Thursday, December 1 2022
Higher rates finally pierced the engine room of the private equity deal making machine – the leveraged buyout.

Until March this year, the playbook for PE has proven itself:

  • find an attractive platform that is best in class in a particular market segment

  • find a group of Wall Street banks willing to finance 70% of the purchase price through syndicated loans and high-yield notes

  • lock in a funding cost that was floating 450 basis points above an overnight lending rate below 1%

  • then use that platform company to make small add-on acquisitions that are even easier to fund

It was the playbook that ultimately produced an unprecedented one-year return of 54.9% for global private equity for the period ending Q2 2021.

Enter the Federal Reserve in March 2022. Three percentage points of rate hikes later, in what would be the fastest tightening in six months since 1977, the playbook disappears.

While no one is calling for a repeat of those dark days when short-term rates soared to nearly 20%, this is nonetheless a historic change in interest ratesand the impact on the PE world is significant. Variable rates on LBO loans averaged 4.8% in February before doubling to 9.8% in September.

Private equity-led deal activity finally felt the bite of rising lending rates in the third quarter. The total value of buyouts was down 20.4% from the third quarter of 2021. These are completed deals, many of which were negotiated months ago.

In terms of announced deals, we believe the drop could be double that, as indicated by Blackstone’s Q3 report last week, which showed a 45% year-over-year drop in the capital deployed. Even more dramatic is the decline in outflows, which stand at 30.1% of levels a year ago.

So how did the EP adapt?

On the one hand, PE is doing more public-private deals. Private catches are on track for a second straight year at $100 billion or more in transaction value for the first time since 2006-07. Not only are these companies more credit-savvy, they allow mega private equity funds to deploy their mega dry powder amounts at knockdown public prices.

Second, private equity is finding a new source of financing in private debt funds. Four of the last major privatization deals announced in the third quarter used private debt. Although this source of financing generally caps at 50% of the purchase price and not the 70% that traditional bank loans covered, this source of financing has dried up because the market for leveraged financing of new issues is practically frozen.

Finally, private equity firms continue to generate strong portfolio company revenue growth. In its third quarter results, EQT estimated that its private equity portfolio further increased revenue by 20% through August. Blackstone reported 17% revenue growth for its private equity firms in the third quarter.

Growth like that goes a long way toward covering higher interest costs.

For more data and analysis, click to download our free Distribution of private equity in the United States in the third quarter.


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