Private equity firms are in something of a bind: how do they exit their investments, secure their returns, and get distributions back to their investors amid a
After years where a stream of buyers was constantly available, opportunities for exit via traditional routes have become muted. The option to list a portfolio company in an IPO is off the table for many: the pipeline of strategic buyers looking to spend cash in order to grow their own businesses has slowed as they hunker down to deal with ongoing uncertainty, while a sale to a private equity buyer throws up questions for both buyers and sellers. The hardest pill of all to swallow is that the concept of what a new normal will look like has yet to materialise.
Meanwhile, inflation, rising interest rates, the shocks from Russia’s invasion of Ukraine and the energy crisis are all hampering debt markets. This in turn impedes private equity firms’ ability to exit deals, says Fahim Ahmed, chief operating officer at BC Partners. “If other firms or other businesses cannot get sufficient leverage and cannot have a functioning equity market, it’s hard for us to exit our deals,” he says. “I’m very, very concerned.”
Macroeconomic uncertainty and the unavailability of debt also have an impact on the settling of valuations. Valuations are driven by growth, cashflows and a projection of the value of those cashflows using the weighted average cost of capital, Milwood Hobbs Jr, managing director and head of North American sourcing and origination at investment manager Oaktree Capital Management, explains. “If a company’s cost of capital is going up, and that’s your denominator, your valuation will likely just go down,” Hobbs says.
For a buying private equity firm that has high borrowing costs and isn’t sure it wants to put forward a large equity cheque for that business, Hobbs imagines the buyer saying: “‘I’m going to pay less for that business,’ and [the private equity firm] selling has to then evaluate: ‘Do I want to extend my hold period, which also reduces [IRR], or do I want to return cash to investors and cycle that cash into something else?’”
In this market, there will be a bigger divide between the winners and losers across all industries and sectors. Those businesses that continue to outperform will command high valuations. They also have another exit option open to them compared with previous financial crises: a thriving secondaries market willing to front up the cash for a continuation fund transaction.
Private market participants have long noted that one of the beauties of the industry is the ability to hold onto assets for longer when it becomes necessary, rather than being forced to sell. In today’s environment, this could become increasingly important. “We are hardly parting with what was, and still is, our perception of the fair value of this company, and we are less agreeable for this to be discounted,” says Robert Knorr, managing partner at MidEuropa. He adds that his firm is rarely under enormous pressure to exit, and is taking a wait-and-see approach.
“It’s probably going to translate into slightly… longer hold periods, which obviously many of us can afford,” he says. “What that will translate into is a slower pace of distributions to the LPs. Again, this could be just over the next three to nine months. It could be a little bit longer depending on how long it will take to [make] this adjustment.”
– Graham Bippart, Robin Blumenthal, MK Flynn, Craig McGlashan, Andy Thomson and Chris Witkowsky contributed to this report.