However, many observed that by the end of 2023 the valuation gap was narrowing and expect that it will continue to close during 2024. With a now approximately 18-month period of muted transaction activity, business owners desiring liquidity may be more willing to entertain lower multiples than those paid during the low-interest era, and it may coax private equity sponsors with considerable dry powder on hand from the sidelines.
As Justin MacCormack, Managing Partner at Imperial Capital, explains: “Market participants with dry powder will be able to take advantage of situations where capital or liquidity is required, potentially resulting in better valuations for any new acquisition”.
There are also encouraging signs that interest rates will stabilize, and perhaps even be cut, in the second half of the year. It is thought that interest rate stabilization will instill confidence in market participants, reduce uncertainty and go a long way towards further bridging the valuation gap. Incidentally, the valuation gap has proven to be far less severe when dealing with top-tier, high-quality assets, which have continued to trade at rich multiples.
Post-pandemic forecasting challenges
Some sponsors observe that it is increasingly difficult to reliably forecast a business’s near-term performance using conventional means, which might involve developing an outlook on the basis of a business’s trailing 12- or 24-month performance. Given where we stand today, the data that has historically been the most relevant for forecasting and budgeting purposes will have been generated during a highly anomalous period of history, which was marred by, among other factors, the COVID-19 pandemic, severe supply chain disruption and skewed customer demand in certain sectors.
Data from this period is inherently limited in its ability to accurately project the future performance of a business. This phenomenon has made it increasingly difficult to value businesses and manage risk, and may also make portfolio company business planning and budgeting challenging in the near term.
For sponsors, remaining disciplined, patient and analytically rigorous will be key in 2024 and beyond.
“Staying disciplined and focused on core strategy will be a key success factor this year”, says Lisa Melchior, Founder & Managing Partner, Vertu Capital. “Sponsors should avoid being distracted by opportunities outside of their core strategy”.
Structured equity and other capital solutions
The current macroeconomic environment creates opportunities for sponsors who are willing to be creative and develop bespoke capital solutions for high-quality businesses dealing with challenging circumstances.
“One of the biggest opportunities in 2024 for sponsors,” says Michael Hollend, Partner, TorQuest, “will involve using capital as a solution for companies who need to shore up their balance sheet and deal with the high cost of borrowing but whose shareholders are not yet ready to sell their business.”
For a company approaching debt maturity, or for business owners looking for partial liquidity without having to market the entire business in current conditions, there may be transactions to be had with private equity in the form of preferred share or convertible debt instruments with yield entitlements that can be paid-in-kind, acquisitions of non-controlling interests or other structured equity solutions.
We anticipate an increase in structured equity transactions this year, and sponsors willing and able to think outside of the box stand to benefit most.
Opinions on the distressed market are mixed. While there is acknowledgment that the pressures on leveraged businesses from higher debt costs may result in an increase to the number of opportunities that come to market through insolvency proceedings, some dealmakers are skeptical that higher quality assets will follow this path. For these assets, it is thought by some that their current owners are more likely to find other solutions to capitalization issues than exiting outright at a discounted price.
Maximizing value in the portfolio
Sponsors also intend to double down on value creation activities at their portfolio companies in 2024.
“Value creation activities at existing portfolio companies will be top-of-mind for investors in 2024”, says Mohit Talwar, Partner, Maverix Private Equity. “We should see a renewed focus on revenue growth, M&A, and exit activity”.
Tuck-in acquisitions, scaling and improving operations by attracting and retaining high- quality talent, improving working capital efficiency and cutting costs are expected to be priorities.
AI will present both new opportunities and challenges across the full spectrum of sponsors’ business interests and may offer ways to improve productivity and reduce labour costs within the portfolio.
“One of the key factors to our success in the middle market in North America is the work done by the GPs managing our portfolio companies”, says Evert Vink, Partner, New 2ND Capital. “This requires us to continue be focused on alignment with these GPs, and make sure that they are focused on value creation and exit opportunities”.
Sectors of note
Healthcare, financial services, consumer services, software and other businesses that are by nature resilient during recessions are thought by some to be especially attractive this year. The energy transition was also highlighted by several leaders as a key investment theme for the year ahead.
In many ways the current economic conditions may dictate industries of focus this year, says Marie-Claude Boisvert, Partner & Head of Sagard Private Equity Canada.
“Recent challenging market conditions and decreased cash flow visibility highlight the importance of a focused and disciplined approach to capital deployment both from a purchase price and leverage standpoint”, she says. “It is prudent to focus on pipeline companies operating in resilient industries with strong management teams and defensible business models”.
The way forward for sponsors
The picture of the direct market that emerges from the private equity leaders that we surveyed is largely one of cautious optimism. The macroeconomic situation remains challenging, but 2024 could be a year of transition: one in which the interest rate hiking cycle moderates, the bid-ask spread closes further and transaction opportunities that have been shelved come to market.
In the meantime, sponsors will continue to put capital to work across a wider range of transaction structures and find ways to create value in their portfolios.
“So much of success can be attributed to leaders taking ownership of getting the right people focused on the right things”, says Ken Rotman, CEO and Managing Director, Clairvest. “It sounds so simple. Pulling it off, however, touches all aspects of business and requires a dispassionate view of your people, performance, position, competition, customer sentiment and macro environment. It also requires strong systems to bolster a ‘trust but verify’ approach as complexity and scale grow. Where we stumbled and excelled in 2023 can be traced, in part, to this”.
Being successful during this period will require sponsors to think about opportunities creatively and to allocate resources—financial and human—strategically.
Strong lender relationships will be important this year, both to winning new opportunities and to managing short-term capital-related issues in the portfolio, since during periods of market uncertainty lenders tend to allocate their capital more judiciously and with a preference given to key clients.
“Our partnerships will be critical this year”, says Aaron Toporowski, Managing Director at BMO Capital Partners. “It starts with the private equity sponsors, law firms and accounting firms on originating and executing deals. Also syndicate partners—everyone needs to work well together within the ecosystem”.