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Hi everyone, and welcome to the January edition of the PE Pulse podcast. My name’s Pete Witte, and I’m part of the private equity practice here at EY, and I focus on researching and tracking the PE sector. And over the next few minutes, we’re going to talk about some of the major themes and activity in the space.

So I appreciate you taking the time to listen, and let’s get into it!  

Deals

“In like a lion, out like a lamb.” That’s something we usually use to describe what the weather’s like in March, at least where I live in Chicago. But it’s also a great way to describe the way markets played out over the course of the year last year. You think back all the way to 2021 – we had record levels of activity – as diligence providers, our phones were ringing off the hook – and a lot of that momentum really carried over into the first half of the year. We saw about US$515b in PE deal activity. And that was a little bit less than what we saw in the prior year, but it was in the ballpark.

And then of course, we saw inflationary pressure start to accelerate, people took a step back to assess some of the impacts of the war in Ukraine, and overall, the environment got a lot more uncertain. And so people got more prudent – and as a result, we saw a pretty steep drop-off in deal activity in the second half of the year. Down about 40% by value, and about 30% by volume from H1.

But there’s value, I think, in putting some of these numbers in context. Before the pandemic – 400, 500b – that was an average deployment year for PE. Last year, PE firms did deals valued at around US$730b.  So I know we all tend to be impacted by recency bias, but when we zoom out a little bit, we can see – deals are still happening, and firms are staying active (albeit not at the pace of the last 18 months). What’s changing though, is the types of deals that we’re seeing, and the way that those deals are getting done.  

And that’s likely to be the case as we get deeper into 2023.

So let’s unpack that.

These kinds of environments always come with interesting opportunities – where certain types of deals become more interesting - and that’s the great thing about the PE model, is that ability to flex with the environment.

And so the challenges that we’ve seen in the financing market, for example, are precipitating a shift toward middle market deals – those packages are a lot easier to pull together, valuations tend to be lower, and firms are able to write higher equity checks for transactions. And add-on deals in particular, saw a lot of activity last year, and that’s a trend that’s likely to continue for the foreseeable future. Over the last decade, for example, add-ons have averaged about 50% of total PE activity versus platform investments; right now, they’re about 60% of the total PE market.

You look at what’s happening in the public markets, a lot of really interesting opportunities there now that valuations have come down – especially in the tech space – where some of these companies were basically trading at 2x what they’ve been acquired for by PE firms versus 18 months ago. With all the IPO activity that we saw in 2020 and 2021, there’s a lot of value to be had for the right assets. And so firms have been really active there. In a typical year, we might see take-privates account for about 20% of the investment capital that PE deploys. Last year, it was about 40%, so a very significant uptick. All in, we’ve seen firms announce about 80 take private deals valued at more than US$262b in 2022.

When we look at the types of deals that we’re going to see over the next 6-12 months, another is probably carve-outs – you think about this kind of environment, and it naturally lends itself to these types of deals; corporates tend to focus on their core business in periods and divest noncore or orphan assets. And those kinds of deals can be real competitive differentiators for PE funds, especially the largest funds – they provide opportunities for firms to leverage their scale and their operational expertise to drive value where others can’t. The level of competition for US$500m asset is much greater than the competition for a US5-10b asset. And the level of complexity involved is much higher.

Infrastructure’s another; we’ve seen a few bellwether deals in that space already, and we should probably expect more. Where a PE firm can come in, work with a corporate to provide financing at scale for capital-intensive projects. And where corporates are able to lower their cost of capital while keeping cash on the books. The semiconductor, telecom, transportation, renewables, digital infrastructure, mobility, and midstream O&G are just a few of the spaces where these kinds of deals can make sense.

And then lastly, just idiosyncratic opportunities in companies with characteristics that are going to let them perform well during a downturn – maybe that’s a value play, maybe it’s distressed, maybe it’s a company with long-term locked-in contracts, and so on. And then rotating out of anything that acts like a fixed income asset, and we’ve seen firms focus on that over the last few months.

Financing

Now I think most folks are aware that the syndicated finance markets have been pretty challenged over the last few months. Over the spring and summer, banks accumulated a lot of LBO exposure that they had a hard time offloading as interest rates moved higher, and that limited appetite for new deals. Bloomberg reported a few weeks ago that there was more than US$40b of hung deals sitting on banks’ balance sheets. Now, not all of that is PE – but the effect’s been the same, higher spreads and increased costs of financing.

And the market’s remained pretty choppy – we’ve seen a few deals test the market, they’ve had mixed results. We did see, before everyone went pens down for the holidays, some signs that investors are coming back into the space, for certain types of assets – certain types of refinancing activity. So I think folks will be watching very closely here over the next month or two how things play out.

But all of this has made it private credit’s time to shine. You think about those take private deals that I mentioned. I don’t think a single one of them was financed by the traditional syndicated finance markets. Instead, they’ve either been over equitized, and the sponsors will come back later and layer in some debt; or more likely, they were financed by consortiums of private credit funds. And the deals that they’re able to do are getting bigger and bigger.

You look at a deal like Blackstone’s recent acquisition of Emerson’s Climate Technologies business  - it’s a great example of how firms can employ really creative financing solutions. The company makes HVAC and refrigeration products, and the deal was valued at US$14b. In exchange for a 55% stake, BX contributed US$2.4b in cash, and is adding US$2b in convertible instruments that can increase its stake at a later date. US$5.5b in financing was provided by a consortium of private credit funds and US$2.3b in seller financing came from Emerson. And so the features of this deal – a carved-out asset, seller paper, deferred equity, private lenders, and a shared ownership model – are all levers firms are increasingly pulling to varying degrees across the market. 

Now – this won’t be the case forever – interest rates will stabilize, the banks will get some of these hung deals off of their books, and the traditional markets will start functioning more normally again. But I think when we look back at this time, this is really going to be the inflection point for private credit, and that’s going to be one of the real legacies of this period of volatility.

Wrap

So, bottom line is that firms will stay active, there’s a lot of interesting opportunities out there, and they’ve used the last six months to develop these alternative financing modalities that I think are going to persist – at least to some degree – even after markets normalize.  

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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