In 2023, private equity faced significant headwinds as interest rates surged, resulting in notable declines in deal activity, exits, and fundraising efforts, and three months into 2024, LPs and GPs are feeling the weight of a sustained liquidity crunch. Signs of recovery via interest rate moderation towards the end of the year feel promising. Yet, continued uncertainty remains the pivotal factor contributing to a largely sustained dealmaking deadlock, and ultimately, igniting the flywheel will require more robust approaches to value creation and innovation in liquidity tools. Looking ahead to how the rest of the year might unfold, we explore five key takeaways from Bain’s much anticipated 2024 Private Equity Report:
Making interest rate payments has become much harder for many buyout-backed portfolio companies. Interest coverage ratios among US buyout-backed portfolio companies have declined to 2.4 times EBITDA (marking the lowest level since 2007), with fast-approaching debt maturities set to exacerbate these cashflow challenges over the next several years.
Boosting EBITDA stands out as the optimal strategy for addressing the hurdles posed by rising interest rate payments. However, despite GPs largely redoubling their efforts on value creation, many will struggle to improve cash flows to the necessary levels to access traditional refinancing avenues. As conventional lenders shy away from debt-laden portfolio companies, innovative refinancing tools have become necessary.
To maintain 100% control, some firms are choosing to infuse just enough equity into a portfolio company to prevent dilution while making its debt more manageable; others are using NAV loans, accessing better rates for cash-constrained portfolio companies. Rolling over single assets in need of capital restructuring into continuation vehicles has also emerged as a refinancing option.
Ultimately, cash concerns in buyout portfolios trigger a series of considerations for both GPs and LPs. For GPs, an imperative emerges to acquire a comprehensive, consolidated view of portfolio companies grappling with loan maturities or cash constraints, devise a data-driven strategy for enhancing EBITDA, or explore innovative approaches to address balance sheet concerns.
Concurrently, LPs need visibility into strategies their GPs are tapping to resolve cash-related issues within portfolio companies. For example, As GPs increasingly turn to NAV loans, it becomes crucial for LPs to assess the quality of underlying assets securing these facilities and understand the implications of added leverage on portfolio performance.
Bain shows: Rising interest rates driving down interest coverage ratios across buyout backed businesses.
Chronograph adds: Rising interest rates do not only impact active LBOs, but also leverage during acquisition. As of September of 2023, equity contribution in LBOs crossed the 50% mark — the first time this has occurred since PitchBook LCD began monitoring in 1997.
Higher interest rates and cash flow management struggles pose a real threat to buyout returns. Over the past decade, GPs have relied heavily on multiple expansion and revenue growth to generate returns. Yet, a strategy shift becomes paramount as the ZIRP era comes to a close, and the prospect of sustained higher interest rates potentially curtails the consistent multiple expansion and growth that has propelled buyout returns in recent history. To deliver outperformance, GPs must adopt value-creation approaches that prioritize enhancing margins, shifting from the ‘growth at all costs’ mentality that has largely defined value creation since the GFC.
Simultaneously, the competition for capital has reached unprecedented levels. Delayed distributions have resulted in significant cash flow deficits for LPs, constraining their ability to reinvest in new funds. As a result, capital has gravitated toward the most established and dependable buyout funds over the past year.
This said, LPs largely maintain a bullish outlook on private equity due to its consistent long-term returns and diversification benefits. However, as allocators adjust to a new macro environment, identifying managers capable of generating performance independently of macro tailwinds becomes crucial. Here, technology offers an essential tool for both GPs and LPs to understand and identify the fundamental value creation mechanisms behind portfolio returns.
GPs are sitting on a record $3.2 trillion in unsold exits, and with exit channels largely dried up, LPs are facing a pressing liquidity crunch. Buyout-backed exits dropped to $345 billion globally in 2023, a 44% decline from 2022. With the imperative to enhance DPI (Distributed to Paid-In Capital) to LPs sponsors struggling to send cash back via M&A or IPO routes have gotten creative with generating liquidity. One of the most popular tools has emerged via the burgeoning secondary market.
Secondaries funds provide an array of tools GPs and LPs can use to manage their own liquidity needs. With many LPs overallocated to private equity, LP-led secondaries transactions have emerged as a useful mechanism for allocators to rebalance their portfolio exposures.
Additionally, to help generate liquidity amid a stalled exit environment, GPs are using continuation funds to provide liquidity to LPs. This allows GPs to find a new consortium of LPs (or GPs) who want to invest in the asset(s) at a new price, allowing them to hold their prized companies until markets improve while providing liquidity to cash-starved investors who want out.
The liquidity crisis has certainly served as a catalyst for the burgeoning expansion of secondaries. However, secondaries will likely sustain a rapid growth trajectory even as market conditions rebound. Since fund and company positions in secondaries vehicles are usually sold at a discount, these funds can be especially appealing from an LP perspective — allocators can often reap a great return profile but with greater j-curve mitigation.
However, amid the growth of secondaries, LPs need an effective, efficient way to price these opportunities and manage scaling data management needs. For example, secondary funds often contain many more underlying assets than buyout funds. If invested across multiple secondaries funds, the chance of LPs accumulating a large aggregate exposure to an underlying portfolio company increases.
Bain shows: Secondaries median returns beating out private equity, venture, real estate, and natural resources across 20 years of vintages.
Chronograph adds: Secondaries are experiencing such levels of popularity not just for their attractive returns, but also for their risk profile. Looking across standard deviations for these asset classes since 1996 shows secondaries consistently operating with lower volatility.
Even with interest rate stabilization and moderate declines expected later this year, sellers will likely continue to face challenges unloading portfolio companies. Beyond dislocated bid-ask spreads, one problem plaguing the exit market is an overarching concern that even well-performing companies may owe their success to market tailwinds rather than true operational improvements — with this sentiment ultimately backed by a decade of buyout returns primarily propelled by multiple expansions.
In the past, market tailwinds empowered buyers to take on greater risk and finance more speculative deals. However, heightened financing costs have markedly reduced the room for error in deal assessments. With buyers largely required to provide more equity upfront to close deals, getting comfortable underwriting based on value creation has become the norm, which, in turn, has required sellers to demonstrate a clear, achievable path to projected EBITDA growth forecasts.
Sellers must revamp their exit strategies to get deals done in a paralyzed market. Crafting a compelling exit story that showcases success during the holding period driven by management initiatives while also identifying opportunities for further value creation and outlining a clear path to achieve it proves essential for closing deals.
As LPs and GPs strive to navigate these challenges, one refrain becomes increasingly evident: understanding portfolios and underlying assets in unprecedented detail has never been more important. Here, technology emerges as an essential tool for both parties to scan their portfolios, identify and address problem areas, and chart a forward-looking path through a prolonged period of uncertainty.
Specifically, emerging opportunities in generative AI and data warehousing present compelling avenues for investors to significantly broaden the range of information they incorporate into investment decisions. For example, GPs are increasingly examining the role generative AI can play across the full value creation lifecycle of their investments, from sourcing to post-investment monitoring and exit strategies. LPs also increasingly recognize the potential of AI and ML in shaping their private equity strategies, with 54% acknowledging the necessity of developing in-house AI/ML skills to optimize investment decision-making.
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We thank Bain & Company for publishing such thorough research. To read the complete report, please visit: https://www.bain.com/insights/topics/global-private-equity-report/
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