Time is running out for private equity firms to prepare for their next wave of deals.
Rising interest rates, inflation and recession risks have eroded consumer confidence and left buyout firms facing a new reality of higher funding costs and potentially lower returns. None of this changes the fact that there is over $1 trillion sitting in their funds that needs to be spent.
“People say there is no funding available, but our clients tell us ‘we have a big fund that we need to deploy,'” said Umberto Giacometti, co-head of financial sponsors in Europe, Middle East. East and Africa at Nomura Holdings Inc. “If you need to deploy, say, $10 billion in four years and you do nothing for six months, you’re under pressure.”
The change is profound for an asset class that for more than a decade has been flooded with liquidity by investors looking for yield in a low interest rate environment. Those same rates allowed companies to leverage on deals to amplify returns, while rising valuations provided exit routes at healthy premiums. So it is, even in the depths of the Covid-19 crisis.
Things started to slow in early 2022 due to creeping fears about inflation and rising rates – trends that accelerated after Russia invaded Ukraine. Private equity spending was around $30 billion in October, according to data compiled by Bloomberg – the lowest monthly spending since the start of the pandemic. Some investors have even asked companies to stop deploying capital as they seek to build cash reserves.
Bankers and advisors at private equity firms expect activity to pick up in early 2023, likely in the form of small minority deals and medium-sized buyouts. Depressed share prices mean that private takes will be a very important source of deal flow, they say, as will secondary buyouts – whereby one fund sells one asset to another to attract new investors.
“It’s really not that we have nothing to do, quite the contrary,” said Burc Hesse, a private equity partner at law firm Latham & Watkins LLP in Germany. “There is still a lot of dry powder and many buyout companies closed funds last year, so they will roll out.”
Pressures in traditional funding markets and the higher costs of finding alternative private debt mean there will be fewer highly leveraged mega buyouts. Companies like KKR & Co. are among those willing to write larger equity checks to get things done, hoping to refinance when credit markets improve or work through debt. existing of a company.
Last week, Thoma Bravo and Sunstone Partners agreed to buy US digital consumer insights firm UserTesting Inc. for $1.3 billion. It was Thoma Bravo’s second all-stock deal in October, following its takeover of software company ForgeRock Inc.
Listed buyout companies like EQT AB and Eurazeo SE, meanwhile, will be able to rely on balance sheets to help pay for deals in the absence of cheap debt.
“It’s a return to all-equity LBOs and holistic financing solutions,” said Klaus Hessberger, co-head of financial sponsors for EMEA at JPMorgan Chase & Co. liquidity in credit markets Until we see a recovery, I expect more minority trades and no change in control.
Target sectors in the new round will include infrastructure, healthcare and energy, according to bankers. These types of companies tend to find it easier to pass on higher costs to customers, which makes them attractive to private equity investors, they say.
“One category of specific deals where I see a lot of interest is the combination of healthcare and software,” Latham’s Hesse said. “Funds love it because these companies are scalable and have predictable recurring revenue in two growth areas at the same time.”
As volatile markets have made investors more nervous and selective about which private equity firms they are willing to give money to – resulting in longer fundraising periods and downward adjustments in goals for some – companies with proven track records in the hottest industries continue to secure engagements.
Nordic Capital, which likes to invest in health care, just hit its hard cap on a €9 billion ($9 billion) buyout fund. Apax Partners, which also targets healthcare, as well as technology, raised $10 billion in five months for the first close of its new flagship.
The immediate challenge for those with cash to burn is allocating those funds at a time when it’s becoming increasingly difficult to predict where corporate rates and earnings will go, and without the crutch of an effect of easy leverage to extract returns.
“The fact that buyers are becoming more price sensitive isn’t necessarily a bad thing,” Hesse said. “They’re pretty good at finding companies with sustainable strategies at all times.”