Introduction

The private equity ecosystem has shown signs of life in recent months. The market, like many others, had its fair share of struggles since the highs of 2021-22, throughout the entirety of the private equity life cycle, from fundraising to exit. While there is a sense of guarded confidence that the light at the end of the tunnel is approaching, the question remains whether recent improvements in the private equity landscape are sustainable.

Fundraising

Over the past several years, sponsors have faced challenging fundraising conditions in the market due to multiple factors – most importantly, a series of eleven interest rate increases beginning in March 2022 and culminating in July 2023. The net result was an aggregate increase in the Federal Reserve rate range from 0.00%-0.25% as of March 2022 to a rate range of 5.25%-5.50% by July 2023.

Those efforts, for the most part, have yielded the Federal Reserve’s intended results of substantially curbing inflation but have also had a collateral chilling effect on private equity fundraising. The Bureau of Labor Statistics report released in August 2024 shows that inflation fell to -0.1% in June, its lowest monthly growth rate since May 2020, with yearly inflation currently at 2.9%. This represents a drastic decrease from peak inflation of 9.1% in June 2022 and is approaching the target of 2.0%. In response to the cooling of inflation rates and the increase of the US unemployment rate to a three-year high of 4.3%, the Federal Reserve has announced that it anticipates cutting interest rates in 2024. Recent market predictions estimate a 0.5% rate cut in September followed by subsequent cuts culminating in total interest rate cuts of 2.25% by the end of 2025. If the anticipated interest rate cuts come to fruition, they stand to spur M&A transactions beginning in Q4 of 2024 and continuing throughout 2025, which should yield an increase in fundraising for fund sponsors and meaningfully reinvigorate the private equity market.

As fund sponsors face slow fundraising environments, many sponsors endeavour to close in new vintages of funds with a core number of anchor (and often repeat) investors. As it currently stands, the majority of capital raised in the first half of 2024 was concentrated in a handful of the largest private equity funds, many of which were buyout funds, placing smaller fund sponsors in an extremely competitive fundraising environment and enhancing the negotiating leverage of potential investors. However, emerging and mid-market funds have begun to adapt by employing innovative marketing strategies, specialising in niche market segments, entering into strategic alliances, and offering more investor-friendly terms.

Unlike the large, diversified funds, emerging funds and mid-market funds are nimble and flexible. They have fewer investors than their larger competitors, which enables them to specialise and tailor their structure and terms to specific groups of investors. These funds offer investors the ability to concentrate on undercapitalised market segments poised for growth, such as specialty service providers, data centres and physician groups. They also have increased flexibility to negotiate investor-friendly terms – for instance, shorter investment periods, more definite fund terms, increased financial information reporting, and enhanced data on portfolio companies’ environmental, social and governance strategies.

The market conditions have also facilitated the rise of hybrid funds, which share elements of closed-ended private equity funds and open-ended hedge funds. Hybrid funds are highly individualised structures, each with differing investment strategies and terms. However, they share certain key characteristics, such as allowing investors to redeem existing investments or add capital during the life of the fund at regular intervals or on the occurrence of certain, specified events, an attractive liquidity feature.

Despite overall positive outlook of the private equity market for the remainder of 2024 and into 2025, regulatory burdens exist that present fundraising challenges. Last year, the SEC aggressively enforced the Marketing Rules, which no doubt will impact sponsors’ future marketing efforts and, accordingly, capital raised.

Fund Finance

Sponsors have also faced tough times in other aspects of the private equity market in addition to fundraising, including the fund finance arena. The disruption caused by regional banking failures of 2023 continues to have an impact on the fund finance market for banks, sponsors and investors alike. The bank pullback that resulted from the failures of Silicon Valley Bank, Signature Bank, and First Republic Bank accelerated the rapid expansion of private credit lending sources in the fund finance market, with private credit lenders now accounting for nearly one quarter of all loans in the fund finance space. Many institutional lenders restructured where fund finance fits into their organisation and some previously involved lenders have exited the fund finance market entirely in the last few years. This transition has left space for other lenders (especially non-bank and non-US lending entities) to enter into or expand their footprint in the fund finance lending market. Many of these new entrants use syndicated fund finance deals to get a foot in the door to develop relationships with fund sponsors. However, lower utilisation on fund lines of credit is hindering bank-led syndications and as a result, anchor lenders have started to look for smaller holds and deals that may produce future accordion expansion.

