Mid-Year Outlook for Private Equity Dealmaking in 2023

Following a piece EisnerAmper published in February on "The Outlook for Private Equity Dealmaking in 2023," several trends mentioned are expected to continue to play out this year and into early 2024 in what I called a shift back to an “old new normal.”

They included:

• Transaction structures shifting more risk to sellers through increased amounts of rollover equity, seller notes and earnout growth targets;
• Extended due diligence periods;
• Pro forma EBITDA adjustments with low probabilities of realization would be heavily discounted;
• Cost of capital would continue to increase with valuations to adjust downward 10-15% from peak levels by the end of 2023; and
• Lower deal volumes on cautious optimism by investment groups and management teams.

Fast forwarding to mid-year 2023, we would like to discuss how these trends and dynamics are evolving and what we have learned through working on several buy- and sell-side transactions; attending ACG Capital Connections in Houston and Las Vegas; and broadly visiting with private equity, family office, and investment banking professionals.

Transaction Structures

There has certainly been a change in how investors are shifting risk back to sellers as we have seen a transition on letters of intent (LOIs). Sellers’ expectations on valuations have not fully adjusted and there seems to be some hangover from 2022. To bridge that gap, we are seeing investors and buyers asking for:

1. Multiyear earnouts;
2. Increased rollover equity amounts;
3. Subordinated equity and promote structures to limit capital at risk at exit; and
4. Long dated seller notes.

Due Diligence Periods

As momentum has swung in the buyer’s favor, transactions are taking longer to close. We not only are seeing longer post-LOI due diligence periods, but we are seeing clients take extended amounts of time executing pre-LOI due diligence with a considerable amount of effort understanding the industry dynamics and sensitivities to a potential near-term recession. After speaking with several private equity and family office professionals in the past five months, the consensus is that they are cautiously optimistic long-term, but the current macro environment is challenging, creating difficulty in assessing sustainable and targeted returns.

Additionally, a few of them voiced that is becoming more difficult to source compelling opportunities and deploy capital in value-creating investments. These trends are expected to continue into 2024 until the markets have some additional clarity on macro growth and a potential recession.

Cost of Capital & Sustainable Cash Flow

Cost of capital has been the story since the beginning of 2023. It’s no secret the Federal Reserve has increased interest rates, which has made its way to the private markets increasing cost of capital and opportunity cost. Senior debt pricing reached 8.1% in Q123 vs. 6.7% in Q422, while pricing on subordinated debt surged to 16.8% vs 14.5% respectively per GF Data. Additionally, GF Data reports average total debt employed on transactions in 2023 was 3.4x EBITDA compared to 3.6x EBITDA for all of 2022, while senior debt had fallen on average to 2.5x from 2.8x the prior year, forcing buyers to deploy increasing amounts of equity commitments. With lenders tightening their standards and regional banks under scrutiny, the cash flow impact of higher amounts of interest and principal payments are putting a renewed scrutiny on seller-proposed EBITDA adjustments.

We are seeing low probability adjustments related to synergies, customer pricing and future events are being heavily discounted. As noted earlier, any value received for these are part of contingent payment structures based on company hurdles. This is a change from the behavior in early 2022, when sellers had market momentum and could dictate negotiations and valuations to some extent. At both the Houston and Las Vegas ACG Conferences, there was an effort to connect with senior and mezzanine lenders to establish new relationships and a lot of chatter on what banks were still active in the leverage markets at the moment as debt capital has become increasingly more difficult to source.

Deal Volume and Valuations

With longer due diligence periods, more complexity on the structures, valuation gaps between buyers and sellers, and increasing difficulty in raising senior and mezzanine debt, deal volumes are significantly off from the fast pace of 2021 and early 2022 time periods. Seventy completed transactions in Q123 were reported to GF Data, which is in line with Q422 and Q322 but well off the high mark of 172 deals completed in Q422. However, they report valuations are holding up with an average of 8.0x for deals completed in Q123 vs 6.8x and 8.2x in Q422 and Q322. We believe valuations are being buoyed by increased structural components that allow investors to meet their targeted IRRs through structures that increase equity rollover amounts and earnouts, and promote structures that limit capital at risk on the exit. With that being said, we are still in the camp that valuations will reset 10-15% over the next 6-12 months. Lower long-term growth, higher cost of capital, and recession indicators are now part of underwriting efforts, and we expect them to get baked in.