This Q&A was published as part of PitchBook’s Q2 2023 US PE Middle Market Report sponsored by Baker Tilly.
Explore the surprising resilience of PE dealmaking in the middle market amidst shifting interest rates, credit market dynamics, and macro trends. In Pitchbook's latest report, industry leaders Frank Walker and Marc Chase provide their insight on key trends, client concerns, and the role of private credit in shaping the US middle market PE landscape.
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In terms of macro trends, outside of general economic performance, we pay close attention to how the credit markets are functioning. We have had the convergence of generally tighter credit standards along with a historic increase in the cost of capital, with risk-free rates bouncing from about zero late last year to more than 5% as of August 2023. When you look at floating-rate debt, which many middle-market companies and deals are financed with, it is now not uncommon to see double-digit current pay interest rates. This is putting a fair amount of pressure on what can be accomplished in terms of traditional leveraged buyouts and, consequently, valuations. However, significant dry powder remains in terms of available private equity commitments, and private credit has stepped in where traditional banks have retreated.
In terms of next year, it will most likely be similar in terms of paying close attention to the credit markets, as they are often the canary in the coal mine, so to speak. It is currently unknown what the lag effect may be from these significant rate increases, how persistently high they will remain, and whether there is any further slack that private credit is unwilling or unable to absorb. In addition, the Treasury yield curve inversion that we are currently experiencing is often considered a harbinger for a recession, but the economy remains seemingly resilient.
One thing that investors are unlikely to forget is that vintage funds from times of economic downturns are often high performers. Although this is something that nobody could predict, we are seeing continued activity in middle-market M&A.
One crucial aspect we focus on is tracking the number of sell-side transactions within our investment bank or transaction advisory services group. This serves as a leading indicator for potential robust M&A activity in the future. An interesting observation we've made is the rise in the number of companies considering coming to market. Investment banks are actively considering bringing more companies to market in the fall. This trend suggests that businesses are becoming more willing to engage in transactions and are accepting the current market conditions.
The sell side serves as an indicator of activity because it is followed by the buy side, where companies are brought to market, typically within an approximately 90-day lag. However, we must consider the impact of debt markets on this. When debt becomes more costly, it adds pressure to the purchase price, which, in turn, may force sellers to accept potentially lower sale prices or walk away in hopes of better market conditions.
Another significant trend we closely monitor is earnings. Considering macroeconomic conditions and inflation, it is hard to determine how much of the input cost increases can continue to be passed on or how much margin erosion may occur if businesses are no longer able to pass the increases on. Fortunately, when looking at the entire portfolio, aside from factors tied to the capital structure, such as interest rates, earnings seem to have held up well, demonstrating the resilience of the consumer market.
From the perspective of our clients, the most complex concerns we are currently focused on revolve around determining their true cost structure, which presents a complicated analysis considering the speed at which changes in cost have occurred. They are grappling with questions about the extent of labor cost increases and other input costs. While certain factors may have subsided, the reality is that companies have experienced significant increases in everyday expenses, such as electric and water bills, among others. All of this raises important considerations about pricing strategies and determining what can be passed on to customers without risking potential margin erosion.
The most surprising aspect in PE dealmaking this year is the remarkable resilience exhibited despite a significant shift in interest rates from nearly 0%. The speed at which this change occurred was unprecedented. Despite such a substantial shift, dealmaking did not come to a halt; it did slow and evolve over time. We noticed a decrease in platform deals and a notable increase in add-ons and tuck-in transactions. This outcome is unexpected because typically, models display high sensitivity to interest rate increases, leading one to expect a more significant impact in such a scenario. However, this situation underscores the remarkable resilience of our economy and this asset class as it continues to find ways to generate returns for investors. So, while we remain active working on deals, they might not be occurring at the same pace as before. Nevertheless, the market remains open for business.
It is evident that private credit has played a significant role in the US middle market and experienced an enormous influx of capital, filling some of the void left by banks. Providers have stepped in where regulated banks could not offer certain loans, thus leading to notable shifts in covenants and credit standards and influencing the dealmaking landscape.
It will be interesting to see how they mature, as many providers have operated mostly in a zero-rate environment. Underwriting is becoming more difficult as rates rise, interest coverage becomes more problematic, and the ability to refinance some of these credits may be more limited.
This situation will differentiate proficient private equity groups from others. Interestingly, those adept at blending credit and equity in turnkey financing might uncover unique opportunities in this evolving landscape.
Uncertainty looms over the future implications of these dynamics, sparking curiosity about what lies ahead. Nevertheless, private credit has a significant and growing role in funding growth in dealmaking.