Private equity-owned businesses are having their valuations pressured by high interest rates and lower revenue growth, but their earnings performance once again offset a contraction in multiples last quarter. And with M&A activity still low, private credit firms are sticking with these companies as competition among lenders heats up.
Lincoln International’s Private Market Index, which tracks more than 5,000 sponsor-owned U.S. companies, found that EBITDA (earnings before interest, taxes, depreciation and amortization) multiples fell 2.7% in the fourth quarter of 2023 but EBITDA growth was 3.4%, leading to the increase in valuations.
While displaying earnings resilience (60% of the companies increased EBITDA) in the fourth quarter, some PE-backed firms have interest payments that consume a large chunk of their cash flow. At the end of 2023, the population’s weighted-average fixed-charge coverage ratio was 1.07x, down from 1.1x in the third quarter of 2023 and 1.13x in the second quarter.
“Borrowers and sponsors knew this was coming,” said Ron Kahn, managing director and co-head of Lincoln’s valuations & opinions group. He said that about 18% of the financing agreements that Lincoln tracks have been amended to avoid covenant violations.
Given the Federal Reserve will probably not cut interest rates until at least June, more companies may run into cash flow problems, Kahn said. But the private credit lenders that financed many deals “do not want to own these companies,” Kahn told CFO. And the exit opportunities are not plentiful.
The average EBITDA multiple of new buyout transactions that closed in the second half of 2023 was 11.8x (for transactions tracked by Lincoln International), “a far cry,” said the firm’s report, from the peak average multiple of 13.4x in the fourth quarter of 2021.
Lender Competition Tightens Spreads
“With [private company] performance holding up, the biggest hurdle to surmount in 2024 for ramped-up deal-making will be the alignment of buyer and seller expectations,” said Kahn.
“Private credit was taking a tremendous amount of market share. Now there is competition.”
Ron Kahn
Managing Director, Lincoln International
Buyers have held out for investment opportunities that reconcile their return requirements with the burden of high financing costs, said Lincoln International’s report. Sellers remain reluctant to part with their investments at lower valuations. A financial sponsor could sell a company at a lower earnings multiple and make its limited partners happy with a distribution, said Kahn. But then the sponsor’s internal rate of return (IRR) on the deal may be significantly less, and “they may not be able to even raise another fund because of that performance,” he said.
There is a bright spot in financing, however, that showed up in Lincoln’s report. As Kahn put it, “The broadly syndicated loan market is back.” That’s good news for “CFOs looking to raise capital, whether for acquisitions, refinancing, maybe even debt and dividend recaps,” Kahn said. “Private credit was taking a tremendous amount of market share. Now there is competition.”
As the BSL market, which generally offers lower-yielding loans, starts to open, “larger lenders are forced to hunt for smaller, higher-yielding credits to deploy capital,” according to Lincoln International.
As a result, Kahn said, spreads have generally tightened 25 to 50 basis points since the middle of December 2023. Spread tightening did happen in the third quarter for transactions involving businesses with greater than $40 million of EBITDA, but the tighter spreads “seeped into transactions for smaller businesses in the fourth quarter,” according to Lincoln International.
The competition among lenders is also manifesting in rates for incremental debt facilities for investments such as add-on acquisitions. These facilities are being “issued at lower pricing, deeper in the capital structure,” according to the report.
“Lenders don’t want to lose these credits,” said Kahn. “It’s hard enough to deploy capital, so they’re willing to give existing borrowers a 50-basis-point decrease on an incremental part of the facility [rather] than lose the credit altogether.”
Each quarter, Lincoln International tracks the aggregate change in company earnings and the prevailing market multiples for approximately 1,500 private companies of the more than 5,000 the firms it values.