The changing structure of the private markets will push the US dealmaking train through whatever 2019 has to throw at it.
“Things are going to keep going strong,” said Christopher Anthony, a partner with Debevoise & Plimpton. “The possibility of a slowdown is on everyone’s radar, but for now we’re not seeing any slowdown in deal activity.”
The economic cycle – although undoubtedly moving into the later stages – is still marked by high consumer confidence and optimistic chief executives. Due to the unwinding of quantitative easing, however, the credit cycle is more of a concern. This is unlikely to have as much of an effect on private equity deal activity as one might think, according to Justin Abelow, who co-heads the private equity practice at Houlihan Lokey.
“Private equity has vertically integrated by in effect buying its suppliers,” he said, referring to the rise of private equity-affiliated private credit funds.
“Firms do that for two reasons: one is to capture margin that was previously shared with suppliers. The second is to control supply of key items and prevent potential supply disruption.”
With so much direct credit locked up in investment vehicles with the same “use it or lose it” structure as a private equity fund, and with that capital not subject to the same regulatory regime or credit cycle timing as traditional bank capital, “when we do hit the back end of this credit cycle, that is going to be enormously muted”.
In effect, no matter where we are in the cycle, lenders will keep lending, and therefore dealmakers will keep making deals.
Abelow predicts this dynamic will particularly insulate the lower and core mid-markets, as those are the parts of the market private credit funds are primarily servicing.
So, no falling off the edge of a cliff in the next few months. But market participants are aware the good times won’t last forever. Abelow and Brian Gildea, head of investments at Hamilton Lane, agree buyers have shifted preference toward business models with elements of defensibility, such as high levels of recurring revenue or diversity of customer, end-market or geography. Both are also seeing managers modelling a downturn into their base case models.
This is not to say investor appetite for risk isn’t there. According to Probitas Partners’ Private Equity Institutional Investor Trends for 2019 Survey Results, interest in US venture capital is up for 2019 from 31 percent to 37 percent.
“We’ve continued to see a lot of investor interest in venture, and yet many of those unicorn companies haven’t gone public yet, and thus haven’t distributed a lot of value back. So you are seeing increasing exposures to venture as a result,” Gildea said. “A number of the big names have planned 2019 or 2020 for IPOs so I think it will be interesting to see how the capital markets respond to that.”
If these IPOs – set to include start-up giants such as Airbnb and Uber – are successful, this could encourage investors to redirect some of their private equity allocation into venture next year. If they don’t, some of these companies could end up in private equity hands, Abelow said.
“That’s been an interesting subterranean story in the last handful of quarters: venture capital has become a pretty good source of dealflow for private equity firms, and it never used to be.”