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Hi everyone, and welcome to the November edition of the PE Pulse podcast; where over the next 8-10 minutes, we’ll give you a rundown of the important themes and trends in the PE space and give you our views on how today’s macro environment is impacting Private Equity. My name’s Pete Witte, and I’m part of the private equity group here at EY. And I appreciate you taking the time to listen.

So, let’s get started.  

So, it’s fall where I live, and I know it’s a little hokey, but it occurred to me that it’s not a terrible metaphor for where we are in the market right now. The seasons are changing, the robustness of summer (alt: summer’s lease) is winding down, and it’s being replaced with rougher winds. At least for a little while.

And we talked about this last quarter, how activity had actually held up pretty well through the first half of the year, all things considered, but that given the macro dynamics, we should expect a more significant measure of slowing across the board over the next several months. And that’s exactly what we’ve seen. Deal sizes getting smaller; pivots toward more recession-resistant sectors and strategies; modest declines in fundraising; and then more significant declines in exits. So we’ll double-click on each one of these, and we’ll start with deals.

Deals

In the first half of the year we saw declines of about 20% versus last year, and that’s really wasn’t bad considering last year was the busiest ever for PE; so we expected a measure of slowdown. When we rolled into midyear, we were basically saying – look, the number of deals is down, but it’s basically about where it was pre-pandemic. But in Q3, that deceleration really intensified. Right now we’re seeing about 20-30 significant PE deals every month. And by significant, I mean anything over $100m. Before the pandemic, we’d see about 35-40 every month. At the height of the recovery, we’d see somewhere around 70 or so; in September, we saw 25. And by value, we saw a decline of just over 50% between Q2 and Q3 of this year.     

And there’s clearly a number of reasons for that – the outlook’s gotten a lot cloudier, and you have the usual disconnect between buyers and sellers and valuation gaps where folks have a hard time arriving to a proper price. But more importantly, there’s the dislocation that we’ve seen in the financing markets and the challenges that some of the large banks have had in offloading the debt that they took on to finance large deals in the early part of the year.

And so where last year, we saw almost a trillion dollars in leveraged loan issuance; this year, it’s been about US$350b all in, and a lot of that was in the first part of this year. And again,Q3 is where we really saw things slow down, down 50% from Q2 on the financing side. 

And so spreads have widened and yields have gone higher, to the point where financing costs for current LBOs are in the 9-10%+ range. Now that’s based on a pretty small handful of deals; so if the market gets comfortable with the direction the Fed is taking, if inflation starts to come under control; then we could very well see these spreads decline a bit and financing costs start to back off of those levels.

But as a result of all that, the locus of activity for PE firms has shifted down-market, where valuations have moderated and financing is more readily available. We’ve seen more add-on transactions in particular – typically, the market is around 50/50 between platform deals and add-ons; right now, the market’s around 60/40. And what’s interesting is that the degree to which the financing for a lot of this is coming from private credit providers, who have been very active in filling the gaps while the syndicated market has been largely closed off.

Last year, for example, private debt made up about one-third of the overall financing market for PE deals. In Q2, private lenders have made up 55% of the overall market, and in Q3 I haven’t seen the stats but I have to think it’s even higher.

I think that’s one of the key stories that’s going to come out of this market – is private credit lenders teaming up to take down larger and larger deals. That was already happening before this year, but this is really going to accelerate that. You look at some of the largest PE deals over the past few months, and a lot of that financing has shifted over to the private side. We just saw a large deal in the tech space, for example, get a 2.5b financing package from a consortium of private lenders. So in that way, it’s very much mirroring what we’ve seen on the equity side, where more and more capital markets activity is shifting from public sources of capital to private.

Last thing I’ll say here, is that they certainly have the capital to execute on that. About 450b in aum across the various credit platforms, and what’s interesting is that 250 of that is dry powder. So the amount of dry powder actually exceeds the amount that’s invested right now. Which, given where the market is probably headed, is a really great place to be.

