Navigating a Shifting Landscape: A Glimpse of Hope for Private Equity in 2023

Over the past few months, the private equity landscape has exhibited a notable slowdown in deal activity, raising concerns about the industry's vitality. However, amidst the clouds of uncertainty, there are glimmers of optimism that suggest a potential turnaround could be on the horizon. Recent developments, including KKR's earnings report and positive economic indicators, point towards a potential resurgence in the private equity market in the second half.

KKR's Earnings Report: A Bellwether for Recovery

In KKR's recent earnings report  Scott Nuttall, KKR's co-chief executive, acknowledged the challenging nature of closing deals in a market where capital flow has constricted. Nevertheless, Nuttall also highlighted a significant uptick in “activity,” especially in recent times, a sign that some analyst point to indicating that brighter days are ahead.

In fact, Nuttall's statement resonates with the broader industry sentiment, reflecting the anticipation of a potential surge in M&A activity once the capital markets regain momentum.  Many believe there will be an uptick in M&A due to restructuring.  Others believe sellers are starting to reconcile (what my friend Drew Brantley calls) tee box valuations (i.e., what your buddy who sold his company tells you what your company is worth before teeing off on Saturday AM) and sanity valuations (the actual value your company is worth according to what the market will bear) and readjust expectations about pricing.  

Cautious Optimism Amidst Challenging Factors

Several factors have contributed to the slowdown in M&A activity during the first half of 2023. The Federal Reserve's consecutive interest rate hikes, now reaching their 11th iteration since March 2022, have created an environment of high interest rates (in relative recent terms but historically the base case is not “high”). Nonetheless, the increase in the fed base case has negatively impacted borrowing costs, making certain deals cost-prohibitive, particularly in the higher end of the market—and more particularly acquisitions instead of tuck-ins or smaller strategic acquisitions as the foregoing (generally) do not require as much leverage to achieve.   

Another deal dulling issue is persistent inflation.  Rising inflation usually is dovetailed with increases in salaries and if companies cannot pass those SG&A costs to its customers, its EBITDA will take a significant hit.  Accordingly, valuations will decrease.  The only answer to persistent wage inflation is increasing workplace efficiency, which could happen if AI is commercialized and the US can re-establish its robotics leadership.

Squeezed in the Middle

Economic uncertainty, coupled with the looming threat of a near-term recession (this recession has been the most anticipated recession since we learned who shot JR—and it’ll probably end up the same way—a bad dream), has prompted both buyers and lenders to adopt a more cautious approach. This has led to decreased deal activity, particularly in cyclical industry sectors. 

Furthermore, the collapse of Silicon Valley Bank, Signature Bank, and First Republic, has created a credit tightening with middle market bankers which is squeezing sponsors.  This sponsor squeeze is sending most sponsors to purveyors of private credit; which isn’t by itself terrible but it increases deal costs or more likely compresses deal valuation.
 
Looking Ahead: A Glimpse of Light at the End of the Tunnel

Despite these challenges, there are encouraging signs suggesting that the sponsor driven (private equity or independent sponsors) market could regain momentum in the coming months. Economic indicators are turning positive (or maybe the waiting for Godot recession call has turned into the recession that cried wolf), injecting a dose of optimism into deal-making sentiment. Perhaps most notably, the rise in the cost of U.S. goods and services has slowed to a two-year low, indicating an easing of inflationary pressures as the economy adjusts to the Federal Reserve's interest rate adjustments.  The foregoing is likely the best base case for restarting the sponsor driven deal economy.  The market abhors uncertainty and with COGS starting to level set, buyers will be able to better ascertain valuations. 

The resilience of the economy is evident in market projections that foresee an end to interest rate hikes in 2023, followed by interest rate reductions in 2024, fostering a potential "soft landing." The public equity markets have rebounded significantly, with the S&P 500 registering a remarkable 17.6% one-year gain as of June 30. This sharp turnaround from the 18.1% negative one-year return six months prior has instilled renewed confidence in the M&A landscape.

A Positive Momentum: Key Factors Driving Confidence

Positive momentum in the private equity landscape is gaining strength as major banks reenter the leverage buyout market, signaling renewed confidence in the potential for profitable investments. This return of significant financial institutions to the fold indicates a growing willingness to provide the necessary funding for strategic acquisitions.

Moreover, the continued activity of credit funds adds to the favorable lending environment, allowing potential buyers to access the necessary capital for strategic deals.

Funds are also sitting on a considerable reservoir of capital, which further fuels optimism for an uptick in M&A activity. This abundance of available funds positions these firms to seize valuable opportunities and contribute to a potential surge in deal-making.

In parallel, the robust state of corporate balance sheets injects stability and capability into the market, offering potential acquirers the financial strength needed to execute strategic transactions with confidence.

Collectively, these factors not only bolster positive sentiment but also lay a strong foundation for increased M&A activity in the near future.

Conclusion

The past few months have indeed been challenging for the private equity industry, with a noticeable slowdown in M&A activity. Amidst these trials, however, the industry is witnessing glimmers of hope that point towards a potential resurgence. While the path ahead may still be uncertain, there is growing anticipation that the private equity market could be on the cusp of a new era marked by increased deal activity and revitalized growth.