What's the deal with PE right now?

Introduction:

During the 2008 financial crisis and the initial stages of COVID-19 in 2020, the Federal Reserve aided investors by lowering interest rates, making it easier for asset prices to rise during an economic downturn. Consequently, PE investors and strategic buyers found lucrative opportunities—the prevailing circumstances allowed them to acquire high-value companies at significantly reduced prices, enabling the acquisition of quality investments at bargain rates. 

But the current situation has taken a different turn, with the Federal Reserve adopting measures that work counter to the interests of investors. By raising interest rates, the Fed is creating obstacles for asset prices to go back up. As a result, the PE market is seeing many changes in trends and policies, with many firms shifting to emphasize their credit arms.

So what exactly is happening? How do rising interest rates affect private equity? Let's find out.

Market in COVID Years

Before diving into the current market and the PE deal slowdown in 2023, let's take a step back and look at the market in the previous years.

Market Pre-COVID:

2018-2019 wasn't great for deal-making. Around this period was the brunt of US-China tensions. Cross-border transactions faced heightened scrutiny and regulatory hurdles. Uncertain trade policies and geopolitical developments caused investors to become more risk-averse, leading to a decline in M&A activity and investment flows between the two countries. 

There was also increased scrutiny in the TMT sector over data privacy and security, market power concentration, and potential antitrust violations within the TMT industry. Overall, there was a slowdown in M&A and IPO activity.

In 2019, the US yield curve briefly inverted, prompting fears of an impending recession. Global M&A fees declined by 10%, US M&A fees declined by 6%, and several tech companies that went public in 2019, including Airbnb, Lyft, Peloton, Pinterest, Slack, Uber, and WeWork, encountered challenging beginnings in the stock market and experienced disappointing results.

Market During COVID:

March to June of 2020—the early stages of COVID—saw some of the biggest market slumps in history across all sectors, with the price of oil becoming negative at one point. Supply chain disruptions and the curtailment of travel from lockdowns caused an unprecedented stock market reaction. No previous infectious disease outbreak, including the Spanish Flu, has affected the stock market as forcefully as the COVID-19 pandemic.

As the government began responding with record stimulus packages, some sectors, such as pharmaceuticals and biotechnology, fully regained their market losses. However, many industries—notably aerospace, air and travel, banking, insurance, and oil and gas—remained down significantly from their pre-pandemic peaks. 

Market Post-COVID:

2021 was a year of high risk and high reward. As the Fed began quantitative easing measures, interest rates dropped to record low levels, and asset prices began skyrocketing. COVID also boosted people's reliance for tech, leading to the rise of many tech and consumer retail companies. 

Source: McKinsey & Company

Most notably during this period was a group of companies dubbed the "Mega 25": 25 companies that experienced significant market capitalization gains, totaling $5.8 trillion, account for a staggering 40% of the overall market gains since 2020. Out of these 25, 22 of them fall into four sector categories: North American technology, Chinese and Asian technology, electric vehicles, and semiconductors. 

In November 2021, valuations reached enormous peaks. In a low interest rate environment, more deals appear favorable, leading to increased valuations due to higher demand. With more buyers able to afford purchases, companies have a higher chance of finding buyers, which drives up their valuation. Software companies were being valued at an average of 30x NTM Revenue (future revenue) on average. LBOs averaged 6x leverage ratio (debt to EBITDA), even higher than 2007 levels (5.8x). Over 861 SPAC (special purpose acquisition vehicles) IPOs occurred in 2020 and 2021, the highest ever in history. 

Looking back, investment theses before February 2022 were optimistic about the post-reopening economy. However, this optimism was quickly shattered by the Russian-Ukraine war, high inflation, and increasing interest rates, offsetting the anticipated boom.

Source: Bain & Company

Private Equity Deal Slowdown

During the 2008 and 2020 market crashes, the Federal Reserve supported investors by lowering interest rates, which facilitated asset price increases. However, in the current market crash, the Fed is acting against investors by increasing interest rates, making it harder for asset prices to recover. 

To curb inflation, the Fed raised its rate from near-zero during the pandemic to a range of 5% to 5.25% over a year, its highest level since 2007. Inflation has cooled significantly during that time, falling from a 9.1% annual rate in June 2022 to 4% as of May, as measured by the CPI.

Source: Investopedia

Interest rates and private equity are inherently interconnected. Take a look below to see why.

Interest Rates and Private Equity:

If we look at the WACC formula, we can see that two of the significant inputs are the cost of debt and the cost of equity, both of which are impacted by the interest rate. 