Exits

Now we’ll talk about exits for just a minute – but frankly, there’s not a whole lot to really comment on, exit activity has really fallen off a cliff this year. No one’s going to sell when the market’s down 20% unless you really have to. And for most PE firms, they’ve been such active sellers the last few years, very few of them really have to. So there’s less recycled capital that’s floating around, and that’s going to ultimately impact fundraising. Overall, we saw a drop in exit activity of 67% in the third quarter versus Q2, and the vast majority of those were sales to strategics. We’ve only seen a very small handful of IPOs this year, and lately its been the same with secondary exits as well. So just really limited activity here, and people are for the most part content to wait out the downturn and sell when things pick up. And for those that can’t, or don’t want to do that, we’ve talked about the options they have with respect to continuation funds and LP- and GP-led secondaries.

Exits

But ultimately, that downturn in exits is ultimately going to affect the fundraising market. And we’ve seen some of that already. Firms have raised US$385b so far this year, 8% lower than the same period last year. And then in Q3, activity slowed by 13% to US$125b versus Q2.

What’s interesting about the fundraising market is some of the stats we see around who’s actually getting funded – because there’s a real bifurcation I think that’s happening in the market right now – and I had a hard time reconciling this in my mind at first, because we know the overall market for fundraising is down, but at the same time, for a lot of the really large PE funds, they continue to report that they’re bringing in a large amount of capital. When the Q2 earnings figures came out for example, we actually saw aums go up at a lot of the funds, despite taking write-downs in the portfolio. Because the capital coming in was more than sufficient to offset those write-downs.  So while LPs can’t fund everything they want right now, they certainly continue to fund their largest and most significant managers.

And then the other tailwind you’ve got here is the fresh capital coming in – about 80% of the industry’s capital comes from recycled distributions, and about 20% from new money – mostly HNW, which tends to favor the larger managers, because in a lot of cases, they’re the ones making the investments in building our those channels. So for that population, that’s going to offset some of that pressure from declining distributions a bit – and that’s very much by design, where firms are being very deliberate in diversifying their funding sources in the same way that they’ve diversified their deployment strategies.

Outlook

So, the open question - where do we go from here – and it’s tough, because the market’s being driven by these massive macro factors that can go a lot of different ways. But I think what we know is this. From a deployment perspective, we’ll see a continued shift away from cyclicals and growthier opportunities and into the value end of the spectrum. Over the immediate term, there’s probably a continued preference for smaller deal sizes here, so more add-ons, more buy-and-build strategies – and then over time, as the syndicated market recovers, we’ll see the return of scale again. And we’ll see folks being really creative in the types of deals they’re doing – firms are looking at the infrastructure space, they’re certainly looking at credit, they’re looking at certain spaces in real estate, they’re looking for companies with high barriers to entry, long-term contracts, the ability to pass along higher costs to customers  - things that give them a bit of  hedge against the macro. 

From a portfolio perspective, it’s sort of a reversion to the pandemic playbook, where you’re looking at your portfolio, figuring out where the trouble spots are going to be, and then working to address those in a way that optimizes the value of the fund. And in particular, looking very closely at cash situations, runway, your Treasury function, and getting visibility into all of those things. You’ll look to control costs as best you can. And then in this environment in particular, you’ll look very closely at your pricing strategies and whether those continue to make sense in light of the inflationary environment we’re seeing.  And our folks have been very busy helping companies with all of those things over the last several months.

So bottom line, it’s an interesting environment, there’s a lot of variability in potential outcomes over the next few months depending on how quickly central bankers are able to resolve inflationary pressures, and at what cost to the real economy. But I’ve said this before, and it’s worth saying again, that the long-term secular trends are really driving the bus when it comes to PE; they’ll remain intact, and they’ll offset a lot of the cyclicality that we’re seeing and will likely see for the next few quarters.  

That’s it for today’s podcast – thanks as always for listening, and I’ll see you next quarter with another update!

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