16 June 2023
Deal volumes have been hit by the rise in interest rates – but not across the board
Private equity (PE) driven investment activity has slowed since interest rates started rising in late 2021. Comparing US and UK deal activity reveals some differences in how the rises are hitting the two markets. The UK is showing surprising resilience in the number of acquisitions made by PE backed businesses.
As debt - a key lever used in leveraged buyouts to increase the equity returns of PE investors - has become ever more expensive, the buy-side investment thesis has come under pressure. Not only has this made investors more reluctant to do transactions, but the downward pressure on prices has been unappealing for many sellers, resulting in the slow down. The US in particular has seen a drop-in activity, starting soon after the rise in Federal Reserve interest rates, and has become more pronounced as interest rates have continued to rise.
Activity by deal type
Breaking the buyout activity down by deal type reveals that both US and UK based platform deals have seen a decline in the number of transactions, as have add-ons (acquisitions by PE-backed companies). UK based add-on activity has, however, remained strong and ahead of pre-pandemic levels, at 247 transactions in Q1 2023 compared to the quarterly average of 179 in 2019, and 261 in 2020.
The relative resilience of UK add-ons is mostly a function of their size, in that they are smaller than all the other categories. The median valuation of all PE buyouts comprised of platforms and add-ons for Q1 2021 to Q1 2023 was $166m and $111m in the US and UK respectively, with add-ons normally always smaller than the platforms acquiring them by a material amount. The reasons for this includes that investors are more comfortable making smaller ‘prudent’ investments than larger ones in the current uncertain climate.
Additionally, PE firms with their high levels of ‘dry powder’ have the fire power to make all-equity offers for smaller deals if the interest charges for debt have become unviable. All-equity offers on larger deals won’t typically give private equity the returns they seek (typically 2.5x on equity capital invested and/or 25% IRR). But relatively smaller deals done without debt won’t as easily erode the returns, especially since add-ons often offer strategic benefits to the acquiring platform company, e.g. a foothold into a new market or new capabilities.
Good news for those considering a PE backing
Businesses considering a PE backing can take comfort in knowing that not all deals are having to settle on a ‘low’ valuation. Firms with high margins, recurring revenue or strong growth prospects (ideally all three, for example, software and professional and consulting services) are still able to draw in high levels of interest. PE investors still have significant capital to deploy and are ideally not slowing the cadence of their investment activity, especially when the right assets present themselves. The cost of debt, and access to it, can’t be ignored but if a compelling and robust investment story can be offered then a transaction will still be very much on the table.