Private equity state of the market

This year we’ve witnessed a calming of the highly turbulent market of 2022. Following an increase of more than 500 basis points in interest rates by the Federal Reserve and other central banks, the macro situation stabilized as inflation cooled off from its highs of 8-10% to 3-6% globally.¹ However, resilient wage growth and a tight job market along with sticky core inflation have kept major central banks vigilant and determined to keep interest rates higher until inflation returns to its target rate of 2%.

The M&A environment is tepid at best. Compared to the same period in 2022, worldwide M&A value decreased by 37% in the first half of 2023. And while still ranking as the fourth largest opening half of the year on record, Private equity (PE) backed M&A value declined by 49% in the same period.²

PE continues to be an attractive asset class overall. The number of active firms continues to increase with assets under management up 50% since 2019 and dry powder being near record highs.³ As PE funds proliferate, general partners (GPs) are not only competing against their fellow generalists. They’re jockeying specialist firms that take a different approach to investing and value creation.

An increasing amount of capital is chasing a limited number of deals and targets. As a result, multiples have been slow to adjust to buyer expectations. In this environment, financial engineering levers are taking a back seat to operational value creation levers as firms are holding assets longer and leaders look to drive more fundamental interventions. This is clear in three trends we’ve seen play out.

1. Tight credit conditions persist, along with rising cost of capital

In a tight credit environment, the surging cost of floating rate debt pushed up the cost of capital for PE-backed companies substantially (10-11% for B-rated leveraged loans), (figures 1 and 2).⁴

Pitchbook data shows that, as a result, the average share of debt to EV in LBO deals has fallen to 43.3%, from a five-year average of 52.2% (figure 3).  Silver Lake’s recent buyout of Qualtrics from SAP had a debt component of less than 10%. As interest obligations increase, sponsors need to use operational execution to manage cash better for their portfolio companies.

In our Conquering the Next Value Frontier research, we surveyed 170 PE leaders who told us they want to lean more on cost management and cash benefit levers than before. PE leaders want to place ~10% more effort on these value creation levers.

Levers like cash management, working capital improvement and global business services are higher-impact/lower-difficulty levers and are being used most often.

2. Increases continue in middle-market deals and smaller/bolt-on acquisitions

The share of add-ons in all PE buyouts climbed to an all-time high of 78% as of H1-2023, expanding 600 basis points since 2022 (figure 4).  The share of smaller deals, between $100-$500 million in value, is also up at more than 50% of all PE deals (figure 5).

57% of PE firms we surveyed engage in add-on deals. Of those, 59% expect deal volume to increase over the next five years, while 61% expect to increase capital allocated to these deals.

As more of these “buy-and-build” assets get acquired in a shorter timeframe, the importance of integrating them effectively into the value creation game plan goes up. PE leaders need the right operating model, customer strategy, pricing and servicing model, distribution/sales channels, and services portfolio to spur growth while driving lower operating cost to serve and realizing overhead cost reduction.

PE firms are using revenue levers like product line expansion, geographic expansion and marketing optimization, and are implementing cost levers like vendor selection and inventory optimization to capture the full potential of the synergies involved.