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In this episode of the NextWave Private Equity podcast, Pete Witte reviews trends in the market, the credit environment and how the macro situation will impact dealmaking this year.
PE Pulse is a quarterly report and corresponding podcast miniseries that provides analysis and insights on private equity market activity and trends.
Visit ey.com/pepulse to view this quarter’s summary and infographic.
Key takeaways:
Sentiment among PE dealmakers rose in Q1 due to more macro clarity, increased visibility into interest rates and perceived valuation gap.
Though tech still dominates sectors, its investment percentage of total deployment dipped slightly in the last 12 months.
Rising activity in coming quarters will be boosted by greater availability of financing.
You can also listen to this podcast on Apple and Spotify.
For your convenience, full text transcript of this podcast is also available.
Teaser
Welcome to the EY NextWave Private Equity podcast, where industry leaders come together to discuss emerging opportunities and industry trends shaping the global private equity landscape.
Pete Witte
Hi everyone and welcome to the latest edition of the PE Pulse podcast. My name is Pete Witte and I'm part of the private equity practice here at EY and for the next few minutes we'll just talk through some of the trends and the themes that we're seeing in the market with respect to deals, the credit environment, how the macro situation is going to impact dealmaking over the course of the year, all these things.
Witte
Thanks as always for joining and let's get started. And let's kick it off as we usually do by talking about deals. You know, we came into the year with strong tailwinds. Q4 was the most active quarter for deployment that we've seen in about 18 months, right. Essentially since the downturn started way back in May of 2022.
Witte
And I think there was a sense that, you know, the momentum would continue to build as we kicked off the year and there are a lot of reasons to believe that. We have greater certainty on interest rates. The credit markets are a lot more open and accommodative than they were at this time last year. And most importantly, you know, there's a sense that the valuation gap, I think, the disconnect between what sellers want for their assets, what buyers are willing to pay, and that macro uncertainty has really started to abate.
Witte
Uncertainty is anathema to dealmaking. And when market participants have more confidence in the forward outlook, it's easier to value assets. It's easier to underwrite transactions.
Witte
Last year around this time, 60% of the economists out there were calling for a recession. Right now, that's about 15%. So, everybody's kind of anticipating a soft landing, that's priming the conditions for a more active market.
Witte
Now all of that said, the deal market continues to be choppy. Q1 wound up being a soft quarter, especially in the upper middle market, we've seen fewer deals.
Witte
Deals under $ 500 million, those have been steady. The mega deals above $5 billion, those ticked higher in Q1. We saw five of those last quarter, but that $500 million to a billion-dollar range, the deals a little bit bigger than, that we saw a little bit of a downtick here over the last few months.
Witte
Now, all of that said, we continue to see some positive momentum with respect to sentiment. Every quarter we go out to the market, we run a survey of GPs, three months ago about two-thirds of them said they expect to see an increase in deployment over the near term.
Witte
Right now, 75% expect an increase. And we hear the same things more broadly across the market. So, we run sentiment analyses for example on the earnings calls of the public PE firms. That's higher than it's been at any point in the last two years.
Witte
And so, I think the takeaway here is that we're going to see activity move up and to the right, but it's not going to be a straight line. We believe it's going to be an active year for deals. It's going to be a great time to make investments, but the recovery is going to be very nonlinear. We're going to have active months; we're going to have fewer active months along the way.
Witte
February, for example, which was one of the busiest months that we've seen in the last year and a half. March was one of the quietest. We’re a few days into April, we've seen a number of large deals announced over the last few weeks. So just a very nonlinear recovery here.
Witte
Now in terms of the types of deals that we're seeing, it's interesting. You know, we saw 21 take private deals in the first quarter. That's roughly in line with the 23 that we saw about a year ago. So, I think it shows that private equity shops still see opportunities in mis-pricings out there, even though the markets obviously had a tremendous run up over the last few months.
Witte
Now those deals aren't necessarily as big as what we saw a year ago. Think deals in the 1 to $3 billion range roughly as opposed to 5, 10, 20, but they are still occurring. And not just in the tech space. We're seeing them in industrials, in energy, defense, consumer, financials. All spaces where we've seen delisting over the last few months.