While the increasing presence of repeat investors across fund vintages signals reliability and helps lenders with the underwriting process, lenders (both institutional and non-bank) reevaluate concentration limits and exposure to the same fund sponsors, individual investors, and even portfolio companies across their active and potential new loans. Further, lenders are adjusting their risk profiles and looking to mitigate risks tied to smaller/more concentrated investor bases at the outset of loans, which has led to some requiring seeding capital calls before initial credit extensions, clean-down provisions, lower threshold percentages of defaulting investors that can trigger events of default, and covenants/defaults related to poor fund performance (especially for funds with longer-term investment strategies).

Additionally, in the face of relatively high interest rates and then-existing uncertainty as to rate cuts, fund sponsors are looking to right-size facilities, reduce tenors of facilities, and diversify exposure to one or two depository institutions, while increasing flexibility and offerings. Interest in NAV facilities (and subscription backed/NAV hybrids) remains high and there is growing discussion and interest in rated feeder and collateralised fund obligation structures. Lenders (institutional and non-bank) and sponsors are working together to create flexible and innovative product offerings in view of potential regulatory changes and ongoing changes in the market.

Rise in Private Credit

Private credit serves as a lending solution for middle market companies deemed too large or too risky by commercial banks and too small for public markets. As noted above in the fund finance context, this was especially true in 2023, which saw banks tighten their lending standards and shift their focus to customer deposits after Silicon Valley Bank’s collapse in March. Private credit filled the void by making loans that banks otherwise would not, and private credit assets grew from around USD1.8 trillion globally at the end of 2022 to approximately USD2.1 trillion by the end of 2023. The increase in assets annually from 2020 to 2023 has outpaced the growth of private credit in prior years. Private credit has even outpaced private equity in performance over the past couple of years. According to The Wall Street Journal, private credit strategies have delivered a cumulative return of 15.5% from 1 January 2022 through 31 March 2024, compared to private equity’s -1.3% over the same period, highlighting the resilience of private credit in volatile markets and its ability to generate consistent income streams.

In addition to increased availability, private credit generally offers companies three main advantages over bank loans:

• flexibility in terms;
• speed in execution; and
• confidentiality.

In terms of flexibility, banks typically require cash interest payments beginning the month after loans close and are less likely to negotiate financial covenant definitions. Private credit often allows companies to capitalise all or a portion of the interest accruing on a loan (providing for payment-in-kind interest), and tailor financial covenant definitions to that company’s assets and operations. Private credit also commonly includes a small number of investors, which provides for direct and more efficient negotiations of loan terms in contrast to broadly syndicated bank-led deals that feature large pools of lenders that must approve changes in loan terms. Lastly, private credit offers a higher degree of confidentiality over a company’s financial information than bank loans, in which rating agency reports and trade publication releases may include unnecessary disclosures.

M&A Climate

Although private equity M&A had a slower-than-anticipated start to the year, recent developments indicate a strengthening market with encouraging signs of a recovery ahead. Based on data compiled by S&P Global Market Intelligence, the first half of 2024 saw 6,066 private equity deals totalling USD309.82 billion in value, reflecting a 24% increase in deal value but an 8% decrease in deal volume in comparison to the first half of 2023. While an improvement from 2023, at least in terms of value, private equity M&A activity is still far off the highs of prior years. By way of comparison, the first half of 2021 saw 9,619 deals totalling USD578.43 billion in value, and the first half of 2022 saw 9,722 deals totalling USD459.89 billion in value. Despite ongoing factors like inflationary pressures, high interest rates and geopolitical uncertainties contributing to lower levels of deal activity, there is cautious optimism among experts that M&A activity will ramp up in late 2024 and into 2025.

