Can PE Justify Buyout Deals in the Current Market?
Hi Monkeys,
Long-time lurker here and currently thinking about PE recruitment.
This got me wondering about how PE are thinking in the current deal / macro environment. There are a few interesting factors at play:
- Valuations low and potentially set to decline further
- Interest rates up roughly 5% over the last 12 months
- Lending from banks seems to be a closed opportunity, but private credit funds could be emerging as a potential way to finance the debt component of LBOs
- Record levels of dry powder
So there is a play-off here between the opportunity of buying companies at lower valuations but challenged by the ability and associated new cost to finance deals given current interest rates.
So, what are PE doing? If new private credit funds can offer credit to the markets (e.g. Oaktree raising a $10bn fund, per FT) , even if at a total cost of +10%, is there an angle for PE being able to still generate sufficient returns given lower valuations?
Is it now more defensible to buy at current (low) valuations and assume some level of multiple expansion (perhaps 1-2x EBITDA on exit) if holding for say, 5 years? Would this be a way to meet traditional returns expectations?
Thanks!
bump
This is arguably one of the best time to be doing buyout deals IMO. Price is the hardest part though, a lot of founders/operators who are quoting multiples from 12-18+ months ago still and don't want to except that's simply not happening.
Interesting - how are you thinking about deal math then? Is the cost of debt not hampering ability to generate returns or is this simply offset by multiple expansion given low valuation levels? What do you think about ability to leverage the capital structure - has this gone down or are similar leverage levels achievable with private credit investors, just at a higher cost?
I would disagree that the current vintage would be the same as the post-GFC vintage. In 2010, good companies are being bought at low multiples in low interest rate environment, followed by massive multiple expansion. Today, the multiples haven't come down, all the recent deals are still being done at really high valuation and interest rate is much higher than what we had post-GFC, cost of debt is 10%+ for LBO financing. It's just not the same and even if returns are okay, deployment rate would be incredibly slow.
Bid / ask spread is currently wide and deployment will likely be slow. Volume will probably not pick-up until the depth and duration of the current recession are known. Some nearer-term opportunities may be found in private credit (higher quality borrowers forced to pay up / agree to more restrictive terms) and down rounds in strong organic growth stories in growth equity.
Where did you get the idea that PE valuations are 'low' right now?
The angle I was coming from is that public equities have come down from their highs in 2021 - but I guess you can definitely make the argument that valuations are still high.
My assumption would be that this correction in public equities will have also been seen for private companies and transactions.
Nope, not true. We don't do MaRk to MaRKeT and our returns are amazing
My belief, and this is just me, is that at the end of the day, an asset is valued by the return on equity it can generate. A company is just an asset. In the current environment, where valuations are low and the cost of financing is higher due to increased interest rates, EBITDA multiples will need to decrease in order to achieve similar returns for PE firms.
This adjustment in EBITDA multiples can happen through a variety of ways, such as buying companies at lower valuations, as you mentioned, or through operational improvements and cost-cutting measures. So if private credit funds aren't offering cheap debt, then guess what, PE firms will still be able to generate sufficient returns as long as valuations remain low, and a PE fund isn't going to model out a 1x return as a base case.
In terms of buying at the current low valuations and assuming some level of multiple expansion, it could be a viable strategy to meet traditional returns expectations, especially if the holding period is >5 years. This approach would allow for potential improvements in the macroeconomic environment and operational enhancements that could contribute to multiple expansion upon exit.
But ultimately, company owners will have to adjust their expectations if they want to sell in the short term. Hell, I just saw a deal come across my desk that the CIM was saying valuation was ~$120M for that I literally would not pay a cent over $25M for. We passed, and guess who came back a month later having no offers? This company. The environment is bad, and funds are either going to have to hold longer, or just sell.
Also, I think that operationally focused funds are going to make a KILLING over the next few years. If you can go in at lower multiples now and do anything to generate additional cash, then the return on that cash is so much higher because the cost of capital is so much higher. It's a beautiful time. But owners/founders are going to have to deal with the fact that, right now, if they want an exit, they're not going to get the multiples that bankers were touting a year ago.
Thanks for sharing your insights (and also enjoyed your post on Income Statement Analysis).
Just wondering how you're thinking about how to lever businesses? Assuming private credit can offer debt financing for a deal, is debt % funding (vs equity contribution) now assumed to be lower in this market?
E.g. If you were able to lever a business at 5-6x Total Debt / EBITDA last year, is this looking more like say 4-5x in this market?
Thanks so much!
Tech buyout fund here - see some smaller deals happening but large ones are quite muted. Valuations have not corrected but growth expectations have come down (atleast for the p2ps I was looking at). So it's not just interest rates, but rather the correction that's not happening. Also a lot of sellers are sitting on fairly high cost base, and not willing to take losses just yet. Let's see when the limbo ends ; either fed will stop raising and markets will shoot up or there will be a moment of realization and equities will correct.
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There's a great post in this thread which touches on a lot of the key points, but I'd add that firstly, from what I see, PEs are not justifying buyout deals (to the same level that they were a year or two ago). Valuation expectations are still pretty high, and in both public and private markets, there'll need to be a bit of a "come to Jesus" moment for equity owners to accept that their assets are worth less than they used to be.
On the other hand, I see a couple of catalysts: (1) PEs are coming under increasing pressure to return capital to LPs, and at some point the investment duration is going to necessitate selling at a lower price than they'd like. Nobody knows how the next 18 - 24 months will play out, and PEs will be reluctant to hold an asset in portfolio for 6+ years. (2) There's a lot of dry powder lying around, as you mentioned, and GPs need to get paid. A lot of funds haven't deployed as much as they need to, and have been struggling to raise funds. Honestly, from what I've seen, some of the BP assumptions I've seen baked into IC papers and models are more bullish than they used to be to justify investments at some houses.
Multiple expansion continues to be a swear word if used as a base case, but there are always "upside cases"
Aside from valuation expectations adjusting on a multiple perspective, a couple of quarters of soft EBITDA performance will make a big difference to headline valuations.
On the debt side, interests costs aren't the big driver for an LBO to stack up, what's more important is that the buyer is getting enough leverage. A lot of deals will still stack up with 10%+ cost of debt, but not many stack up with less than 5-6x leverage. The debt markets basically closed in the last 6 months of 2022 - and they're only starting to gradually re-open now.
So in 6-9 months when the valuations have actually adjusted and lenders are back to normal lending volumes, then you'll likely see a more active investment market.
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