Witte
We also continue to see carve-outs as strategics continue to rationalize their businesses, they raise cash to invest in core competencies. Last quarter, carve-outs made up about 20% of deployment activity by value, versus just 5% in Q1 last year and about 10% last quarter. So, corporates, while they're not necessarily focused on buying from private equity right now, they are thinking very hard about rationalizing their businesses and selling off those noncore assets to PE.
Witte
And then from a sector perspective, tech really remains a dominant theme. No surprise there. Tech investment has dipped slightly over the last 12 months versus the prior 12 months from about 30% of total activity to about 28. But you know, give, or take the same.
Witte
We have seen big jumps in two spaces. So, consumer jumped from about 10% of deployment by value, to about 14% and especially in financials which went from about 6% of PE investment a year ago, to about 16% over the last 12 months. And insurance has been a big driver of that. But we're also seeing more activity in brokers and wealth managers and to some degree the regional banks as well.
Witte
Now let's talk about the credit markets for a bit, because that's one of the tailwinds that we've seen for the recovery here. You know, we've seen some interesting dynamics there. Last year, of course, was really the coming out party for private credit. The bank stepped away, they were wary of the risk and private credit shops really stepped into that vacuum. They wound up financing about 85% of all the private equity transactions last year. That's remarkable for an asset class that barely existed a decade ago.
Witte
Now we've been saying for a while that the banks at some points are going to reassert themselves in this market, right. We're going to find this new equilibrium between deals that are funded by private credit and deals that are funded by the banks. We're starting to see that play out right now.
Witte
So leveraged loans backing the LBOs are up about 80% versus last year at this time. And we've seen several high-profile deals that are being bid by both the banks and the private credit shops.
Witte
And that's a theme that we'll continue to see play out over the course of this year, right. This fight for market share between the incumbents and the upstart with respect of who gets to finance these large private equity deals.
Witte
And then beyond that, we've seen a good deal of refinancing activity. You know the window is certainly open right now, spreads have come down. We're seeing companies take advantage of that to push out their maturities.
Witte
On the demand side for that, CLO formation has hit a 12-month high in February and it's up about 40% by value versus this time last year. So, there's certainly buyers for this paper out there.
Witte
So, credit conditions are certainly stabilizing, if not improving, and that's reflected in our survey as well. When we asked six months ago what folks thought the credit market would look like, about a third expected it would improve. About a third said it would say the same. And about a third said things were going to deteriorate.
Witte
Now folks are more optimistic, about 90% expect conditions to either stay where we are or get better from here. But they also expect that rates are going to stay higher for longer. Right now, the market’s pricing in about three rate cuts in the US totaling 75 basis points.
Witte
Similar situation in the UK. In our survey, two-thirds of GPs think central banks are going to be less dovish than that and they'll cut more slowly than what the market’s currently expecting. So, it sounds like firms are leaning a little bit more conservative here. They're under rating for higher rates, making sure that those value creation plans can support this investment, regardless of whether interest rates are 5.5% or 3.5%.
Witte
Now, what could that mean for deal activity? I think there's been an expectation that as buyers try to get ahead of the easing cycle that you could potentially see a pull forward in deal activity. As rates come down, valuations start to head back up. Buyers naturally want to get in front of that. But if GPs think that rates are going to stay higher for longer than the market is expecting that might relieve some of that imperative and spread out some of that deal activity over a longer period.
Witte
Now ultimately shops are going to remain active. They have enormous amounts of capital to deploy, and they'll be busy doing that over the balance of the year. But just how intense that activity is will in part be driven by how successful the central banks are in solving for that last mile of inflation over the next few months. That's going to impact rates, valuations, and the relative ease of doing deals.
Witte
That's it for this month. Thanks everybody for listening and we'll see you next quarter.
Teaser
Thanks for joining the EY NextWave Private Equity podcast. For more insights and perspectives, visit ey.com/privateequity.
