PE firms are attempting to navigate a barren M&A landscape, with trillions in capital ready to deploy. But where?

Author: Anthony Noto

Private equity firms are sitting on a vast store of cash. Some $3.7 trillion in dry powder, by Bain & Company’s current estimates, is waiting to be put to work. Yet, dealmaking is in the doldrums.

The problem is, “there just aren’t quality businesses for sale these days,” says Sunaina Sinha Haldea, global head of private capital advisory at Raymond James. 

Private equity firms have spent the better part of the last year holding onto solid portfolio companies with the hope that auctions will attract higher bids when the timing is right. That is, if, inflation subsides and there’s more certainty to the overall economic outlook.

And when it comes to putting together deals, private equity firms face an uphill battle; global central banks are raising interest rates, which makes it difficult to secure funding for leveraged transactions.

Consider the numbers. In the first quarter of 2023, global M&A activity plummeted to its lowest level in more than a decade. According to Bloomberg, of the $559 billion spent across 12,200 transactions, just $182 billion came from 4,200 acquisitions involving private equity firms: a 59% drop from the $439 billion invested in first-quarter 2022.

So far this year, only one private equity deal north of $10 billion has been concluded. Silver Lake, the Menlo Park, California, firm whose past investments have included China’s Alibaba Group and Spain’s Grupo BC, made a play for Seattle software firm Qualtrics International. The $10.44 billion price tag was backed by equity commitments from Silver Lake and the Canada Pension Plan Investment Board, with $1 billion in debt.

It’s too early to tell how the second quarter will look, but at the time of writing, a private equity consortium led by CVC Capital Partners is considering a $2 billion acquisition of Dubai-based credit card processor Network International Holdings, and KKR in April agreed to buy FGS Global in a deal that values the London-based financial communications group at $1.4 billion.

“Today’s record levels of dry powder will coincide with the largest private equity firms taking an even bigger slice of the capital pie,” Haldea predicts. “As capital concentrates at the larger end of the market, we’ve seen a squeeze on those down below as coffer-rich general partners can more easily dominate sale processes for quality assets.”

With valuations for quality assets at a premium, this is when limited partners look to general partners to “really earn their money,” she adds. In other words, general partners are relying less on the exits, and choosing instead to focus on investments with “long-term growth potential either through operational improvements and organic growth, or scaling platforms through executing add-ons, or acquisitive growth.”    

In the middle market, where private equity investment vehicles typically have capital commitments below $1 billion, deal activity has indeed stalled. Firms at this M&A tier are opting to stay “focused on the long term,” says Karin Kovacic, president of the Association for Corporate Growth, a private equity network. “If a seller doesn’t have to sell right this second, why would they?”

2023 vs. 2022

The present scenario poses a stark contrast to 2021 as well as the opening three months of 2022, when, despite inflation, Russia’s invasion of Ukraine, and growing tensions with China, worldwide M&A activity pushed past $1 trillion for the seventh consecutive quarter going back to the first quarter of 2020.

“Those were unprecedented times,” Kovacic says. “It wasn’t sustainable.”

By June, the Federal Reserve had announced the first of nine consecutive rate hikes with the intention of offsetting inflation. From there, “dealmaking fell off a cliff,” Kovacic notes.  

The second half of 2022 totaled just $1.5 trillion. That was a 32% decline: the largest second-half percentage drop since 1980. The total number of deals for the year worldwide was nearly 55,000, a 17% dip compared to 2021 levels and a two-year low.

Recent fears across the banking industry don’t help, either. In addition to the collapse of Silicon Valley Bank and New York’s Signature Bank, along with the liquidation of crypto lender Silvergate, there are concerns about Credit Suisse, which saw more than $68 billion withdrawn in 2023 ahead of its UBS takeover. Contagion concerns will continue to dampen the outlook, as interest rates continue to climb and syndicated loan volumes remain down. “However, unlike 2009, there isn’t a Lehman Brothers equivalent that has collapsed,” Kovacic says.

While the likes of Silver Lake, CVC, and KKR orchestrate megadeals and raise the total value of transactions for 2023, smaller firms—those inking deals in the so-called lower middle market—need to get creative. Happily, some corners of the playing field may still present opportunities.

“A lot of these sub-$10 million or sub-$15 million EBITDA companies aren’t as affected by interest rates,” Kovacic says. Therefore, they’re easier to finance. “They can get money outside of the big banks, and so when it comes to the lower middle market, you’re never going to see the KKRs of the world doing deals there.”

They will need to seek quality targets that aren’t necessarily being actively shopped around on the auction block. What makes a quality target? “A business that has a track record, a product or service that is necessary, useful, or proven,” says Sarah McLean, partner at Shearman & Sterling, who heads up the law firm’s private equity group. “Sometimes it is just a question of having the relationships that put you in the right position to be introduced to the right people to help you find those businesses. As a buyer, if you can find a target that isn’t being actively marketed and approach it about how you can add value to its business, that often leads to a better deal than just reviewing and bidding on marketed deals.”

The current market is challenging but it favors firms that invest in businesses with room for operational improvement and growth, McLean argues.

“The obstacles on the front end are finding these businesses and funds with the relationships to source such transactions,” she says. “The obstacles on the back end relate to exit timing and structure and can be mitigated if the business is providing cash flow and dividends to the fund and investors at regular intervals.”

US-based firms would perhaps be wise to take a cue from their UK counterparts, Haldea suggests. “We’ve seen UK investors prioritize investments in sectors that are seen as critical to the UK economy,” she notes, citing technology, business and financial services, telecom, media and technology as well as health care, infrastructure, and environmental, social, and governance areas. 

Haldea says, “the inflation genie is still out of the bottle,” so general partners face higher costs of borrowing—and therefore downward pressure on returns—along with lower valuations from the use of higher discount rates on future cash flows, and reduced profit margins as inflation impacts goods and services prices.

Private equity firms must also remain disciplined around the use of debt at both the portfolio and fund level. Limited partners will be keeping a close eye on how general partners structure their portfolios and whether they maintain investment discipline in the face of prolonged uncertainty.

“LPs can be easily scared and aren’t quick to forget,” Haldea warns. “Over the next cycle, the best dealmakers may be the ones that end up protecting capital rather than shooting the lights out.”