Private Equity Dealmaking Outlook for the Remainder of 2024 Pre-Election

The private equity (“PE”) sector is still adjusting to the new era of higher interest rates and market uncertainty. As such, 2024 has been promising with increased deal flow and stabilized valuations across the board. Over the past year-and-a-half, large platform transactions have fallen out of favor, with bolt-on acquisitions to existing portfolio companies becoming more attractive. Looking ahead to 2025, several factors could make the landscape interesting: potential Federal Reserve intertest rate cuts, the upcoming U.S. presidential election, and uncertainty surrounding tax policy. Moreover, private equity will need to shift its focus from revenue growth and multiple expansion to enhancing margins through sustainable operational efficiencies. 

Interest Rate Cuts Coming … Is It Enough to Ease the Short-Term Pressure in the Real Economy? 

The hawkish stance by the Federal Reserve is coming to an end where it increased interest rates 11 times from March 2022 to July 2023 in a response to accelerating inflationary pressures. In Jackson Hole, Wyoming, Federal Reserve Chair Jerome Powell signaled to the markets: “The upside risks to inflation have diminished, and the downside risks to employment have increased.”  

The points below highlight the pressures building up for consumers and provide some indication on why the Fed is changing policy. EisnerAmper has heard from private market investors that their portfolio companies are experiencing slowing top-line growth and an increase in cautionary behavior from their customers. At the same time, most have mentioned the compounding effects of the inflation surge have subsided.  

Current data points from the Federal Reserve and the CME Group: 

• The unemployment rate has crept up to 4.3% as of July 2024 from 3.6% in March 2022. The Bureau of Labor Statistics revised its previously reported estimates of job creation in August. Revising previous estimates signify job creations are down by 818,000. 

• Total household debt has increased from $15.85 trillion to $17.8 trillion year-over-year, an 11% increase. Delinquency transition rates for credit cards, auto loans, and mortgages increased slightly. Over the last year, approximately 9.1% of credit card balances and 8.0% of auto loan balances transitioned into delinquency. Mortgage delinquency transition rates remain historically low.  

• The markets are betting on a 25-basis point cut to the benchmark rate in September, followed by another 50-100 basis points cuts by year end.  

• The Federal Reserve started 14 rate-cycle cuts since 1929. Of those 14 cycles, 10 of those corresponded with a recession already underway or followed shortly after. 

Tax Policy Post the 2024 Election 

Every four years, PE investors wonder how tax policies will be impacted by the results of the U.S. presidential election, and this time it’s no different. In 2025, there are a bevy of tax policies scheduled to sunset. The 2017 Tax Cut and Jobs Act (“TCJA”) expires at the end of 2025, which means Congress will need to enact significant tax legislation next year prior the TCJA expiration. For private market investors, the two relevant policies up for debate include:  

• Taxation of carried interest at capital gains rates after a three-year holding period. 

• The tax deductibility of interest paid on debt, which creates a tax shield for levered portfolio companies. 

Neither candidate has officially announced their policies on either of these two topics. However, significant changes to the capital gains rates and interest deductibility tests could have valuation and cash flow implications to portfolio companies and, ultimately, returns. As the election nears, it is expected that the candidates will refine their tax policy stances.  

A Return to Old School Value Creation

PE has experienced a remarkable run over the last ten years, consistently achieving returns that have surpassed public markets. However, sustaining this level of performance in the current landscape of higher interest rates will necessitate a stronger emphasis on operational value creation. PE funds have relied on industry tailwinds, multiple expansion, and revenue growth to create enterprise value at exit. Hence, there has been a shift toward margin improvement via: 

• Optimizing pricing strategies. 

• Creating a more efficient sales force. 

• Developing products. 

• Sustaining operational efficiencies. 

