A new playbook for private equity dealmaking?

The post-crisis years have been a golden period for private equity (PE). Cheap debt financing and the ability to raise substantial equity funds have powered a wave of deals, particularly their staple – the leveraged buyout (LBO). But with the economic climate tightening, and financing drying up, the tried and tested model is having to be revamped.

“Higher interest rates have breached the engine room,” says Tim Clarke, senior analyst, PE, at private markets data platform, Pitchbook. “For a while it was like magic for the PE deal-making machine in terms of the rates they could borrow at. Then they would do their deals, add onto their platform companies, grow the revenues and margins, and then have a liquid market to sell into four or five years down the road. That hasn’t entirely stopped, but the old playbook is definitely out of the window.” However, he stresses: “PEs are very adaptive creatures and they are in the process of doing so.”

Last year was a blockbuster one for all types of mergers and acquisitions (M&A), with global volumes hitting $5.9tn, according to Refinitiv – a record-breaking year by a clear margin. PE-fuelled deals were no exception, with deal value hitting $1.2tn, the highest amount on record and more than double the previous year’s total.

All signs are that 2022 has been a far less lucrative year, with deal value hitting $2.8tn for the first nine months – a 34% year-on-year decrease. However, by historical standards 2022 is no damp squib, with forecasts suggesting volumes could reach levels seen in 2018 and 2019 (particularly for US deal activity) which, when discounting 2021, were strong years. Although levels of PE M&A have fallen, they have held up better than the rest of the market – decreasing by 25% year on year, but accounting for a record high 23% share of activity.

Dirk Albersmeier, global co-head of M&A at JPMorgan, comments: “For PE, they are still looking to do deals, but they will be different.”

Add-on deals

One obvious example of the shift, particularly in the US markets (which account for 42% of global M&A deals) is a shift in focus towards so-called add-on transactions, that is adding a smaller firm onto an existing company, rather than platform deals, which are foundational investments in a particular industry area. According to Pitchbook data, as of the end of the third quarter 2022, add-ons as a share of PE buyout deals in the US accounted for 77.9% of activity.

“They’re not doing as many platform acquisitions anymore, because it’s harder to borrow,” says Mr Clarke, so in the meantime “they are tending to their garden” and focusing on improving what they already have in their portfolios.

However, in terms of the bigger ticket deals, this pace has slowed. “There’s clearly a bit of a pause right now, which is driven by everyone trying to understand the ‘new normal’ and to be able to get a clearer view, at least over a couple of quarters, of how the markets are likely to look,” says Vito Sperduto, co-head of global M&A at RBC Capital Markets.

It is often said that M&A is a confidence industry, and with significant uncertainty remaining about the trajectory of the global economy, there is some understandable hesitancy from both buyers and financiers to do large deals at present. 

Debt markets constrained

“The traditional sources of financing that PE firms have relied on, in terms of debt from financial institutions, have become constrained, with deals being looked at very selectively,” says Mr Sperduto. “With current situations, there is likely to be a long period between transactions being signed and closing, and with a volatile market in between, it makes it really difficult to price that risk.”

There is also the challenge for larger banks that provided financing for buyouts earlier in the cycle, when the debt markets were at different levels and asset values were higher, but where the deal has only just closed. They may now be carrying debt on their books that they may not be able to syndicate, or syndicate at a competitive value in the current market. The $12.7bn financing package for Elon Musk’s purchase of Twitter is an example of this, where several media reports have suggested that the banks that provided debt financing for that deal have accepted they may need to keep it on their books until market conditions improve.

Scott Wieler, CEO of international mid-market investment bank DC Advisory US, says: “The old standard syndication where a large bank writes the cheque and does their own marketing and distribution, that’s probably over until their existing inventory from previous buyouts gets worked through.”

Where PE firms are able to access debt financing, the interest rates have increased substantively, making the deal economics more difficult. Deals are still going ahead, but Mr Albersmeier suggests a big change that has happened is that “in the current markets, you have to start with the debt – because it’s not a given – and build the deal from there. That is a big mindset change that everyone has had to go through.”

PE firms have also had to begin to think more creatively about the source and structure of financing packages. Direct lending as a source of finance in place of bank debt has continued to be a robust trend, although some suggest that direct lenders will also find it more difficult in the current market conditions and may too be more selective.

Equity shake-up

The debt-to-equity ratio of deals going through has also been shifting. “The average amount of equity PE firms are putting into an LBO is currently at around 45% to 46%,” says Mr Sperduto, “which is at around the same level as in the financial crisis period of 2008/2009, after dipping down to 36% to 37% in 2013 and 2014. In the pre-Covid period it was in the low 40s.”

There have even been some all-equity deals taking place in recent months. In October, Bloomberg reported that PE firms Francisco Partners, Thoma Bravo and Stonepeak Partners have all announced new acquisitions with no debt in place. Bankers suggest that where a buyer has a high level of conviction about a deal, it may be worth going down this route in order to get the asset off the table. Given the financing backdrop, an all-equity deal will speed things up considerably. This approach is typically taken on the basis that it will be possible for the PE to refinance the deal down the line. However, this may be difficult to achieve in the current markets, and buyers will not be able to bank on refinancing the deal in the short term.

