Private Equity Valuation: A High-Stakes Standoff in Leveraged Land

Abstract

In recent years, the private equity landscape, particularly for leveraged finance companies, has been marked by inflated valuations. Fueled by a low-interest-rate environment, abundant liquidity, and high demand for private assets, this trend seemed unstoppable — until interest rates started their ascent. The anticipated valuation adjustment has led to market stagnation, with buyers perceiving current valuations as inflated and sellers being reluctant to accept lower returns, causing friction with investors seeking liquidity and returns. This paper delves into the current state of private equity valuations, supported by data and trends, and provides strategic insights for navigating this high-stakes standoff.

Current Market

The past few years have been a rollercoaster for private assets, particularly leveraged finance companies, with valuations inflated by low interest rates and a surplus of cash chasing too few deals. Firms, armed with record levels of dry powder, engaged in aggressive bidding wars, driving up asset prices. However, as interest rates climbed, the party mood soured. Higher borrowing costs reduced firms’ leverage capacity, putting a damper on the once-celebratory IRR on leveraged transactions. Buyers, now cautious, are reworking their valuation models to reflect the new cost of debt and risk premiums.

PitchBook data shows a 30% year-over-year decline in buyout-backed exits for the first half of 2024, underscoring the tough exit environment and sellers’ hesitance to accept lower prices. Deal value and deal count have fallen, 60% and 35%, respectively, from their peaks in 2021, with the exit value down 66%, and the number of funds closing off by nearly 55%. \[1\] \[2\]

Market Stagnation

Potential buyers, expecting further price drops, are adopting a “wait and see” approach, like spectators at a high-stakes poker game. Sellers, unwilling to settle for lower returns, are holding onto assets, hoping for a market rebound. This standoff has led to a significant slowdown in deal activity, much to the frustration of investors who are growing impatient for liquidity and returns. Limited partners (LPs) are putting the squeeze on general partners (GPs) to distribute returns, but the challenging exit environment is making this a tough ask. The high level of dry powder only adds to the pressure on GPs to deploy funds effectively.

Impact of Valuations x Interest Rates on Returns

The combination of high valuations and rising interest rates is a recipe for lower returns. When interest rates were low, debt was cheap, and firms could leverage their investments to achieve higher returns. But with rates on the rise, borrowing costs have surged, reducing leverage and impacting the IRR on leveraged transactions.

In leveraged buyouts (LBOs), the return on equity is typically amplified by the use of debt. The IRR, which measures the profitability of potential investments, is heavily influenced by the cost of debt. Higher interest rates mean higher borrowing costs, reducing the leverage capacity and leading to a higher equity contribution. This increases the discount rate used in calculating the present value of future cash flows, resulting in a lower IRR.

For instance, consider an asset valued at $100 million with expected annual cash flows of $20 million. Under a 3% interest rate, financing 70% with debt would result in an annual interest expense of $2.1 million, leaving $17.9 million for equity holders. If the interest rate doubles to 6%, the interest expense jumps to $4.2 million, leaving just $15.8 million for equity holders, thereby lowering the IRR and returns for the same asset valuation.

Insight Commentary

The current market stagnation in private equity is a consequence of the misalignment between buyers’ and sellers’ expectations. Sellers are reluctant to adjust to economic realities, while buyers fear overpaying in a declining market, stalling activity, and creating uncertainty.

Recent market data indicates a notable decline in valuation multiples for private equity deals. The average EBITDA multiples for buyouts have decreased from a peak of 12.5x in 2021 to 10.8x in 2023, reflecting a recalibration of risk premiums due to rising rates. Across the board, reports highlight a significant slowdown in deal activity, with both transaction numbers and total deal value falling below historical averages. \[3\]

From 2018 to 2021, private equity exits surged, driven by favorable market conditions, abundant liquidity, and low interest rates. However, the landscape began to shift dramatically in 2022 as inflationary pressures, rising interest rates, and increased market volatility led to a sharp decline in IPO activity. The first half of 2022 saw a significant drop in PE-backed IPOs, with firms increasingly avoiding public listings due to choppy public markets. Consequently, the total value of private equity exits fell by nearly half year-over-year to $30.78 billion in the first half of 2022. This trend continued into 2023 and 2024, with a marked decrease in IPO exits and a shift towards other exit routes. \[4\]

In 2024, sponsor-to-sponsor deals have remained strong, driven by the need for liquidity and the availability of capital within the private equity industry. Selling to strategic buyers continues to be a favored exit route, with sponsor-to-sponsor deals accounting for 64% of all U.S. exit value in the first quarter of 2023, while public listings made up only 0.6%. Additionally, there has been an uptick in continuation funds, which allow firms to extend the holding period of successful investments, providing additional time to realize value. Partial sales and recapitalization methods also enable firms to extract value from investments without fully exiting their positions. \[5\]

Insight from a Veteran Risk Manager

Private equity firms find themselves at a critical juncture where the valuation landscape has dramatically shifted due to rising rates and economic volatility. Many firms were aware that they were paying high valuations during the “cash bonanza” days but must now accept current conditions. Unlike many other corporate or fund structures that are under different sources of pressure, private equity funds operate under a ticking clock to return capital to investors, necessitating a swift adaptation to new economic realities. This should compel firms to embrace flexible and innovative exit strategies to ensure liquidity and meet investor expectations.

Strengthening investor relations by providing detailed updates on portfolio performance, market conditions, and strategic plans is crucial. According to a 2024 Preqin survey, 45% of LPs expressed concerns about the liquidity of their PE investments, up from 30% in 2022. A study by McKinsey found that firms with robust investor relations practices reported higher investor satisfaction and retention rates. Offering transparency around valuation methodologies, including using third-party valuation practices and the impact of market conditions on expected returns, builds trust and confidence among investors. Clear communication about how valuations are determined and the factors influencing them is crucial. \[6\]\[7\]

As a risk manager, I see the market conditions opening up as an opportune moment for disciplined strategic investments. There is a strong argument that the temporary stagnation presents a chance to acquire high-quality assets at more reasonable valuations. Taking a long-term perspective, I remain bullish on private equity, but as always, I emphasize the importance of meticulous diligence and strategic flexibility to capitalize on growth potential.

Conclusion

The private equity market is navigating a period of adjustment as valuations come under pressure from rising interest rates. This environment requires a strategic shift from both buyers and sellers, emphasizing transparency, operational excellence, and selective investing. By addressing these challenges, private equity firms can overcome the current market stagnation and align better with investor expectations, fostering a more sustainable and resilient market environment. Firms need to embrace these strategies to thrive in the current market landscape. By focusing on value creation, transparent communication, and strategic flexibility, the industry will navigate the complexities of valuation adjustments and should continue to deliver robust returns for its investors.

 Sources:

\[1\] PitchBook. Private Equity Report 2024

\[2\] Bain. Private Equity Outlook 2024: The Liquidity Imperative

\[3\] Preqin. Global Private Equity & Venture Capital Report

\[4\] Bain. Midyear Private Equity Report 2024

\[5\] Pitchbook. Tracking trends in private equity IPOs, mergers and buyouts

\[6\] Preqin. Limited Partners’ Sentiment Survey 2024

\[7\] McKinsey. Global Private Markets Review 2024

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