In recent years, PE has successfully passed rising costs onto customers. However, the limits of price increases are now becoming evident, and labor costs remain a prominent factor. Enhancing margins will likely depend on optimizing processes, improving supply chains, and streamlining the workforce to address technological challenges and opportunities. General partners will need to scrutinize every aspect of their operations—from marketing budgets and sales structures to raw material procurement and logistics—to identifying the most efficient ways to drive growth, reduce customer acquisition costs, and improve unit economics. Achieving this will likely require more advanced systems, processes, and technology to accurately assess costs, quantify their impact, and find effective ways to cut expenses without compromising topline growth. 

Importance of Due Diligence to Enhance Value Creation Opportunities 

EisnerAmper has seen an increasing number of buy-side firms requesting scopes that include procedures focused on teasing out margin-enhancing opportunities. As buyers are asking for more time to execute due diligence, they have found it easier to implement a deeper due-diligence process. A multitude of vectors are hitting at the same time, including cash flow implications to higher interest rates, leverage levels, the ability to pass on inflation to it suppliers and customers, labor market implications, and the ability to obtain portfolio company talent to execute a growth strategy. These all must be succinctly analyzed together with some understanding of the sensitivity of how they interplay.  

In the second half of 2021 and 2022, processes were happening in a compressed time frame. Why? Sell-side processes had transaction leverage because deals were ultra-competitive, forcing buyers to rely on sell-side due diligence findings.  

That changed in late 2022 and 2023:  

• The due diligence process has returned to a phased approach as financial/tax/commercial are the first in, followed by legal, environmental, and insurance process. 

• Pro forma EBITDA adjustments related to synergies and future events are being heavily discounted. Value considerations for these are now moving toward part of structured contingent future payments based on actual realization as risk is shifted away from buyers and back to sellers. 

• The timeline to close letters of intent has increased from 45-60 days to 60-90 days as buyers want multiple looks at the business and roll forwards to ensure they are not buying peak EBITDA.  

It is expected that these due diligence trends will continue during the remainder of 2024 and into 2025 as private investors rethink how to create value going forward, entry points into new markets, and how they want to differentiate themselves from the pack. 

Private Company Valuations Have Seemingly Stabilized 

With the most aggressive rate-tightening cycle in history behind us and the Federal Reserve signaling rate cuts in September, valuations have seemingly stabilized as long-term cost of capital becomes more transparent, inflation has cooled, and real economic growth grinds forward at a moderate pace. 

GF Data reports the following data highlights: 

• Leverage multiples increased. Total debt averaged 3.7x for the second quarter 2024, compared to 3.6x for transactions in all of 2023. 

• Buyers addressed the increase in debt by reducing the amount of equity they contributed to deals. Average equity commitment for transactions in 2024 year-to-date decreased 1.7% percentage points to 50.3%, compared to an average of 52% for all of 2023. 

• Senior debt pricing has fallen in 2024 and averaged 9.3%, down 1.7% from Q4 2023 where on average senior debt was pricing out at 11%. Pricing fell for all transactions uniformly when compared to the end of Q4 2023. Larger transactions in Q2 2024 ($100-$250 million in enterprise value) commanded on average 9.9%, while smaller transactions for the same period ($10-$25 million) were able to secure pricing at 9.1%. 

• Valuations on completed deals through the second quarter of 2024 averaged 7.1x in line with 2023 at 7.2x. Transactions sizes between ($10-$25 million) saw multiples jump to 6.4x in 2024, up from 6.0x in 2023. Conversely, up market, transaction sizes in the $100-$250 million enterprise range, multiples fell on average to 9.8x in 2024 from 10.7x in 2023. The change is consistent with a theme where private market investors are finding more value in the lower end of the market executing add-on acquisitions to their existing portfolio companies and moving away from lower-quality platform investments. 

• In a turn of events from 2023, transaction volumes have ticked up this year. GF Data reported 180 transactions year-to-date, which is on pace to do 360 for the year, up from 293 transactions it recoded in 2023 and in line with volumes from 2020. This is a sign that buyers and sellers are being much more active this year. We speculate that some of this activity is being driven by getting ahead of the 2024 elections and potential change to tax policy into 2025, specifically capital gains rates.