Headwinds Affecting Dealmaking

Some of the headwinds affecting private equity M&A include high inflation, high interest rates, and geopolitical uncertainties.

Inflation

Inflation trajectories impact the timing, structure, and financing of M&A. As noted above, inflation spiked coming out of the COVID-19 pandemic, with a peak at 9.1% in June 2022, but inflation rates are stabilising, with the current rate at 2.9%. Assuming no additional macroeconomic shocks or geopolitical crises in the near future, economists believe that inflation will continue to stabilise but generally doubt that the Federal Reserve’s target of 2% will be reached by the end of 2024. Decreasing inflation rates could lead to a decrease in the cost of goods and services and increase in valuations, which could generate more M&A activity in the near future.

Interest rates

High interest rates make it more difficult to secure financing at attractive rates, hindering growth and restricting the practicality of utilising debt as a funding source. As noted above, due to the significant increase in inflation in 2022, the Federal Reserve raised interest rates in an effort to reduce inflation. Despite the Federal Reserve’s decision not to cut rates in July 2024, the Federal Reserve is expected to lower interest rates in the coming months. Even a minor decrease in interest rates would reduce borrowing costs and permit more attractive financing options, thus supporting an increase in deal activity.

Geopolitical uncertainties

2024 is a major election year for 64 countries around the world. As a result, the economy faces uncertainties in connection with policy and regulation. The US presidential election is of chief concern for US-based private equity firms, as the administration that ultimately prevails will direct economic and foreign policy plans and regulatory framework for the next four years. Market volatility and hesitation among firms to engage in deals may persist with elections ongoing, especially in sectors particularly vulnerable to the effect of the election. Thus, firms need to be proactive in assessing potential risks and strategically plan transaction timelines.

Global conflicts have further negatively impacted the deal market. Instability in the Middle East and the ongoing war between Russia and Ukraine have been especially detrimental to the energy sector and created global supply chain issues in connection with food products, critical minerals, and other commodities. Additionally, worsening relations between the USA and China have exacerbated concerns about global economic deceleration, particularly through heightened trade tensions, tariff disputes, and disrupted supply chains. In light of these geopolitical uncertainties, private equity firms may be taking a more cautious stance on investments in affected industry sectors.

Industry Sector Implications

Certain industry sectors have been more susceptible to headwinds than others. The commercial real estate sector is particularly stagnant, with offices and warehouses not faring well due to the shift to remote/hybrid work environments following the COVID-19 pandemic and higher construction costs driven by increased prices for building materials. Similarly, the retail and consumer goods sectors have been adversely affected by ongoing supply chain disruptions, higher product prices, and reduced consumer spending. The raw materials sector has also seen reduced deal volume and value as private equity firms hold out for more profitable conditions.

Other industry sectors, however, have fared better. Of the 35 megadeals announced this year, the technology and energy sectors are leading the way, with significant M&A activity also in healthcare and life sciences, financial services, and industrial manufacturing. Economists anticipate that the technology sector will continue to flourish due to transformative developments in emerging technologies and artificial intelligence. The energy sector is also expected to remain a key player in dealmaking due to the global push for clean and renewable energy sources, such as solar and wind. Growth in the healthcare and life sciences sector has been fuelled by technological advancements, scientific breakthroughs, and new drug developments. The financial services sector is active due to trends in digitisation and the emergence of new technologies, including cryptocurrency and blockchain. M&A in the industrial sector has had a particular emphasis on acquisitions designed to enhance software and data services revenue, especially in the automotive, aerospace, and industrial equipment subsectors.

