Investment manager review the private equity outlook in the face of macroeconomic headwinds
ComplianceInvestorsDecember 06, 2022

Private equity outlook in the face of macroeconomic headwinds

Private equity fund performance has been unprecedented in recent years, with returns generally outpacing public markets. However, current economic conditions have posed considerable challenges for the industry.

Factors such as high inflation, the ongoing supply chain crisis, ballooning interest rates, and the war in Ukraine have all contributed to a decrease in deal volume and lower overall equity valuations for sellers.

Those lower valuations, coupled with the high cost of debt, have made private equity M&A transactions less appealing to private equity firms. Although many firms have plentiful cash reserves and will likely put them to use in M&A where possible, difficulties in raising funds from investors may make even that alternative more challenging. In these challenging times, it is crucial that every investor have an expansive view of all aspects of a target — the tumultuous market alone is risk enough.

Debt financing woes

There is no question that private equity deal activity (along with the broader M&A market) has slowed in 2022. Compared to the previous year, the volume of controlling-stake M&A deals has fallen by 46%, according to Bloomberg Law.

One factor affecting deal volumes is the difficulty in securing financing for typical private equity LBOs (leveraged buyouts). Financing for LBOs, which for years has been an important driver of private equity M&A volume (especially in 2021), faced significant roadblocks in 2022.

In addition, as yields surged throughout 2022, banks that have underwritten financing for LBOs have been struggling to re-sell high those debt obligations, leaving them with high-risk debt on their balance sheets, and often forcing them to sell that debt at steep discounts. As a result, many banks are now wary of buyout transactions, leaving private equity dealmakers without the primary source of funding for M&A in the last decade. When surveyed by Private Equity Wire in October 2022, more than 70% of private equity general partners said they expect a decrease in deal volume during the first half of 2023 because of the borrowing environment. They also expressed concern for the elevated cost of debt pricing.

Deepening this issue is the challenge of finding exits in an M&A market that is expected to become increasingly difficult to sell into. Liquid capital, which is normally received from the distribution of private funds, will be critical in a down market as managers seek new capital to boost growth in their funds.

The rise of private debt

Faced with these macroeconomic challenges, investors are finding opportunities in the private debt market.

The decline in bank financing and the increase in private equity dry powder are fueling demand for credit. Institutional investors can access private debt investments through general partners and limited partners.

According to Preqin, debt financing in the private markets soared from less than $500 million a decade ago to $1.2 trillion by the end of 2021. Those funds include hard money loans, distressed debt, and mezzanine loans. Prequin also predicts that assets in private debt funds will account for $2.3 trillion in assets by 2027.

Direct lending

After experiencing rapid growth over the last decade, the direct lending market has proven itself to be a source of capital throughout the pandemic, and there are opportunities for it to support more complex credits. 

A subset of private debt, direct lending refers to a non-bank loan made to a mid-market company without the involvement of an intermediary (such as an investment bank). These loans may be revolving credit lines or second lien loans. There has also been an increase in unitranche facilities, which combine various debt instruments into one.

In the volatile market that persisted throughout last year, private capital proved attractive to many borrowers for its ability to provide higher leverage solutions for the right credit, along with fixed terms and execution without syndications. Considering recent events in the world and ongoing market uncertainty, this appears set to continue.

As with traditional lending, there are UCC due diligence steps to consider in a direct lending transaction. Those transactions employ standard due diligence searches, including searches of UCC records. In the financial sector, UCC filings are crucial to identify potential risks associated with a particular asset class or lien description. In addition, with access to UCC filings, private equity investors can find acquisition targets, and potential direct lenders can identify strategic opportunities.

UCC filings can also provide excellent indicators of revenue or cash flow, which is especially important when evaluating investment opportunities. They can be difficult to access, however, as these filings are managed by state registries, each with its own unique systems, schema, and delivery mechanisms.

There are also compliance and entity management considerations. A fund is typically formed with a complex structure of legal entities; most commonly limited liability companies, but can also involve partnerships, corporations, and statutory trusts. All entities must comply with the business entity statutes applicable to that entity. Additionally, business license requirements must be met at the start and throughout the lifecycle of those entities—particularly important in the case of operating companies and portfolio companies held by the private equity fund.

In addition, to protect loan collateral, lenders commonly use the SPV (special purpose vehicle) structure to isolate the risk of bankruptcy or default. With that structure, lenders often need to appoint an independent director or manager, that is, someone who will have no interest in the SPV, the borrower, or its affiliates.

Finally, lenders almost always require confirmation of good-standing status in order to approve financing.

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Growth In distressed investing

In this environment of rising interest rates and the diminishing ability to refinance debt to “kick the can down the road,” distressed investors now have an opportunity to capitalize on investments related to overleveraged companies that had been able to withstand narrow operating margins because of years of low debt service costs. Distressed investors buy the debt of troubled companies at discounted prices, often with the intention of profiting from the company's recovery or, if it goes bankrupt, of taking control. A distressed debt investor looks for, in the words of Oaktree co-founder Howard Marks, "good company, bad balance sheet". Distressed investors also acquire other obligations against distressed companies, ranging from vendor receivables to illiquid assets.

With a liquidity crunch facing overleveraged companies, there are likely increased opportunities for distressed investors to acquire debt as a means to the acquisition of a target. Banks looking to offload debt from their balance sheets often do so at a significant discount; indeed, 2022 has seen a fair amount of this as a result of the significant change in market conditions between underwriting and closing of leveraged transactions. Moreover, distressed deals have and will continue to become more complex due to current market conditions and the impact of the COVID-19 pandemic on the global economy.

There are risks to buying debt or other obligations on the secondary market. A lender may face challenges regarding the validity of its liens if they fail to record them properly and the company files for bankruptcy. In addition, a purchaser may face challenges to the validity of a claim in bankruptcy court on any number of bases in the Bankruptcy Code. Holders of distressed debt “step into the shoes” of the seller, and thus take on any risks associated with those obligations. Accordingly, due diligence — including verifying ownership and validity and conducting full UCC diligence — is therefore crucial before investing in distressed debt or illiquid assets.

Indeed, as Stuart King, Director of Research and Co-Portfolio Manager at Fulcrum Capital notes, “When looking at more on-the-run distressed debt investing (bonds and bank debt), we are primarily focused on determining the underlying value of the business and assets in question, and then we move to establishing the makeup and rights of claims facing those assets. As we look at more non-traditional distressed investments (e.g., claims or contingent liabilities) we perform all our other analysis plus want to establish the validity of the claim and make sure there are no disputes as to who has the right to that claim.”

It is also vital that investors understand the tax implications associated with distressed transactions, as well as the opportunities and pitfalls that can be found in the tax impacts of private equity and M&A transactions.

Conclusion

There are conflicting views as to whether the “peak” in rising interest rates is approaching, and accordingly, whether we will see private equity M&A transactions return to 2021 levels (or even pre-2021 levels). Recessionary fears remain, and thus it is unlikely that a dramatic turnaround is near.  However, there are likely opportunities for niche investors in specific sectors, such as technology, or in specific asset classes, such as distressed loans or illiquid obligations. But no matter the economic environment, the key to success in any transaction is comprehensive due diligence.  

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Danielle Bennett
Major & Strategic Accounts Associate Director

Danielle Bennett is a major & strategic accounts associate director. She supports a broad range of investment funds and alternative investments customers.

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