Writedowns are coming, but the pain may be muted

Competition for portfolio companies and dry powder may support private equity valuations, but immense tailwinds exist.

Private equity valuations will likely fall as marks are revealed in the coming weeks, but not by significant amounts, according to industry sources.

Michelle Davidson, co-head of advisory at consultant Aksia, told the New Jersey State Investment Council on July 27 to expect declines but not at catastrophic levels. Buyouts watched a webcast of the meeting.

“We believe private equity will be down somewhere around 5 percent in the first quarter,” Davidson said. “We also expect ongoing declines in the second and third quarter. But we do not expect values to be down significantly.”

Why values aren’t falling sharply

Public equities have had a rough ride this year, with the Russell 2000 – frequently used as a public market comparison for private equity funds – down by 17 percent year-to-date.

But a floor exists under how far private equity valuations can fall. According to a study from Bain & Company, GPs currently hold $3.6 trillion in dry powder. And the large amount of unspent capital held by managers who need to find deals will help support pricing, according to Ron Kahn, a managing director and co-head of the valuations and opinions group at Lincoln International.

“Managers are more selective than they were before,” Kahn told Buyouts. “But if a company has good credit and stable earnings in this environment, there might not be any decrease in their pricing at all. A lot of managers want to invest in good companies and there is a lot of competition for them.”

Indeed, firms pursuing buy-and-hold strategies should show resilience this year, according to Charlie Jolly, a partner and head of private equity coverage at RSM UK. He cited consolidation in managed services and tech services companies as an example.

“These are seen as reasonably lower risks because a manager has already backed a team, gotten comfortable with the company’s strategy and is not taking a risk in backing a new management team,” he said. “Those strategies are going to continue, and with great pace.”

Davidson said private equity funds usually fare well during tumultuous economic periods.

“Over the long term, private equity thrives on dislocations common in recessions,” she said. “You can see historic returns in certain vintages that come right after a recession. You get the ultimate benefit of getting a lift of rising valuations while also building revenues and earnings over time.”

Buyouts, the mid-market and interest rates

Large buyout fund valuations, however, may take a hit for two reasons, Davidson said. According to her, large buyout fund valuations tend to track public market comparisons more than other strategies.

The growing expense of debt in a spiking interest rate environment is also a factor, Davidson said. “Leverage is applied more to larger companies and leverage is more expensive.”

According to Kahn, the three-month LIBOR rate increased at 0.21 percent at the start of 2022 before reaching 2.10 percent at the end of June. On average, rising interest rates have resulted in 10 percent being taken out of portfolio company earnings, he said.

But lower and mid-market valuations should hold up despite escalating interest rates, according to Davidson. She said lower and mid-market funds tend to use less leverage, and valuations are typically based on multiples, earnings and a cashflow base. “Their fundamentals remain strong, and managers have a lot of tools and time on their side.”

A slowdown in mid-market M&A activity occurred at the start of the year, but deal flow has started to pick back up, according to Emily Maier, a senior vice president who leads the M&A insurance practice at Woodruff Sawyer.

“Middle market private equity is quickly seeing the opportunity compared to their competitors,” she told Buyouts.

Inflation’s impacts

Pension system boards and investment staff have focused on inflationary pressures at many meetings throughout the year.

“We’re starting to see how inflation is actually affecting the performance of companies,” Kahn said.

He said revenue growth across all industries Lincoln International tracks was 12.5 percent higher during the second quarter of 2022 compared to the previous year. During the same time period, earnings growth was only 2.2 percent higher.

This shows how companies are paying more for labor and supplies and reducing profitability, according to Kahn. “While some companies were able to increase their own prices, it was obviously not enough.”

Healthcare and consumer services were heavily impacted due to rising labor costs, Kahn said.

The average company multiple was 10.7 times earnings in the quarter, which is the third straight decline, he said. But two years ago, multiples averaged 9.5 times earnings.

“It’s a cyclical business,” Kahn said. “Basically, when we’re at the top or the trough, everyone knows what valuations are going to be. But when you’re going up or going down there’s a lot of uncertainty, and that’s why we’re not seeing as many deals getting done.”

Late-stage fright

According to Davidson, late-stage venture capital ranks as one major area of concern, especially for funds that spun-off portfolio companies in an IPO. “Late-stage venture is the strategy hit the hardest. Early-stage venture will feel less of an impact,” she said.

Davidson’s sentiment was shared by San Bernardino County Employees’ Retirement Association investment officer Amit Thanki, who at a recent meeting said venture capital funds could suffer losses of 10 percent.

According to Thanki, late-stage funds holding shares from an IPO typically cannot sell them during a vesting period, which places their value at the behest of public markets.

Maier said funds focused on tech, real estate and discretionary spending could suffer the most. “I think a 10 percent drop in valuations for those types of funds is maybe even a little optimistic.”