Private Equity Outlook for 2024

Private equity is still in a period of adjustment amid the new era of higher rates and market uncertainty. Yet the outlook is positive since there are signs that near-term opportunities could be attractive for buyers with access to capital.

As we shift back to an “Old New Normal,” we see some emerging themes developing in the private markets that shape deal volume, returns, valuations, and stakeholder interest.

The Rise of GP-Led Secondaries and Continuation Funds

Private equity exit activity has fallen to historical lows relative to the industry’s dry capital. Global private equity dry powder increased 8% to $2.59 trillion in 2023 as lower deal activity and longer lead times have slowed capital deployment, according to S&P Global Market Intelligence and Preqin data.

Historically, private equity funds would wind down their portfolio company holdings through orderly liquidity events, mainly:

• A sale to a corporate or strategic buyer,
• A sale to another private equity fund or
• An initial public offering

Maturity Walls and Slowing LP Distributions

With most private equity funds having a 10–12-year life span, vintages from 2012-2016 are running into a maturity wall as interest rates and cost of capital have risen, with liquidity conditions turning negative in 2022 and 2023. Private equity funds now have to deal with a backlog of maturing investments, ultimately slowing LP distributions and reducing internal rates of return as time is a key factor in the calculation.

Navigating Risks and Conflicts in Continuation Funds

GP-led secondaries, or continuation funds, involve a sponsor setting up a new fund vehicle to purchase one or more assets from an existing fund managed by the same sponsor, with capital commitments from new investors taking out the LPs from the prior fund who are looking for liquidity. Pitchbook notes that $68.1 billion in capital was raised through Q3 2023 for continuation funds, outpacing the 2022 total of $57.6 billion and adding to the $202.7 billion in accumulated dry powder dedicated to GP-led secondaries and continuation funds.

Continuation funds do come with risks and conflicts. Sponsors leading continuation funds must prepare independent third-party fairness opinions, valuations, tax, and other related exchange offer materials. At the same time, LPs need sophisticated internal due diligence teams to review these materials, provide consent, and negotiate the transaction at arm’s length while still being an LP in the fund. Therefore, these vehicles will be limited in who they can be marketed to in the near term.  

Holding Periods for Private Equity Backed Companies to Increase

With the cost of capital expected to remain relatively high and liquidity options minimal, funds are expected to extend portfolio company holding periods in the process. Portfolio companies will likely remain in their funds for longer to allow for performance enhancements to compensate for lower transaction multiples. According to Pitchbook data, the PE inventory is the largest it has ever been, as deal activity outpaced exits.

• The median holding period of U.S. PE investments exited in 2023 reached 6.4 years, crossing the six-year mark for the first time since 2015.
• The exit-to-investment ratio has also hit a historically low mark, standing at 0.37x by the end of Q3 2023, compared with 0.48x in 2021 and 0.41x in 2022.

Importance of Due Diligence to Increase

M&A processes have slowed down as buyers ask for more time to execute due diligence. As a buyer’s market emerged in 2023 into 2024, acquirers found implementing a robust due diligence process easier. A multitude of vectors are hitting at the same time: cash flow implications of higher interest rates and leverage levels, the extent to which companies can pass on inflation to their customers, labor market implications, and the ability to obtain portfolio company talent to execute a growth strategy all must be succinctly analyzed together with some understanding of the sensitivity of how they interplay.

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

In late 2022 and 2023, we saw that change:

• The due diligence process has returned to a phased approach as financial/tax/commercial were the first in, followed by legal, environmental, and insurance processes.
• Pro Forma EBITDA adjustments related to synergies and future events are heavily discounted. Value considerations for these are now moving towards part of structured contingent future payments based on actual realization as risk is shifted away from buyers and back to sellers.
• In LOIs, we routinely saw 45-60 days to close negotiated in good faith to keep both parties moving to close. Currently, we are seeing 60-120 days to close as buyers want multiple looks at the business and roll forwards to ensure they are not buying peak EBITDA.

These due diligence trends are expected to continue into 2024 and 2025 as deal volumes remain relatively low compared to the 2021 and 2022 frenzy and the long-term effects of a higher cost of capital become the norm.

Private Company Valuations to Stabilize

With the most aggressive rate tightening cycle in history behind us and the Federal Reserve signaling no near-term dovish intentions, we believe 2024 will set the stage for valuations to stabilize as the long-term cost of capital becomes more transparent, the rate of inflation falls, and real economic growth slows.

GF Data reports the following data highlights through Q3 2023:

• Leverage multiples fell slightly. Total debt averaged 3.5x for the third quarter of 2023, compared to 3.7x for the third quarter of 2022.
• Buyers addressed the shortfall by increasing the equity they contributed to deals. Average equity commitment on platform deals in the year to date increased by 3.1 percentage points to 57.9%, compared to an average of 54.8% for all of 2022.
• Senior debt pricing up by another percentage point, reaching an average of 10.5% in the third quarter compared to 9.5% in the second quarter. Pricing increased for all deal sizes largely uniformly, a contrast from the second quarter, where smaller and larger transactions bore the brunt of higher pricing.
• Valuations on completed deals in the third quarter of 2023 averaged 7.5x Trailing Twelve Months (TTM) adjusted EBITDA—an increase of 0.9x from the second quarter and on par with the first quarter. The increased quarterly total aligns with the 7.6x average from the first quarter. Year to date through Q3 2023, 2023 now stands at an average of 7.3x, just off the 7.4x average recorded in 2022 and not far off 2022’s average of 7.5x.

Transaction volume remains relatively low, with just 56 transactions in the third quarter per GF Data. On an annualized basis, 2023 is on track for 271 completed transactions—18 percent off last year’s total and 46 percent off 2022’s total.

Boader Employee Ownership Structures to Gain Momentum

With pressure from ESG activism, competition for talent, and ways to align interests with all the stakeholders at private equity backed companies, there is increased momentum in broader employee ownership structures that allow all of the companies’ employees to participate in the value creation process and exit proceeds at close.

Ownership Works, a nonprofit dedicated to broad employee ownership, reports implementing these programs:

• Improves operational, financial, and employee engagement
• Increased competitiveness for acquisitions
• Increased portfolio company value

C.H.I. Overhead Doors, acquired by KKR and sold in 2022, reported the following stats after implementing a broad-based ownership employee plan:

• 10x MOIC
• 1,400bps increase in EBITDA Margin
• 4x EBITDA growth
• 800 employees made owners via a pool of stock appreciation rights (SARS)

As broad employee ownership gains momentum and the success stories to follow, we see this structural tool as a differentiator for private equity funds.