M&A activity remains muted despite performance growth and lower interest rates, indicating a continued dislocation between buyer and seller valuation expectations
The Lincoln Private Market Index (“LPMI”), the only index that tracks changes in the enterprise value of U.S. privately held companies, increased by 2.2% during the third quarter of 2024 as the index reached a new high. As has been the case in most quarters since the index’s inception, the index’s growth was primarily driven by strong fundamental performance, rather than multiple expansion.
When comparing the LPMI to the public markets, the S&P 500’s quarter-over-quarter enterprise value increase of 4.4% surpassed the LPMI. Additionally, the S&P 500 excluding the “Magnificent Seven” increased 5.9% in enterprise value driven primarily by multiple expansion likely due in part to investor optimism on the back of the Fed’s 50 basis point rate cut in the third quarter. This growth of course did not yet factor in the impact of the U.S. presidential election on public market valuations.
While overall deal activity has turned a corner, the leveraged buyout transaction count for YTD 2024 was lower compared to the same period YTD 2023 and materially down from 2021 levels. Average purchase price multiples also experienced a downward trend decreasing from 11.5x EBITDA in 2023 to 11.2x in YTD 2024, which was well below the peak of 13.4x in Q4 2021. Despite the decline in multiples, each industry tracked in the LPMI experienced EBITDA growth in Q3 2024 relative to Q3 2023, indicating that the current stagnation in deal volume is not performance driven, but likely reflective of the valuation mismatch between buyers’ and sellers’ expectations.
While purchase price multiples remain below record highs, closing the valuation gap between buyers and sellers may prove more difficult for certain industries relative to others. At one end of the spectrum, while the Industrials industry accounted for 17.0% of transactions in FY 2021, it accounted for approximately 24.0% of transactions in YTD 2024 indicating buyer and seller expectations of the Industrials industry are perhaps aligning more quickly. Conversely, Technology and Healthcare represented 14% and 17%, respectively, of buyouts in 2021 whereas YTD 2024 they represented 12% and 11%, respectively, indicating a wider valuation gap.
Private Company Growth Levels Out
In Q3, 63.1% of companies tracked by Lincoln demonstrated EBITDA growth, an increase from 62.0% in Q2 and above the 58.9% average since 2019. Year-over-year LTM EBITDA growth of 5.7% in Q3 increased from 5.5% in Q2 2024. On the other hand, the percentage of companies growing revenue declined from Q2 while the magnitude of growth was consistent quarter over quarter. “Although revenue growth has slowed, private companies have continued to experience earnings growth despite the variety of macroeconomic challenges posed to them in the last few years,” said Steve Kaplan, Neubauer Distinguished Service Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business, who assists and advises Lincoln on the LPMI. “Businesses have shown resiliency and lower interest rates could provide an opportunity for renewed investment in future growth initiatives.”
Based on a new analysis from Lincoln’s proprietary private market database, the LTM adjusted EBITDA CAGR has remained positive on average for every single vintage year from 2019 through 2023. This EBITDA includes inorganic growth, but only tells one side of the story. Lincoln observed that across deal vintages dating back to 2019, 55% of currently tracked portfolio companies saw leverage increase between the initial deal close and today. The average increase was approximately 0.5x with the highest increase occurring in the 2019 vintage. There are many different catalysts that could be driving this increase including survivorship bias among weaker performing portfolio companies that have not been able to be sold or refinanced, increases in debt to finance add-on acquisitions and other growth capital expenditures, or EBITDA failing to translate into cash flow as a result of the unrealized pro forma adjustments and increased interest expense.
Borrowers in the Driver’s Seat in the Direct Lending Market
A prevailing theme in the direct lending market in 2024 has been intense competition and that certainly didn’t slow in the third quarter. Average unitranche loan spreads tightened another 25 bps and clocked in below the levels observed at the height of the market in 2021. The lasting trough in M&A activity led to lenders fiercely competing for the limited buyouts that did go to market and other transactions such as dividend recaps and refinancings filled the void left by the lower M&A volumes. Other sweeteners such as lower OID and PIK toggle options continued to remain prevalent to entice borrowers and remain competitive with the BSL market, particularly for larger borrowers on the direct lending spectrum. Although slowing, Lincoln also continued to observe proactive repricings of strong performing deals that lenders wanted to keep in their portfolio rather than risk being refinanced out.
Another area of competitive pressure has been covenants. Over the last few years during the sustained period of higher rates, lenders put stricter and tighter covenants on deals, but with the increase in competition, the prevalence of covenant-lite deals has increased. Likewise, even for loans with covenants, lenders are offering more covenant headroom as the average headroom for leverage based covenants increased to 2.1x in Q3 2024 compared to 2.0x in 2023 and 1.8x in 2021. This headroom only increases as the size of the borrower increases, with the smallest cohort of companies with $0 to $25 million of EBITDA having the tightest headroom at 1.2x as compared to 3.1x for borrowers over $100 million, where competition with the syndicated markets is the steepest.
As a result of these competitive tailwinds and resilient portfolio company performance, the average fair value of loans in the Lincoln Senior Debt Index (“LSDI”) increased marginally in the third quarter from 98.56% to 98.64%. Similarly, covenant defaults continued to decrease in the third quarter to 2.2%, which matches Q4 2021 for the lowest level of defaults dating back to the beginning of 2020.
