Deal-making in the current, turbulent economy may provide a unique opportunity for private equity (PE) investors.
Stubbornly high inflation, rising interest rates and recession risks have created an atmosphere where pessimism permeates through many segments of the economy. But many factors in the current environment actually favor deal-making, according to Grant Thornton LLP Partner and Private Equity Tax Growth Leader Melanie Krygier. She said discerning professionals can discover solid investment targets and take advantage of market conditions to strategically deploy capital.
Krygier has identified five trends that are critical for PE and dealmakers to understand as they head into the new year hunting for investment targets.
- Diminished competition puts PE in the driver’s seat. The pace of public deals has slowed markedly due to the volatility in the market and public companies’ tendency to fund acquisitions through share consideration.
Meanwhile, special-purpose acquisition company (SPAC) activity has ceased almost entirely after regulatory scrutiny on these companies heightened. Many SPACs are approaching their expiration date in early to mid-2023.
“Competition outside of PE deals has decreased,” Krygier said. “This is driving a decrease in valuations as well, which provides a great opportunity for PE buyers who still have a substantial amount of dry powder to deploy.”
- Public company carveouts and take-private deals are bubbling up. The potential of a recession has many companies looking for cash to prepare for the lean times they fear are coming.
This means that large public companies are more eager than usual to offload non-core operations in exchange for liquidity. And more public companies are considering take-private opportunities that will extract them from a stock market that might take a beating.
“Take-private transactions that are offering premium returns are often quite attractive to shareholders if they expect to be facing a continued depressed market in the short term,” Krygier said.
- Fizzling tax hike fears have created stability. The political climate in Washington has eased concerns that capital gains tax increases or new carried interest rules will materialize in the near future.
“Sellers are not as reactionary related to potential looming tax implications as in years past, making for a more stable deal environment,” Krygier said. “This stability allows for PE investors to take control of the diligence process and deal timeline, ensuring higher quality in executed transactions.”
- Rising interest rates are a drag — but private equity structures may have short-term fix. It seems like a lifetime ago that persistently low interest rates provided outstanding access to low-cost capital for deals.
Looking back at the totality of the Federal Reserve’s actions over the course of the entire year provides a sobering perspective on how dramatically access to capital has changed. In a total of seven rate hikes during 2022, the Fed raised its benchmark interest rate a total of 425 basis points.
PE is facing a double dose of discouragement in this area because beginning in tax year 2022, interest expense limitations are computed at 30% of earnings before interest and taxes rather than 30% of earnings before interest, taxes, depreciation and amortization.
This calculation shift in IRC Sec. 163(j) may diminish the deductibility of interest expense for some PE firms.
“Where high interest rates may have provided companies with a tax benefit, that tax benefit is being lost or limited in many cases under the more restrictive limitation calculation, increasing the cost of leverage” Krygier said.
For some PE funds, the play in this situation may be to use their dry powder now to write a higher equity check instead of borrowing money to fund transactions at the lower valuations that exist in the market now.
“PE investors may have an opportunity to wait out the storm and consider introducing leverage at a later point in their holding period through a dividend recap,” Krygier said.
- Strong fundraising has given PE plenty of cash to invest. Many of the headlines related to PE focus on the decrease in fundraising in 2022 compared with the previous year.
Krygier believes those headlines are leading to significant underestimation of the amount of PE funds available for deals. She said fundraising in an extremely heated deal market in 2021 was record-breaking.
PitchBook data shows that U.S. PE funds raised $258.8 billion through the third quarter of this year. That’s on pace to be far short of the $366.1 billion raised in 2021, but it compares favorably with pre-pandemic fundraising hauls.
Bottom line, that means there’s lots of funding ready to be deployed in PE deals.
“We’ve seen, in combination, two stellar years of fundraising,” Krygier said. “That’s resulted in a ton of cash available in the PE ecosystem waiting to be deployed in transactions.”
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