Private equity outlook in the face of macroeconomic headwinds

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.