This Q&A was published as part of PitchBook’s Q2 2023 US PE Breakdown sponsored by Stout.

Markets remain uneasy for a multitude of factors. Which factors are you watching most closely, and why?

Ted: It has been a difficult year for private equity dealmaking. The Fed rate cycle continues to dominate the macro landscape. Rising rates, inflation, and uncertainty have negatively impacted M&A conditions. Many industries have seen rapid shifts in valuation, portfolio company performance has slowed, and financing costs have increased. That said, the Fed has followed a reasonably predictable and well-communicated path, so there have been few surprises, and firms have adjusted expectations accordingly. Notably, while geopolitical events always impact markets, the war in Europe and the pandemic are no longer having a significant effect on the appetite for dealmaking.

We started to see some green shoots of increased M&A market activity in late Q1, but they were mostly quashed by the liquidity crisis in US regional banks, which culminated in the failure of SVB and others. This summer has seen a similar mini spike in new launches, as some sellers try to get transactions done by year’s end. Overall, most of our clients are seeing deal flow down 25% to 40% YoY, resulting in far fewer opportunities to deploy capital.

Today, we are mostly focused on the long process of buyers and sellers realigning on value. There is no real catalyst other than time to truly reignite deal activity. The exact timing remains difficult to predict. For much of the last year, we have been hearing the return of active market conditions is three to four months out. The pressure for private equity funds to deploy capital is intense and building, so we anticipate a significant spike in activity when markets return to something like what we saw in early 2021 after the pandemic-driven slowdown.

Sponsor M&A activity has been quiet this year, and competition for attractive assets remains significant. Where are you seeing pockets of activity?

Ted: Overall, sponsor-backed deal flow in the middle market is materially down as market volatility makes aligning buyer and seller valuation expectations more difficult. As a result, many sponsors are not even considering selling portfolio companies until 2024.

However, the drivers of activity in the lower middle market (particularly for founder/family-owned businesses) are less dependent on financing, cycle, and valuation than other areas. Stout has been very active with platform and add-on deals under $25 million of EBITDA backed by founders, and we continue to be busy pitching and executing in this space. Many sponsors have been playing down the market to take advantage of this flow, especially in situations wherein continued consolidation opportunities allow further deployment of capital.

Certain sectors are healthier than others. We see activity in services broadly, healthcare services (especially non-reimbursement risk plays), and less cyclical industrials. Meanwhile, consumer/retail has been weaker overall, and growth tech has been challenging. However, our tech bankers are busy working on old-line industry tech enablement, which remains a huge opportunity.

How can sponsors play this market?

Ted: Firms are more actively considering minority and structured deals through their main funds or dedicated pools of capital. Sellers, particularly those attempting to fundraise in a tough environment, are also more open to these transactions, as they can provide a valuation mark for a current portfolio company and some return of capital. Continuation funds remain popular as a way to record a valuation mark while holding an asset longer through a cycle.

In this environment of limited supply, competition for quality assets that hit the market is fierce. We are seeing numerous attempts to preempt processes, and speed to close is a real advantage.

With deal flow down, how are investment professionals and operating teams spending their time?

Bartley: Many are taking this slowdown as an opportunity to get the house in order at portfolio companies across the obvious pillars of people, process, and technology. This includes downsizing and businesses not replacing headcount lost through the ordinary course of business attrition.

Additionally, the role of the operating partner has changed. Previously, the operating partner was a C-suite executive ready to parachute in, but more and more (even with middle-market and lower-middle-market sponsors), there is a greater emphasis on deep functional skills (go-to-market, finance, and supply chain, for example) and a direct remit to drive EBITDA. Firms that shifted to this model will likely fare better through this slowdown.

Sponsors with platforms that have been highly acquisitive over the past 24 months are slowing the add-on pace and are taking a deeper look at back-end integration and efficiencies, with a focus on driving more top-of-funnel demand and sales efficiencies so that they are poised for growth when the economy improves. Companies are also focusing on fixing processes within the cash conversion cycle, such as order-to-cash and procure-to-pay, as well as faster invoicing, collections, and cash management. Healthy portfolio companies are upgrading key parts of the application stack like enterprise resource planning (ERP) and enterprise performance management (EPM) solutions.

How are valuation processes and terms and conditions evolving in the current milieu? How do they vary on the sell side versus the buy side?

Ted: In the current environment of diminished deal flow, sponsors have been aggressive on deals for quality assets. We have seen more attempts to preempt sell-side processes in the past year, and the trend is continuing. Several clients have found it difficult to compete if they are not on a highly accelerated timetable.

This dynamic has several implications for launching sale processes. For example, as speed is paramount, we have seen more prevalent equity backstops and/or over-equitizing for sponsors, especially for the A/A+ assets.

There has also been more caution around broad marketing launches. We have seen some sellers speaking to a small subset of buyers to see if a preemptive bid is possible, and then waiting for better market conditions if there isn’t enough interest.

Getting an advance view on leverage before launching a process is increasingly important from the sell-side perspective. As available leverage levels have dropped and cost of debt has risen, valuation has come down modestly for assets that are more sponsor oriented. We have seen less of an impact in strategic-focused deals.

Another continued trend is the increasing use of buy-side advisors with material fees in situations wherein banks bring real access and origination on deals. Most of our middle-market clients now recognize the importance of rewarding advisory partners for differentiated advice and idea flow.