Private equity titans including KKR & Co. and Thoma Bravo pursued unorthodox paths to dealmaking this year in response to a challenging environment likely to persist in 2023.
Firms sold stakes in their portfolio companies, took on private debt, offered preferred equity and plunked down billions in cash to make deals happen as leverage became scarce.
After a red-hot 2021, private equity funds raised $404.6 billion of capital during the first nine months of 2022, a decline of more than 20% from a year earlier, according to Preqin. Deal volume as of Sept. 30 was only a third the record $404.4 billion for all of last year.
Private equity boomed in 2020 and 2021 after Covid-spurred volatility in financial markets gave way to government stimulus that sent asset prices soaring. That rally reversed starting this year as inflation and higher interest rates thwarted dealmaking. The tough environment may persist until the Federal Reserve stops hiking rates and inflation cools further.
“There’s no question that it is currently, and will likely be, a more challenging time for private equity firms,” Jason Strife, head of private equity and junior capital at Churchill Asset Management, said in an interview.
Debt Alternatives
The Fed’s monetary tightening has made it more expensive to access debt financing that greases private transactions, with the benchmark rate increasing to around 4.75% in December from about 0.2% a year earlier. Investors’ reluctance to fund risky transactions has shelved about $40 billion of debt that banks would have otherwise sold in the public markets.
Some firms have resorted to doing all-cash deals rather than saddling themselves with costly debt. That’s highly unusual for an investment model that takes advantage of leverage to boost returns. KKR agreed to fund its entire €2.3 billion ($2.4 billion) purchase of insurer April Group, while Francisco Partners, Thoma Bravo and Stonepeak Partners have also funded deals entirely with equity in recent months.
But firms might not have enough liquidity to fund all-cash deals as falling valuations make it harder to sell assets.
Private company valuations declined 5.3% in the first half of the year, compared to an increase of 25.5% for the same period in 2021, according to Cambridge Associates. The firm predicts a continued slide as inflation and labor shortages weigh on companies.
Those dwindling valuations could also put pressure on portfolio companies bought during the heady days of late 2020 and 2021, according to Andrea Auerbach, head of global private investments at Cambridge Associates.
“I’m actually really worried about all the investments that were made in 2020 and 2021,” she said. “How are you going to earn the return that you told us about? You’ve got to work really, really hard, and that company’s probably going to have to do things that it didn’t think it had to do in order to earn that return for us.”
If portfolio companies don’t make those expected returns, private equity firms will have even less less cash on hand to make distributions to their investors or pursue new deals. That’s created an opportunity for providers of private credit, such as loans backed by the value of a fund’s portfolio, and preferred equity that pays a dividend and can offer protections similar to debt.
Churchill Asset Management has seen more interest from borrowers that want to structure payment-in-kind debt that doesn’t require interest to be paid in cash. Forgoing cash interest payments allows private equity firms to fund other obligations, such as distributions to their investors.
In this environment, private equity firms can also benefit from co-investment, which brings in limited partners to take a stake in a portfolio company rather than a fund. Firms might also pursue continuation funds, a secondary market option that has sponsors move an existing asset into a new fund—often bringing in new investors at the same time.
“The story of 2023 will be all of the continued evolution and growth within the secondary market,” said Drew Schardt, head of global investment strategy at Hamilton Lane.
Despite these creative funding strategies, the near-term outlook for private equity remains cloudy. Still, dealmaking could pick up in the second half of 2023 if the Federal Reserve halts its rate hikes and inflation decelerates.
If a recession does materialize next year, the downturn could yield better returns for funds that can scoop up potentially profitable companies at a discount.
“Great returns are made in recessionary periods,” Auerbach said.
This article was provided by Bloomberg News.
