This Q&A was published as part of PitchBook 2022 Annual US PE Breakdown sponsored by Stout.

In the past few weeks, how has the tone shifted in talks about ongoing deals, and what do you find most surprising in these conversations?

Kevin: We always see a push for year-end closing around this time, and 2022 has been no different. However, more so than in years past, it feels like deals are falling into two categories: those pressing hard for a year-end close and those punting and re-engaging in 2023. Interest rate increases are definitely affecting dealmaking, but counterbalancing that is a strong appetite among strategics and financial groups to put money to work. In particular, rate hikes are affecting add-ons more significantly, as many groups will balk if the significant increase in financing expense requires a complete revamp of their existing credit facility. The financial groups that have relied most heavily on maximum leverage and financial engineering are certainly more challenged to put money to work in this environment.

Eric: From our ongoing dialogue with numerous PE firms, deal volume is consistent or slightly down from 2021’s record-high levels. Our PE clients note that the quality of marketed opportunities is slightly lower, which typically results in longer transaction timelines and lower close rates. There’s also been a shift to more targeted processes or strategic dealmaking. Bankers are being more selective in their outreach, and more time is being spent determining which groups are most qualified based on a thematic interest in the space or a relevant platform investment. This leads to more targeted buyer universes and more focused processes, with the most likely buyers putting forward more aggressive proposals.

There is also an increase in creative or structured equity transactions, even between sponsors. In such transactions, there’s an opportunity for owners to achieve partial monetization without necessarily selling the entire company, as well as an opportunity for a new investor to gain exposure to an attractive business while keeping existing owners and lenders invested. GP-led single-asset continuation strategies continue to be in favor as PE firms are interested in backing their winners for longer. This market has slowed in the near term but remains a fundamentally attractive option for certain companies and their sponsors.

Scenario forecasting is hardly new, but now the stakes seem that much higher for both deals in progress and PE-backed portfolio companies facing more difficult economic conditions. Has the gamut of scenarios expanded?

Kevin: Investors are clearly being more discerning due to today’s more uncertain environment. Downside scenarios are being further stress-tested, and due diligence is taking longer and therefore pushing timing out on deals. Overall, investors have been far more conservative in 2022 than they were in 2021, and that directly correlates to the more challenging market we’ve seen since the beginning of 2022. Some companies are just electing to hit the pause button and wait for greater clarity in the macroeconomic environment, while others with more resilient business models are finding it easier to stand out.

From a current portfolio management perspective, what are your clients bringing to you?

Kevin: For PE firms with differentiated companies that have performed well, the current choppy market with reduced deal volume is an opportunity to stand out. We expect highly attractive businesses with multiple growth vectors to receive as much interest as ever.

Eric: We are active with several sponsors seeking our help to grow their platforms through acquisition. Companies in most sectors have one or more PE-backed consolidator, and many of these companies and their owners are not slowing down consolidation plans despite fears of a recession. Some investors and their partner companies are viewing a potential recession as an attractive backdrop to continue building platforms through M&A.If you have conviction in your investment thesis, a softer market is an opportunity to be proactive and potentially average down your overall investment multiple, while also playing the long game as a strategic consolidator.

Debt markets are getting more interesting and dynamic for a variety of reasons. How is that playing into the transactions you’re currently advising on?

Eric: Over the past five years, middle-market debt financing has continued to shift away from committed commercial bank and syndicated financing to unitranche and other private credit providers, which are often investing from private funds. While this market is less volatile than the large cap syndicated markets and more accepting of risk than the commercial banking market, it is more reliant on the ability of debt funds to raise capital.

We are seeing middle-market direct lenders and debt funds being more selective with investment opportunities and requiring higher economics (rate and fees) as well as lower leverage than they did in 2021. Regarding the transactions on which we are advising, we typically work with our clients in advance of launching a sale process to assess debt financing options available to potential buyers. It’s important for the advisor to understand the available senior debt and junior capital financing options that will be available to sponsors in the leveraged buyout scenarios. Understanding this backdrop increases certainty and strategic insights, and also helps sponsor buyers allocate time when they know debt financing is available to them. We’ve also noticed that certain sponsor-backed platforms have become more selective about add-ons because of concerns about having to reprice their debt facilities. In these two types of situations, we often engage our Capital Markets team to provide our clients with debt market insights and to help deliver new lender relationships and/or more attractive terms.

Which sectors stand to benefit the most among the companies you’re working with?

Kevin: Not surprisingly, the sectors showing the most resilience in an uncertain environment are getting the most attention. Buyers are shying away from some sectors such as building product companies with more exposure to residential housing as well as certain areas within consumer. Within industrial, sectors such as industrial automation are seeing a boost in activity. As supply chains have been disrupted the past few years, there has been a reshoring of manufacturing activity. But that’s happening in a tightened labor market. Therefore, businesses that are automating tasks both big and small are getting a lot of attention and bumps in valuation. Additionally, certain services-focused businesses within the industrial economy, including value-added distribution, are seeing strong activity, with investors homing in on predictability of revenue and more consistent earnings.

Eric: Stout is active in the market with several attractive healthcare mandates, and within the broader healthcare sector we’ve seen continued strong investor interest due to relatively little pullback in core business performance or outlook. Another area of strength and robust activity has been in environmental services- and infrastructure services-related businesses. We’re working with several companies that are demonstrating strong year-over-year momentum with expectations for continued organic growth in the long term.

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