Podcast transcript: PE Pulse: five takeaways from 1Q 2023
9 mins approx | 23 May 2023
Hi everyone, and welcome to the May edition of the PE Pulse podcast. Our intention here – over the next eight to ten minutes or so – is to give you a quick rundown of what we’re seeing in the private equity space. All the important themes and trends, and how today’s macro environment is impacting PE – in terms of deployment, fundraising, financing, and some of the longer-term impacts. My name’s Pete Witte, and I’m the Lead Analyst for PE here at EY; I appreciate you taking the time to listen.
Let’s start off talking about deals – because that’s where everyone’s focused right now. A few months ago, we were dealing with an environment defined by high inflation, challenges in financing deals and a lot of macro uncertainty that was leading to valuation mismatches. And that hasn’t changed; those dynamics are still very present and at the forefront of everyone’s mind.
At EY, we do an annual survey of PE CFOs – more than 100 PE CFOs – and in that survey, more than half of the folks said that a recession was their number one concern around the operating environment – ahead of valuations, competition for deals, and political pressures. And the instability that we’ve seen in the banking system doesn’t help – it puts immediate concerns around risk management in the forefront and pulls focus from longer-term value creation opportunities and opportunistic deployment.
So, there’s a lot of volatility out there. And that’s the environment that PE firms continue to operate in.
So where does that get us in terms of the types of deals that we’re seeing?
From an activity perspective, in the first quarter we saw firms announce deals valued at US$92b; that’s a pretty steep decline from $240b they announced in the first quarter of last year, but it’s about the same as Q4. What’s kind of interesting though, is that activity picked up pretty significantly as the quarter progressed. I looked at the numbers in January, and said, oh my gosh, US$12b, this is pandemic-level activity. But by March, we were up to more than $60b. So, a really choppy market right now, where some months we’re seeing really low volumes, and the next month much more of a spike.
Now the deals we’re seeing are pretty bifurcated – think about a barbell, where on one end, you’ve got a bunch of smaller middle market deals. And then on the other end, you’ve got these large take private transactions. And not necessarily a whole lot in the middle.
At the smaller end, we see a lot more add-ons. Typically, the market is around 50/50 between platform deals and add-ons; right now, it’s about two-thirds in favor of add-ons. And then I think we see anecdotally, minority stake deals, where perhaps a seller doesn’t want to sell their whole business into this market, because valuations might be disjointed, so they conclude that it’s a good time to take on a minority-stake investor.
So that accounts for a lot of the volume that we’re seeing right now.
When we talk about the value of deals – and the bulk of the capital that’s being deployed – it’s altogether different. And frankly, I think it’s one of the most interesting things that we’ve seen in a while is this hard, hard pivot toward take private deals. In an average year, take-private deals might represent 20% of total PE activity by value. Last year, as stock prices fell, it was about 40%; first quarter of this year, 80% of PE activity by value was deployed in take-private transactions – that’s by far a record. If you look at a list of the top 10 deals this year, all of them are take-private deals. And 16 of the top 20 are take-privates. It’s a pretty remarkable dynamic – and I think underscores the degree to which firms are trying to stay disciplined and looking for opportunities to invest in high-quality assets that they believe are temporarily mispriced.
So that’s what today’s market looks like. Now let’s take a few minutes to talk about what we think it means.
First and foremost, we know that it elevates the significance of operational value-add. When we think about today’s operating environment, we know that 1) debt is less widely available and has become more expensive – average new-issue rates currently in the 10%-11% range, and sometimes higher; and 2) multiple expansion is a lot less likely. And so, to a large degree, it’s operational value creation that’s going to drive those returns.
And certain levers in particular come to the forefront in times like these. For example, if you talk with our working capital people, their phones are ringing off the hook right now. Because periods of increased volatility always elevates the importance of having strong discipline around cash. As a PE firm or a portco, you need real visibility into your liquidity needs and your cash position in order to really have full control over the business. That builds resilience in the business, which is of course critical right now but it also gives you the opportunity to be strategic when your competitors are being defensive.
Cost takeouts – that’s another. Somewhere in the neighborhood of US$500b in debt is maturing for portcos over the next two and a half years, which really adds urgency around maintaining EBITDA. So how do you stay lean and efficient, and keep your input expenditures in check in a time of rising prices? And most importantly, how do you do that in a way that doesn’t impede your growth drivers?
These levers are always important for PE, now more than ever, and we’ll see a doubling down given the market environment that we’re in.
The other thing that periods of excess volatility tend to do is to catalyze emerging trends and new market innovations. And it’s highly likely that today’s market conditions will provide tailwinds to a number of evolutions that are already underway in the space.
We’ve talked about private credit before. And how last year, when PE’s traditional lending sources stepped away from the market, private credit funds stepped in as a major source of alternative funding for a much larger swath of PE deals. Recent banking instability that we’ve experienced is likely to exacerbate that trend. Credit funds continue to work together on large deals and will ultimately take some measure of share from the broadly syndicated loan market, even after those markets normalize. According to S&P Leveraged Commentary and Data, of the 73 PE deals tracked in Q1 by LCD, just four were financed by the syndicated markets. That’s pretty remarkable.
Another is the secondaries market – constraints in PE’s traditional exit routes are going to be a tailwind there. And the last several years have seen explosive growth in that space. But despite that growth, it’s just a fraction of the size of the overall market for primaries. And that’s in sharp contrast to markets for other financial products, where secondary trading is magnitudes larger than the primary market.
And then lastly, as fundraising becomes more challenging for PE’s core institutional market – and we’ve seen that, where funds raised by PE shops fell 14% in the first quarter – larger firms in particular will continue to pursue investors that are new to the asset class. Already, firms that have invested in these capabilities have seen a measure of resilience in their fundraising relative to the broader market. And in the coming years, blockchain, and tokenization, and the experimentation that we’re seeing there will be powerful enablers that allow PE to unlock a much broader population of investors than they’ve been able to before.
So, some obvious challenges out there in the market right now, but at the same time, a lot of opportunities for PE firms to acquire some interesting assets at interesting prices. I think it’s important to remember, PE investors have survived and indeed thrived through difficult markets before - the pandemic, the GFC and, for some, the internet bubble. Through each one of those, firms have remained active. They've deployed capital opportunistically, and they’ve made investments that have tended, over time, to perform very well, and I think that's probably the likeliest outcome from today's market as well.
That’s it for today. Thanks as always for listening, and I’ll see you next quarter with another update!