Types of Deals Anticipated

Before the COVID-19 pandemic, private equity firms’ investments historically demonstrated a 75-25 ratio with respect to deal volume between platform deals and add-on acquisitions, respectively. Add-ons, bolt-ons, and tuck-ins have become more attractive due to their reduced complexity and more accessible financing, and firms have been pursuing add-ons in the current environment to strengthen their current portfolio companies, with the goal of increasing value through strategic growth before exiting. This shift in focus has resulted in a new 50-50 balance between platform deals and add-on acquisitions.

Private equity firms have also moved toward a preference in acquisitions of companies from the middle and lower-middle markets in an effort to navigate the barriers posed by elevated borrowing costs. Middle-market private equity deals in the USA have grown from representing 45% of the total private equity volume in 2021 to 53% in 2023. These smaller-scale companies offer a more precise evaluation, quicker post-acquisition integration, and opportunities to fill gaps in private equity portfolios.

In a leveraged buyout, where the objective is to maximise investment returns by covering a significant portion of the purchase price with borrowed funds, debt typically constitutes a majority of the acquisition cost. However, unfavourable financing conditions and elevated borrowing costs have made securing large loans more challenging and expensive, leading some private equity firms to adopt a more equity-heavy capital structure. Less leverage can diminish the potential for higher returns on investment and put more equity capital at risk, resulting in lower EV/EBITDA multiples and more conservative deal valuations. To navigate the new financial landscape of reduced leverage and potentially lower expected returns, private equity firms may extend holding periods and explore alternative exit routes to maximise value and achieve more optimal returns.

The M&A market has recently seen a rise in deals financed by alternative providers. Just as in other areas of funding needs, private credit firms, in particular, have stepped in for traditional bank lenders, funding 85% of private equity M&A transactions in 2023, up from 41% in 2021 and 59% in 2022. As interest rates stabilise toward the end of 2024, borrowing costs are expected to become more favourable, which would make leveraged buyouts and other debt-financed investments once again more attractive to private equity firms. In response to the increased demand, traditional bank lenders may try to take back some of the ground ceded to private credit firms. Competition between bank lenders and alternative credit providers may influence the availability of credit and the terms of loan offerings for the benefit of sponsors in the private equity M&A market.

Amid ongoing economic challenges, distressed companies are focusing on restructuring their operations to enhance efficiency and profitability. This drive for restructuring has led to a rise in distressed asset sales, as companies seek to reduce leverage and generate cash flow. Consequently, private equity firms may capitalise on this trend by acquiring undervalued assets at attractive price tags. By doing so, they not only position themselves for substantial returns but also emerge as instrumental in revitalising struggling businesses and advancing broader market recovery.

The last few years have also been notable for robust activity in strategic transactions for funds, commonly known as secondaries. Secondaries have gained popularity due to the flexibility they offer sellers seeking to liquidate or rebalance their portfolios. Buyers benefit from potentially faster returns on capital, discounted access, and increased transparency into the underlying assets or portfolio. The opportunity to sell stakes before a private equity fund’s life cycle ends is particularly advantageous, considering that investments typically have holding periods of seven to ten years under current market conditions, up from the previous norm of five to seven years. Reports indicate that transaction volume in the secondaries market reached USD114 billion in 2023, a 10% increase from the USD103 billion volume in 2022. These transactions continue to prove successful, surpassing USD72 billion within the first six months of 2024. At this rate, secondaries are expected to become a key transaction vehicle to ride out market volatility.

With the economic downturn and a decline in platform investments, firms have stockpiled dry powder, accumulating an unprecedented amount of approximately USD3.9 trillion over the last four years. This substantial capital reserve may drive a surge in acquisitions by private equity firms eager to deploy funds to secure long-term returns for investors. Further, headwinds are beginning to dissipate, revealing clearer skies on the horizon. Economists anticipate inflation to cool, interest rates to gradually decrease, and ongoing geopolitical uncertainties to settle in due time. Moving into the fourth quarter of 2024, there is cautious optimism for an increase in M&A activity and an improved overall private equity market.