Private equity titans including KKR & Co. and Thoma Bravo pursued unorthodox paths to dealmaking this year in response to a challenging environment likely to persist in 2023.
Firms sold stakes in their portfolio companies, took on private debt, offered preferred equity and plunked down billions in cash to make deals happen as leverage became scarce.
After a red-hot 2021, private equity funds raised $404.6 billion of capital during the first nine months of 2022, a decline of more than 20% from a year earlier, according to Preqin. Deal volume as of Sept. 30 was only a third the record $404.4 billion for all of last year.
Private equity boomed in 2020 and 2021 after Covid-spurred volatility in financial markets gave way to government stimulus that sent asset prices soaring. That rally reversed starting this year as inflation and higher interest rates thwarted dealmaking. The tough environment may persist until the Federal Reserve stops hiking rates and inflation cools further.
“There’s no question that it is currently, and will likely be, a more challenging time for private equity firms,” Jason Strife, head of private equity and junior capital at Churchill Asset Management, said in an interview.
Debt Alternatives
The Fed’s monetary tightening has made it more expensive to access debt financing that greases private transactions, with the benchmark rate increasing to around 4.75% in December from about 0.2% a year earlier. Investors’ reluctance to fund risky transactions has shelved about $40 billion of debt that banks would have otherwise sold in the public markets.
Some firms have resorted to doing all-cash deals rather than saddling themselves with costly debt. That’s highly unusual for an investment model that takes advantage of leverage to boost returns. KKR agreed to fund its entire €2.3 billion ($2.4 billion) purchase of insurer April Group, while Francisco Partners, Thoma Bravo and Stonepeak Partners have also funded deals entirely with equity in recent months.
But firms might not have enough liquidity to fund all-cash deals as falling valuations make it harder to sell assets.
Private company valuations declined 5.3% in the first half of the year, compared to an increase of 25.5% for the same period in 2021, according to Cambridge Associates. The firm predicts a continued slide as inflation and labor shortages weigh on companies.
Those dwindling valuations could also put pressure on portfolio companies bought during the heady days of late 2020 and 2021, according to Andrea Auerbach, head of global private investments at Cambridge Associates.