It says a lot about the magnitude of the recent global private equity (PE) market boom that deal value (including buyouts and secondary buyouts) fell by 46% in 2022, year-on-year, and yet still managed to outperform every year going back to 2007. Similarly, deal volume in 2022 slipped by 12% year-on-year to 6,557 deals—but this was still almost double the annual deal counts recorded between 2018 and 2020. PE fund managers have hardly had a moment to catch their breath.
PE activity may have slowed in 2022, mirroring the slowdown in the broader global M&A market, but it appears to have found a bottom, assuming no further shocks are forthcoming. There were 1,552 deals in Q1 of this year, a year-on-year decline of 26%, but a 20% increase on Q4 2022. Value came to US$148.4 billion, down 51% year-on-year, but a gain of 13% on the previous quarter. GPs will hope this signals a turning point.
Fundraising frictions
Fundraising contracted last year as investors managed the impact of the denominator effect on their portfolios, which sees them become overallocated to private assets by virtue of the decline in the valuations of their public equity holdings. The less-discussed numerator effect compounded this result. Because PE performed so well in a period of abundant and inexpensive debt financing, funds’ net asset values became heavily marked up and portfolios became more misaligned against their target allocations.
In December 2022, Preqin estimated that global PE fundraising dropped by 22% year-on-year as investors exercised greater conservatism and forecast a smaller decline of 2.7% in 2023 with the stabilization of valuations. The recovery in public equities since the beginning of Q4 last year could see investors grow more comfortable with committing to new PE fundraisings—although, with a possible recession on the horizon, there is the chance of more downside to come for stock markets.
Regardless of the slower fundraising year in 2022, dry powder stores are in fact accumulating, by virtue of the slower rate of capital deployment. Preqin estimates that committed but uninvested capital stood at US$1.96 trillion in December 2022, compared with US$1.62 trillion at the same time in 2021. Fund managers are not short of cash, but the debt side of the financing equation has proven more challenging.
Leveraged finance lags
The large-cap end of the market has struggled with financing challenges since midway through last year. High yield bonds have been prone to the tightening cycle given the product’s fixed-rate profile. Across North America and Western and Southern Europe, high yield issuance for the purpose of financing buyouts was at US$11 billion in Q1 2022; in Q1 2023, this same issuance fell to just US$2.4 billion, a year-on-year decline of 78% and a low not seen in more than two years.
The syndicated loan market meanwhile has been highly volatile. In Q3 2022, US$65.2 billion in leveraged loans were issued to back buyouts in North America and Western and Southern Europe, but this fell dramatically over the following two quarters. In Q1 2023, this issuance collapsed to just US$7.9 billion, below levels during the worst of the pandemic. Pricing has been trending higher in lockstep with rising interest rates and tighter structures are on offer. Leverage ratios have also been tightening.
This has been great news for direct lending funds, which have stepped in to replace some of the lending capacity left by the syndicated loan market void. While there were some signs of greater prudence on the part of these private debt funds toward the latter half of the year, they have generally shown a greater willingness to club together to finance multi-billion-dollar buyouts and refinance existing deals than in previous years.
Large-cap buyouts still on the menu
That is not to say that banks are unwilling to underwrite loans for deals. The largest buyout of Q1 this year saw a consortium led by private equity firm Japan Industrial Partners selected following a competitive process to acquire conglomerate Toshiba for US$15.2 billion. The winning bid was reportedly backed by US$10.6 billion in loan commitments from major banks. What is unique about the recent period, however, is that direct lenders have been playing an increasingly central role in syndicated loan markets themselves in lieu of demand from institutional investors for leveraged paper as they continue to exercise greater risk aversion.
In many cases, banks have been left holding debt they have been unable to sell down. As we previously highlighted, lenders in the US and Europe were sitting on around US$42 billion in buyout loans they had been unable to syndicate as of late 2022, according to Bloomberg, and private debt managers have been selectively acquiring these. In Europe, one of the most widely reported loan packages to be stuck in syndication was the £6.5 billion debt backing the buyout of UK supermarket Morrisons. Debt fund manager Pimco would ultimately buy nearly 10% of these loans.
Tougher financing conditions have not just trimmed leverage ratios, but in some cases have seen sponsors backstop most of their deals with equity. This was the case in the second largest PE deal of Q1 this year, in which Silver Lake Partners and the Canada Pension Plan Investment Board (CPP Investments) paid US$12.5 billion for Qualtrics, acquiring the survey software company from Germany’s SAP as part of the latter’s restructuring. The transaction is fully financed by equity commitments from Silver Lake and co-investors together with US$1.75 billion in equity from CPP Investments and US$1 billion in debt. While this is a growth-oriented deal, it is likely that full or partial equity backstops will be more common than they were during the era of cheap and abundant debt financing.
In the case of Q1’s third-largest PE deal, Apollo Global Management and the Abu Dhabi Investment Authority were able to secure a debt package to support their US$8.1 billion buyout of US chemicals company Univar Solutions. This included a US$2.1 billion senior secured term loan facility, a US$2 billion bridge loan, and a US$1.4 billion senior secured asset-based revolving credit line. Fitch Ratings notes that the company’s strong position in chemicals and ingredients distribution and impressive free cash flow generation make it a relatively healthy credit.
Given the unpredictable macro outlook and difficult trading and financing conditions that are likely to persist in the near term, sponsors and lenders alike will be seeking these defensible cash flow characteristics in deals that PE funds will be looking to lever up over the coming months.
