Private Equity in Focus

Below are highlights of our views on private equity market conditions and opportunities looking ahead.

Market turmoil and investment opportunities

In the wake of the current market volatility, Private Equity managers (“general partners” or “GPs”) are taking steps to ensure the strength of existing portfolio companies, in addition to taking into account updated considerations during underwriting and due diligence processes.

We observe that public-to-private and corporate carveout transactions are becoming highly attractive opportunities as well as tuck-in acquisitions for existing portfolio companies.

Sellers are currently mindful of the multiple compression found in public comparable companies and are waiting for a rebound. That said, we do not believe there is any immediate impetus for a market rebound as inflation continues and the central banks consider additional rate hikes to temper inflationary prices. On the other end of the spectrum, buyers are looking to capitalize on lower prices and are seeking to obtain high quality assets at more attractive price levels. We expect deal volumes to be more measured until this misalignment gap between buyers and sellers comes into balance.

Also impacting the market is the availability and price of credit, which is a critical component in the private equity transaction landscape. We have seen banks and traditional lenders pulling back from the market with private credit providers stepping in to fill some of the gap. That said, the price of leverage has increased, and this too is putting pressure on asset prices.

Measures for interest rate hike

GPs are inwardly focused to ensure portfolio companies can manage through market volatility and any softness in the market. They are re-forecasting financial projections based on adjustments to top-line growth while stress-testing covenant compliance, refinancing risk and liquidity, where applicable. Unlike the GFC period, covenant-light transactions significantly increased over the past several years, which provides liquidity buffer for companies during downturn.

While underwriting new transactions and organizing financing packages, GPs are looking to lock in rates across the board where possible given the rising rate environment. This can help enable portfolio companies to avoid higher debt servicing costs found in transactions financed with floating rate debt.

Taking steps to reduce the burden of increasing debt servicing costs can preserve value creation options offset by potentially lower revenue growth and profit margins that are stressed in the current inflationary environment.

Thorough review on impact of inflation

Sector expertise continues to be a major theme for managers who will thrive in the current market. PE investors should have a more nuanced view on the actual impact to portfolio companies and fundamental performance. Software generally has high pricing power due to its mission critical nature and tends to stay ahead of inflation by increasing prices.

Wage pressure continues to be the biggest concern regarding inflation in tech businesses right now. Increased expenses related to salaries, bonuses, etc. continue to drive inflation at tech companies.

However, inflation is not currently the biggest concern found in tech focused companies – rather, a recession has the potential to dramatically slow down buying activity, new revenues, and the corresponding growth rates of the businesses drop sharply.

Looking ahead

Flight to quality: Investors are rewarding profitable growth, quality business models, and leading players. The market is differentiating between cash flow positive and cash burning businesses. In the growth sector, higher valuations are rewarded to businesses that have ample liquidity for the next few years.

Volatility creates opportunity: Volatility is good for private equity as managers can take advantage of dislocations in the markets, where asset prices may have over rotated, or where great companies with bad balance sheets need to be recapitalized. Furthermore, the lack of a robust IPO market will lead to the opportunity to invest in strong businesses that will remain private for longer.

Patience is key: A focus on downside mitigation and prudent deployment behind secular tailwinds may be rewarded.

Multiples vs IRR: Internal Rates of Return (“IRRs”) might end up being lower for the investments made in the vintages preceding such market downturn given a protracted hold period, however, Total Value to Paid In (“TVPI”) will be an important indication on actual performance of the investment.

Growing demand for sustainable companies: Demand for sustainable companies is supported by a number of macrotrends, including focus on health, attention on the environment and thoughtful use of resources. The opportunity set is growing and becoming more diverse across several sectors that are ripe for disruption.