 2024, hedging may not be an important issue for much longer, but the intense focus on cash will, and probably should, remain.
