The private equity mid-market is proving to be a port in a perfect storm

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A perfect storm has been brewing these past few months. Liquidity has been drying up and it’s hitting the very largest buyout funds hard. The monetary tightening path that central banks are now walking combined with weakening risk sentiment has made high-yield bonds particularly unattractive to investors. In the US, the average yield on these junk-rated bonds has approximately doubled to 9% in less than a year, a high not seen since the pandemic first hit two years ago.

It’s been a slog for companies to issue in these public markets. In Q4, there were only 23 such bond offerings in the US, raising less than $19bn, according to data from Informa Global Markets cited by Reuters. This compares with nearly $108bn raised by 154 placements in the same period last year. Meanwhile, Axios reports that the average cost of newly issued high-yield bonds surged above 11% in October. The most recent comparator for this is the global financial crisis.  

Syndicated loan markets, which offer investors the security of floating rates, have been similarly stretched. Pitchbook data show just $10.6bn of leveraged loans were raised to fund US buyouts in Q3, the lowest reading in almost seven years.

Securing debt has become a major issue for the PE industry’s largest players.

Private options
Direct lenders have been a godsend in this rocky environment. Financing costs are higher than they’ve been for years, but private debt funds have had plenty of dry powder at their disposal and as one-to-one, bilateral lenders have provided stability and certainty for PE funds. In some cases they have been clubbing together to finance even the largest buyouts.

However, even these steadfast loan providers have begun to get jitters over big deals. Pitchbook reports that debt funds are now pulling back from mega unitranches in the multi-billion bracket, such as Blackstone Credit, Apollo, Blue Owl, HPS and Ares Management’s $5bn backing of Permira and Hellman & Friedman’s $10.2bn Zendesk take-private in June.

It’s understandable. They don’t want the concentration risk as default rates look set to rise and, since stepping in to fill the breach left by banks earlier this year, now have an eye on what has become a more challenging fundraising market after burning through dry powder. This has called for a more softly-softly approach.

The resilient middle
Believe it or not, private equity deal activity has been holding up remarkably well amid the commotion. It’s just that everything is tilting towards the smaller end of the scale. In the US, GPs made nearly $281bn worth of deals over Q3, a decline of around 20% since last year. Deal count, meanwhile, was actually up by 3.7% to 2,255 buyouts. That puts the mean deal size at $125m, down from $162m at the same time last year.

Direct lenders have played a central role in keeping the wheels turning. Undoubtably they are going to be more selective than ever over the coming months, tightening their underwriting criteria. These private debt funds have their own LPs to think about, therefore deals have to align with their ESG standards. They will also be looking for revenue and earnings resilience as macro clouds gather.

Crucially, mid-market GPs that have developed close relationships with this growing cadre of direct lenders are at a distinct competitive advantage. It is these managers that have the best chance of deploying capital at a time when asset valuations are looking far more attractive. Private equity’s unassuming middle market is relatively well positioned here. If current financing conditions persist, the same can’t be said for the industry’s mega-cap titans. Marquee names have raised mountainous multi-billion funds over the past two years yet are now struggling to put them to use.

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