September 26, 2023 — The anti-war folk song, “Where Have All the Flowers Gone?”, was initially written by American folk singer and activist Pete Seeger in 1955 and popularized by various artists in the decades since. It has become an iconic protest song and is often associated with its era’s peace and anti-war movements. The music continues to be performed and remembered as a powerful call for peace and an end to the ravages of war.
In today’s capital markets, one asset class is waging a war of its own: private equity.
While private equity fundraising remains robust, with the largest leveraged buyout firms launching larger and larger funds, the expectations of market-beating returns have pitted the private equity firms at war against a seemingly unbeatable enemy: high interest rates.
Last week, a founder of one of the largest private equity funds posed a rhetorical question. “If you can earn 12 percent, maybe 13 percent on a really good day in senior secured bank debt, what else do you want to do in life?” He continued, “If you are living in a no-growth economy and somebody can give you 12, 13 percent with almost no prospect of loss, that’s about the best thing you can do.” By pointing out the attractiveness of returns available to private credit in the current market environment, he exposed the extremely challenging conditions faced by leveraged buyouts.
Historically, private credit investments have funded 94% of leveraged buyouts by number and 70% of LBOs on a dollar basis. Private credit is the other half of the private equity pie, with each representing a different securitization, or tranche, of the same asset. What private credit gains in returns, private equity loses, and vice versa. Private credit now takes up a significant portion of the return pie of private assets, at the expense of private equity.
Year-to-date, the average private equity buyout was struck at 14.0x next year’s forecast EBITDA, equating to an EBITDA yield of 7.1% (the inverse of its EBITDA multiple). This EBITDA yield means that on average, these buyouts produce a 7.1% earnings yield before accounting for interest, taxes, and estimated capital expenditures (assuming the depreciation and amortization is a rough estimate of run-rate capex). Assuming these leveraged buyouts are funded by the 12–13% interest rates allegedly available in private credit, the math just does not work. A deal earning less than 7.1% financed by debt costing more than 12% falls apart quickly.
While high interest rates have produced good prospects for the private credit asset class, high rates have devastated the future of private equity returns. As an asset class reliant on copious amounts of debt struck at low interest rates, private equity’s inverse correlation to interest rates is to be expected. In contrast, other asset classes, including variable rate credit and “cash plus” liquid alternatives such as arbitrage, long-short equity, and managed futures, are positively correlated with interest rates and provide higher returns in a high interest rate environment.
Where Have All the Leveraged Buyouts Gone?
Given the negative prospects and seemingly impossible battle leveraged buyouts face due to high interest rates (at the hand of their sibling, private credit), it is not surprising that PE deal flow is down markedly. This substantial decline in leverage buyouts occurs despite record amounts of dry powder held by LBO funds.
For example, in the third quarter, there were $21.4 billion of private equity buyouts of U.S. public companies, down -31% quarter-over-quarter and down -40% compared to Q3 last year.
Leveraged buyout activity has not been this low since Q3 of 2020 when the economy was in the midst of the COVID pandemic, the stock market was highly volatile, and credit markets were still largely ceased up from the pandemic market shock that occurred that spring.
As the private equity industry remains wounded from battle, strategic acquirors now have the upper hand in mergers and acquisitions.
Overall M&A activity remains brisk, as corporate acquirors with solid strategic rationales and demonstrable synergies available step in to fill the void left by shell-shocked PE firms. These strategic acquirors have never been overly reliant on debt to fund acquisitions. Many corporate strategic buyers fund bolt-on acquisitions through retained earnings or the issuance of shares, instead of now high-cost debt.
Given that many corporations trade at lofty multiples as the S&P 500 hovers above 20x earnings, it is arguable that many firms currently have a cost of equity below their cost of debt, with the equity risk premium below 0%. This negative equity risk premium gives strategic acquirors consolidating their industry utilizing their equity a further leg-up compared to embattled leveraged buyout operators.
Ergo, with many private equity firms stepping back from buyouts, all is not lost, as strategic acquirors have stepped up to keep M&A activity continuing at a steady pace. Among the $60 billion of deals announced in the U.S. across eight transactions this month, just one featured a private equity buyer. Similarly, while Canada had a busy month for public M&A, with five deals struck representing a total deal value of $2.3 billion, just one was a private equity buyout.
With short-term interest rates expected to stay elevated throughout the rest of 2023, we expect private equity firms to continue to face a challenging buyout dynamic. However, we may see more PE firms executing UBOs (unleveraged buyouts that do not utilize debt), as they become increasingly incentivized to put their dry powder to work in order to earn their lucrative fees, despite a deal environment with reduced return expectations. No or lower debt used to fund buyouts means private equity returns will fall.
While a near-certain decline in private equity returns represents a battle lost, the industry has not lost the war as it continues attracting record fund flows despite facing its most challenging opponent yet.
The AlphaRank.com Merger Monitor below represents Accelerate’s proprietary analytics database on all announced liquid U.S. mergers. The AlphaRank Merger Arbitrage Effective Yield represents the average annualized returns of all outstanding merger arbitrage spreads and is typically viewed as an alternative to fixed income yield.
Each individual merger is assigned a risk rating:
- AA — a merger arbitrage rated ‘AA’ has the highest rating assigned by AlphaRank. The merger has the highest probability of closing.
- A — a merger arbitrage rated ‘A’ differs from the highest-rated mergers only by a small degree. The merger has a very high probability of closing.
- BBB — a merger arbitrage rated ‘BBB’ is of investment grade and has a high probability of closing.
- BB — a merger arbitrage rated ‘BB’ is somewhat speculative in nature and has a greater than 90% probability of closing.
- B — a merger arbitrage rated ‘B’ is speculative in nature and has a greater than 85% probability of closing.
- CCC — a merger arbitrage rated ‘CCC’ is very speculative in nature. The merger is subject to certain conditions that may not be satisfied.
- NR — a merger-rated NR is trading either at a premium to the implied consideration or a discount to the unaffected price.
* AlphaRank is exclusively produced by Accelerate Financial Technologies Inc. (“Accelerate”). Visit Alpharank.com for more information. Disclaimer: This research does not constitute investment, legal or tax advice. Data provided in this research should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this research is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Accelerate may have positions in securities mentioned. Past performance is not indicative of future results.