Interest Rate Reductions: A Catalyst for Growth
Directly correlated with the Fed’s 50 basis point rate cut in September 2024, the SOFR forward curve reflected a steep decline relative to Q2. As observed in the LSDI, the overall yield declined to 10.4% from 11.5% in the third quarter, reflecting the largest quarter-over-quarter change in average yield since the LSDI’s inception. Currently, SOFR is expected to decline to around 3.8% by the end of 2025, which would imply yields of roughly 8.5% to 9.5% for a unitranche security priced at SOFR+4.75% to SOFR+5.75%. While this is still north of the floor levels in 2H 2021 of approximately 8.0%, should rates move down any further, those levels could be reached. “We may be approaching a floor on direct lending spreads,” noted Ron Kahn, Managing Director and co-head of Lincoln’s Valuations & Opinions Group. “BDCs and other direct lending funds have minimum return requirements in order to attract new capital and if rates continue to fall, the only variable that can change to stay above that floor is an increase in the spread on floating rate loans.”
With direct lending yields approaching a potential floor due to the aforementioned competitive pressure on spreads and the expectation for further decreases in SOFR as well as continued growth in private credit dry powder, market participants are exploring other alternatives to drive attractive risk adjusted returns. Investments in asset backed finance (“ABF”) are another route for lenders to deploy capital they have raised. For those seeking higher yields relative to the direct lending market albeit for more junior risk, structuring of deals can allow for an investor to sell down the senior pieces of the capital structure and retain equity risk. Examples of this include equity in collateralized loan obligation (“CLO”) new issuances, with yields ranging from 10% to 18%, and equity in collateralized fund obligations (“CFO”), which offer yields ranging from 18% to 30%.
With lower interest burden from the rate cut and repricings also comes improved portfolio company cash flow. All-in interest expense has decreased approximately 200 basis points since Q4 2023, which has led to additional headroom for fixed charge coverage ratios (“FCCR”). As of Q3 2024, 36.5% of companies had fixed charge coverage ratios under 1.0x, which was an improvement from 43.0% in Q2 2024. Furthermore, the average FCCR, which was 1.1x as of Q3, is expected to improve to closer to 1.2x in 2025 as SOFR declines further. With free cash flow improving from the lower interest burden, portfolio companies may take the chance to invest in growth capital expenditures or inorganic growth through acquisitions.
Aside from investment in growth for existing portfolio companies, another advantage of the lower interest burden is increased debt capacity for new buyout transactions. “Coming off of record M&A volumes in 2021, the persistent increase in rates led to much of the slowdown in transaction activity the private markets have endured in the last few years” noted Kahn. “Sponsors and lenders were laser focused on managing free cash flow, which came with reduced debt capacity in new buyouts. With yields now approaching a potential floor and the Fed cutting rates once again in November, the pendulum may have swung the other way with a greater appetite for higher leverage in buyout transactions.”
About the Lincoln Private Market Index & Lincoln Senior Debt Index
The LPMI is the only index that tracks changes in the enterprise value of U.S. privately held companies—primarily those owned by PE firms. With the LPMI, private equity (PE) firms and other investors can benchmark private companies’ performance against their peers and the public markets.
This index is differentiated from other indices as it (1) tracks enterprise values of private companies over time, (2) is based on valuations rather than executive surveys and (3) covers a wide sampling of companies across a range of PE firms’ portfolios.
The LPMI seeks to measure the variation in private companies’ enterprise values by analyzing the aggregate change in company earnings as well as the prevailing market multiples for approximately 1,400 private companies, each generating less than $250 million in annual earnings. The index is calculated using anonymized data on an aggregated basis by Lincoln’s Valuations & Opinions Group, which has distinctive insights into the financial performance of thousands of portfolio investments of financial sponsors, business development companies and private debt funds.
The methodology was determined by Lincoln in collaboration with Professors Steven Kaplan and Michael Minnis of the University of Chicago Booth School of Business. While other indices track changes to a company’s revenue or earnings, the LPMI is different in that it tracks the total value of these companies. Significantly, the large number of private companies used to create the LPMI helps ensure that the confidentiality of all company-specific information used in the index is maintained.
Further, in 2020, Lincoln launched the LSDI which provides insight into the private credit market as a fair value index tracking the total return, price, spread and yield to maturity of private credit securities. The index is developed using much of the same data as the LPMI and the methodology was determined by Lincoln in collaboration with Professor Pietro Veronesi of the University of Chicago Booth School of Business.
Important Disclosure
The Lincoln Private Market Index is an informational indicator only and does not constitute investment advice or an offer to sell or a solicitation to buy any security. It is not possible to directly invest in the Lincoln Private Market Index. Some of the statements above contain opinions based upon certain assumptions regarding the data used to create the Lincoln Private Market Index, and these opinions and assumptions may prove incorrect. Actual results could vary materially from those implied or expressed in such statements for any reason. The Lincoln Private Market Index has been created on the basis of information provided by third-party sources that are believed to be reliable, but Lincoln International has not conducted an independent verification of such information. Lincoln International makes no warranty or representation as to the accuracy or completeness of such third-party information.
About Lincoln International
We are trusted investment banking advisors to business owners and senior executives of leading private equity firms and their portfolio companies and to public and privately held companies around the world. Our services include mergers and acquisitions advisory, private funds and capital markets advisory, and valuations and fairness opinions. As one tightly integrated team of more than 850 professionals in more than 20 offices in 15 countries, we offer an unobstructed perspective on the global private capital markets, backed by superb execution and a deep commitment to client success. With extensive industry knowledge and relationships, timely market intelligence and strategic insights, we forge deep, productive client relationships that endure for decades. Connect with us to learn more at www.lincolninternational.com.
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