When interest rates increase, the cost of debt increases, and LBOs become more challenging to execute—since LBOs are primarily based on debt. 

Imagine a company that has a limit on how much interest it can afford to pay. When interest rates go up, that limit stays the same, but it becomes harder to borrow money because the amount of debt the company can take on decreases. This means that the company can borrow less money compared to when interest rates were lower. As a result, the amount of debt that can be raised for LBOs will be lower, and the potential returns on those investments will also be lower. (Remember that LBOs depend on high leverage to generate returns, so a lower leverage ratio naturally decreases returns).

Another piece is that interest rates make other asset classes more attractive—such as bonds, high-yield credit, and cash. This is because the return on those instruments increases as interest rates increase. However, riskier investments tend to do better when interest rates are low, as investors chase yield. Fast-growth industries such as TMT and fast-growth healthcare often see a decrease in their valuation as interest rates increase. This is because the higher the interest rate is, the higher the discount rate/WACC is, and the value of the future cash flows will be lower. 

The third factor is that portfolio companies may struggle to raise capital and fund growth. As a PE firm, you have multiple companies in your portfolio. When interest rates are high, those companies have a harder time raising money and capital. For the PE firm, this could potentially cause their revenues or EBITDA to decrease, ultimately impacting their returns.  

TLDR: high interest rates are bad for PE firms because: 

1. higher interest rates = higher cost of debt = LBOs harder
2. higher interest rates = other asset classes become more attractive
3. higher interest rates = PE firms' portfolio companies struggle to raise capital and fund growth

Current Trends in the PE Market

Now let's go back to the current PE market. With high interest rates, PE firms aren't doing so hot. From Q1 2022 to Q1 2023, PE-related deal volumes have declined ~30%, taking the market back to pre-COVID levels. 

The current deal-making environment is seeing 3 major trends:

1. Increased interest in credit
2. Slowdowns in the deployment of capital and record level dry powder
3. Continuation funds

1. Increased Interest in Credit

With interest rates rising, returns on credit instruments are also increasing. Investors are now obtaining 10-12% returns on loans, and since loans are typically repaid sooner, credit is also considered safer than equity. Additionally, raising a credit fund is often easier than raising funds for other investment strategies, contributing to its appeal.

TPG's recent acquisition of Angelo Gordon is evidence of PE firms' attempts to expand their credit arms. In the current economic environment, credit is a more lucrative option as it offers similar levels of IRR but with lower risk.

2. Slowdowns in the Deployment of Capital and Record-level Dry Powder

In PE and VC, "dry powder" refers to uninvested cash or liquid assets that are readily available and held by investors or investment firms. From the end of 2022, dry powder in private equity sits at around $3.7 trillion. While this may seem like it represents possibility, it is not a good sign for LPs who expect their investments to be paid back in time. With trillions of uninvested capital, competition to find good investments is tougher than ever.

3. Continuation Funds

2 years ago, PE firms' primary focus was to invest as much capital as possible without considering the IRR and to deploy capital extensively and leverage that period to raise a new fund. Remember, GPs earn money based on 2 factors: investment performance and the total amount of capital managed. Thus, even if IRR was mediocre, they remained profitable by swiftly turning over capital and securing a new fund. Nonetheless, 20% IRRs were commonly achieved 2 years ago, so returns were generally favorable.

In contrast, the current investment environment has become more risk-on. A+ assets are not readily available in the market, and the deals currently on offer are generally not considered good. Even if a seemingly good deal emerges, it may not meet the expected standards by 2023 due to higher debt costs, leading to lower IRRs. 

The current investment environment and PE's record-level dry powder gave rise to the PE secondary market. In particular, continuation funds have become a lot more prominent than before.

What is a Continuation Fund?

A continuation fund is a new vehicle set up to take on the portfolio investments of a fund nearing the end of its lifespan. Traditionally, LPs will invest in a fund with the understanding that they will see a return in around 5-10 years. Now that GPs are finding it harder to pay LPs back in time, they are given the option to cash out or stay invested in the portfolio by recommitting to a new vehicle.  

Continuation Funds are smart options for PE firms right now because when funds are initially raised, PE firms commit to returning the capital within ~5 years. However, if they were to sell the assets at this moment, the return would be unsatisfactory. This is where Continuation Vehicles come into play: An external LP buys out the other LPs and transfers the assets to a new fund that the GP will still manage. This arrangement ensures profitability for both the GP and the LP.