Creative structuring

Although all-equity deals are likely to remain a niche option for specific circumstances, market participants expect there to be a more general shaking up of financial structures. The recent deal agreed between large PE fund, Blackstone, and global technology and engineering firm, Emerson, with Blackstone to purchase a 55% stake in Emerson’s climate technologies business, is touted as an example of the more unusual approach to structuring we may see. 

The deal values the business unit at $14bn. Blackstone will invest $4.4bn of its own cash, with a further $5.5bn coming from debt financing comprised of both bank debt and finance from private credit. Significantly, Emerson is also providing $2.25bn in seller financing towards
the deal.

“I believe the Emerson deal is something of a blueprint for the kind of deals we can expect to see: a substantial seller note, that has effectively bridged a financing gap. The remaining financing was also an interesting mix of bank debt and direct lender financing,” says Mr Albersmeier. “We have not seen seller notes for a long time and I expect them to be much more important in the current market.”

He adds that such a structure will only be available on certain transactions. “The mixture of bank debt and direct lender commitment is a combination that in the past we haven’t seen. It reached a similar quantum as in the old world, but it’s more complex, it’s more expensive and it’s less flexible. This is only going to work for the top class of assets and a tier one sponsor.”

Sovereign wealth funds Abu Dhabi Investment Authority and Singapore’s GIC will also co-invest alongside Blackstone in the transaction. Co-investment in and of itself is not especially unusual, but market analysts point to an emerging trend of PE funds seeking investment from international investors, notably sovereign wealth funds to boost the coffers, particularly, where some US pension funds have had less capital available for PE investment.

Take-private promise

With public market valuations taking a substantial hit in the last year, and with 2021’s boom in initial public offerings and special purpose acquisition company activity, there is no shortage of public targets that could be attractive to PE buyers. Although take-privates have been taking place, there has not yet been a significant surge. The challenging financing circumstances and uncertain macroeconomic backdrop are playing their part – interestingly the four take-private deals announced in the US between July and the end of September are all reportedly being funded by private credit rather than bank financing.

There is a sense that valuations may drop further and investors are also holding off to see what happens. In relation to UK markets specifically, Stuart Ord, head of M&A at mid-market investment bank Numis, says PE investors active in this region “think that the best valuations will be in three to six months, because it’s a falling knife, and it’s got further to go”.

Market participants suggest that although there may be plenty of attractive public targets, expectations for both buyers and sellers are yet to fully adjust. “There are opportunities for PE to look at public market companies whose valuations have been over-penalised. But at the same time there is a delay while those company boards accept where valuations have been reset to,” observes Mr Sperduto.

Mr Albersmeier similarly suggests: “There have also needed to be some adjustments from both sides, where buyers were wanting to do deals at today’s pricing but still expecting to access yesterday’s financing. And some sellers who have been trying to hang onto yesterday’s pricing – clearly, they will not get the prices they did a year ago. That will take a little bit of time to filter through.”

Although the deals themselves may not yet be being done, market participants suggest there is considerable activity going on behind the scenes in preparation. “[PE buyers] want to screen now; they want to speak to people, build their relationships with management teams, etc. And then be ready to strike at the right time next year,” says Mr Ord. “The dynamism and the engagement is still there, we’re seeing a lot of marketing and a lot preparing for what might be actionable in six months.”

Mr Wieler backs up this view, suggesting there is a lot of “testing” of the market going on where buyers are going to speak to management teams at companies that are on their radar. “It’s the special meeting where a dozen people spend a couple of hours with the management team to decide that ‘yes, this is where I want to spend our money’ and make sure they can be first in line when the market conditions change and, as we know, they can change on a dime.”

He says this bilateral approach is particularly important in current market conditions. “Three or four years ago, this was a best practice for a few firms. Now everyone is doing it,” he adds.

2023 bounceback?

Mr Sperduto says, “Driven by pent-up demand from the slowdown in the second half of 2022, my view is that 2023 could be as strong as what we saw in 2015, which prior to the pandemic was the all-time high for M&A. In volume, I think there’s the potential to get to $2tn in the US.”

Certainly, some of the other market dynamics suggests a loosening will have to take place in the coming period. At present, PE firms appear to be holding on to investments rather than being forced sellers in unattractive market conditions, which is slowing the pace of exit transactions.

“We’re almost at a 10-year low in the ratio between PE investments and exits,” says Mr Clarke in relation to the US markets. “There’s about four exits for every 10 investments, so it’s obviously very lopsided and that can’t go on forever. Eventually, portfolio companies will have to be sold at prices below what they were bought at and then the market will clear itself of some of the backlog.”

Although fundraising has been more challenging for many PE funds during 2022 than in previous years, funds continue to sit on record levels of dry power for buyouts, – $958bn according to Preqin as of the end of October 2022. This is a far cry from an industry that is down and out.