Private equity dealmakers have had a tricky 18 months. Globally, buy-out values in 2023 were down by 60%, and volumes by 35% from their 2021 peaks, according to Bain & Company’s Global Private Equity Report 2024. Exits fell even further, by 66%, while the number of funds reaching final close declined by 55%.

Rising interest rates have made debt more expensive. An uncertain economic backdrop has dented dealmaker confidence and is feeding into these numbers, as is a lack of exits to limited partners, who are increasingly cautious with commitments to new funds. 

Challenging times

The biggest sign of a hangover from the more exuberant period leading up to 2023 is the record dry powder languishing in buy-out funds. Globally, they have $1.2trn of uninvested capital at their disposal, as per the Bain report, of which 26% was raised at least four years ago – a proportion that has been on the rise over recent years. Given funds’ typical five-year investment period, private equity firms face a conundrum in this challenging market for new deals.

“Private equity is in a complicated place right now,” says Jamie Austin, UK partner and head of BDO global private equity. “It needs to deploy the capital it has raised or hand it back to investors. But it needs to deploy the capital well.”

ECI partner Michael Butler says that “capital deployment is challenging” at a time of low deal flow and plenty of dry powder. “High-quality deals are scarce and, given the macroeconomic backdrop, there has been a flight to quality among investors. For us, that means being very focused on where we spend our time – we need absolute conviction on a business and want to build relationships with management teams well ahead of any deal. We focus the maximum amount of time on a smaller number of deals in today’s environment.”

Yet for firms that don’t raise outside capital, the pressure to invest is less pronounced. These firms tend to target smaller deals, where there can be more choice. BGF, for example, seeks to invest around £500m annually, with the aim of creating a diversified portfolio across cycles as well as sectors and regionally.

“At our end of the market, there are more businesses than in the large and mid-market space,” says Alistair Brew, head of investment operations at BGF and chair of the ICAEW Corporate Finance Faculty. “There is always a sector or individual companies that are growing, regardless of the macroeconomic backdrop.”

LDC, which is effectively funded from Lloyds Bank’s balance sheet, made 14 new investments last year in addition to providing follow-on funding to existing portfolio companies. But completing was time-intensive, says John Garner, LDC managing partner. “We’ve also increased our headcount by 30% over the same period,” he says, “so we’ve had the capacity to do the extra work needed to get deals done against a challenging backdrop.”

Today’s deals are necessarily different from those done up to 2022. More expensive debt and a continued buyer and seller price expectations gap are playing into structuring decisions. Brew, for example, says that BGF can use loan notes in addition to equity to mitigate higher prices. Further up the deal-size spectrum, firms are using more equity in new deals to keep debt costs down. “In new deals, we are seeing a judicious use of leverage,” says Austin. “Private equity backers know debt markets won’t be this way forever and can refinance at a later date. This may shave off some return, but they can make this up with value creation initiatives.”

Beyond structuring, private equity targets are also more reflective of the uncertain economic outlook. “There is more of a focus on resilience today,” says Garner. “That always moves to the fore in challenging times. That means businesses with highly visible, contracted earnings and those in sectors that can’t be switched off in a downturn typically fare well, sectors such as healthcare and software.”

A challenging deal environment means that exits are more difficult to come by, as the Bain figures clearly demonstrate. Private equity sellers are therefore taking a more focused approach to transactions. “Sale processes today are slightly different from how they were a couple of years ago,” says Austin. “Better prepared, smart businesses are thinking much earlier about sales processes. 

“They are not just sprucing themselves up ahead of a sale, but are thinking hard about the potential buyer group. They are hand-picking bidders to invite to small auction processes and they have often already built relationships with them.”

They are also ensuring that the story is right for buyers. “You have to demonstrate that the business has a good track record for growth,” says Garner. “If it has grown strongly over the past 24 months, when the backdrop has been difficult, that stands out in today’s market. Buyers will pay a premium for resilient companies with credible plans for future growth as well as plans for mitigating any risks they face.”

Perhaps surprisingly, some UK mid-market firms say the exit environment is favourable, provided businesses reach a quality threshold. “The market is experiencing bifurcated pricing, where the best businesses are fetching high prices, while lesser quality business are either not getting away or are achieving much lower valuations,” says Butler. “The pricing is so polarised that, if you’re confident about an asset, it has never been a better time to sell – there is significant competition for these businesses.”

Value creators

With exits generally down, hold periods have extended. They have increased from an average 5.3 years in 2020 and 2021, to a record high of 6.1 years, according to Bain. 

Extra time with portfolio companies means more work to generate returns – especially as companies bought a few years ago may need extra support and a different strategy to reflect today’s challenges. “We had a rising tide for a few years before 2023 and people could maybe get some good exits away without really delivering on value creation strategies,” says Butler. “Now they’ll need to drive these through businesses.”

This is leading to “more details and intense plans” for portfolio companies, according to Austin, with an emphasis on areas such as improving margins, managing working capital and reducing tax burdens.

Firms say they review their portfolio company value creation plans regularly, but the macro environment has placed a sharper focus on certain aspects. “A downturn can make you challenge your assumptions a bit more,” says Garner. “In 2023, for example, we focused on pricing because of inflationary pressures. Now, we’re looking at product development, international expansion and new markets.”

Meanwhile, one relatively recent development in the private equity value creation playbook – buy and builds – is under more scrutiny. Some acquisitions are continuing apace (see case study above), but others involving more debt and executed without sound strategic logic are off the cards. “In a high interest rate environment, engaging in M&A purely for multiple arbitrage is challenging,” says Butler. “When putting more equity into deals, acquisitions need to be strategic as opposed to purely scale-building. M&A should be an enabler of a strategy, not a strategy in itself. You want to build a better business to drive higher exit multiples.”

Overall, the figures paint a gloomy picture. Yet, as is so often the case, the reality on the ground is more nuanced. The UK mid-market is continuing to do deals and achieve exits, while focusing more on operational improvement to drive value creation in a changed interest rate environment. The backdrop is injecting more rigour and discipline into the private equity lifecycle – and that can only be a good outcome.