As a private equity (PE) lawyer whose bread and butter is doing transactions for PE clients it is fair to say that 2023 felt somewhat different to the years preceding it.
Stating the obvious, much of this is macro: continuing (and worsening) economic headwinds, driving rising interest rates, in turn making access to third party debt more challenging and hitting balance sheets of potential investment targets. However, deal conditions feel still more challenging when set against the Covid-19 era of ready debt (and even readier capital). As a consequence we have seen:
- many PE funds feel the heat to deploy capital to keep their LPs happy (and indeed to show they know how to get a deal done when the market gets tougher); and
- PE funds doubling down on ‘favourite’ sectors, both to drive returns in themselves and also to counter any less lucrative investments that they made in the 2019-2022 vintage, which have not weathered the storm as successfully as they had hoped.
With these challenges in mind, we have seen the following trends in the PE market during 2023:
Caution is contagious
Whilst seemingly contrary to the imperative to deploy capital, acquirers have been increasingly focussed on conducting more granular diligence. Whilst there are multiple drivers for this – pressure variously from lenders, W&I insurers and investment committees, the objective is the same: ensuring risks are properly understood so that any Target acquired is a worthy investment and deal terms properly accommodate such risk (whether via price, conditional consideration and/or warranties/indemnities). Deeper dive diligence both extends deal timetables and can sometimes lead to changes in deal terms following receipt of those reports. Whilst an acceptable commercial landing can often be reached, sellers inevitably take a dim view of ‘late changes’ and a not-so-merry go round of a hiatus in discussions, sellers considering other offers and talking to other interested parties frequently ensues. As a result, transactions are both taking more weeks (and sometimes months) to reach completion and occasionally dying a death before being resurrected with changes to deal terms months later.
The fast track is getting faster
That being said, owners of the hottest assets have never had it so good. Auction processes for the most investible sectors are more competitive than ever. In such an environment everyone on a deal team must be on the front foot to stand out from the competition. This extends to the lawyers advising on transactions ensuring that the competitive terms being offered, and deliverability of the PE Funds they are advising, is communicated loud and clear to the sell-side. Of course, with all the PE funds involved doing the same thing and advising their lawyers to give the same front-of-house messaging, many Sellers are taking several bidders to the wire, resulting in highly competitive and unpredictable contract races.
Predictions for 2024
Given continued economic uncertainty going into 2024 coupled with major elections on both sides of the Atlantic, we may continue to see slow deal progress in the first quarter and hot auctions for the best assets, but with many assets being prepared for sale in the first half of the year and the imperative to make capital work, we predict that things will move more speedily in the latter half of 2024.
Three is not a crowd
As covered in greater detail in Cracking the Club Code (shoosmiths.com) we saw many more co-investments between PE funds (in particular incumbent sponsors reinvesting alongside an incoming investor) in the market in 2023, and this trend will likely continue into 2024 due to the benefits resulting from fund diversification, combined expertise, the predicted increase in available targets in the latter half of 2024 and the benefits of sharing the cost and workload in respect of such portfolios. By extension, nascent market terms on managing multiple sponsors will continue to evolve.
Continued rise in minority investments
A trend for some time now but one we predict to continue to be popular in 2024 is increasing numbers of sponsors traditionally known for taking majority positions increasingly making minority investments. For PE Funds, the driver for doing minority investments is, of course, multi-faceted, but 2023 saw something of a perfect storm: for sponsors, large cap majority deals being so rare was a catalyst for greater creativity in finding deal opportunities; and for certain Sellers- who previously wouldn’t have considered PE investment as a funding option - rising interest rates and the overall tightening in the debt markets led to a willingness to explore alternatives to traditional third-party debt to fund growth. Such Sellers are typically keen to get financing, but not at the expense of giving the keys away to their prized business and so offering a minority investment opportunity to PE is the lesser of two evils. In the lower mid-market, as a general election comes ever closer, owner managers will also horizon scan potential increases in CGT and take the opportunity to de-risk – again providing fertile ground for a minority play. Of course, where PE funds who typically favour majority position enter the minority investment space, we are increasingly being asked to formulate deal structures which enable the potential flexibility to move to a majority position in the future.
Smaller sweet equity pools
The trend towards heftier sweet equity pools in the market, frequently topping 20%, came to a halt in 2023. Over the last year there has been a near-universal tightening in management terms with some sweet equity pools reducing back down to 10-15%. The shift is, again, driven by the increasing need for PE Funds to demonstrate good returns on assets to their LPs, particularly where assets acquired during Covid-19 haven’t done as well as anticipated and where interest rates on third party debt are increasingly eating into their returns. Of course, this all needs to be balanced with providing a decent incentive to management to grow the business, and so, increased use of ratchets in investment documentation, more protracted conversations around management compensation and even a return of the lesser-spotted cash bonus will, we predict, be a theme in 2024.
Increasing ESG focus
LPs are requiring increasingly detailed ESG reporting. This is both because they have their own ESG obligations to fulfil and because there is a well-informed belief that a focus on ESG leads to better returns. Larger PE funds have been resourcing this demand by increasing the size of their in-house teams dealing with such reporting and monitoring or by outsourcing this function to a third-party provider. We anticipate that this will continue into 2024 and will be a trend that filters further into the mid-market fund practices. From a documentation perspective, we mostly see relatively high level ESG reporting/monitoring obligations on the portfolio companies within the investment documents but anticipate continue to be an area which is commonly refreshed and updated in the coming year, as the monitoring and reporting requests from LPs develop further.
Still quiet on the Exit front and increased use of continuation funds
With the uncertainty in the market, and EBITDA multiples being offered being more conservative as a result, many PE funds in 2023 held onto their existing investments for longer within their existing funds or utilised continuation funds to enable them to do so, in the hope of sunnier skies in 2024. This means from a legal perspective, taking a more careful look at lock-up periods, permitted transfers and drag/tag with the possibility of transfers to continuation funds in mind is essential. As we head into 2024, we expect exit activity will be heightened due to the backlog of assets which are maturing within portfolios being gradually unwound explaining why CF advisers are already reporting an increase in the number of processes they are preparing to market in Q1 and Q2 of 2024.
Flexing of PIK toggle provisions
Owing to the difficulties in obtaining new facilities and due to mounting pressures on the balance sheets of portfolio companies, inhibiting cash flow for growth plans, we are seeing more portfolios flexing their PIK toggle provisions in existing facilities, in order to free up the cash they would otherwise be paying in interest to fund their business plans and defer the payment of interest to a later date, once those plans have (hopefully!) paid off.
Rise in bridge funding by PE funds
Linked to the lack of accessibility to third-party debt is the rise in bridge funding by sponsors. Keen to secure the hottest assets, PE funds cannot afford to wait for third party funding to come through and so are having increasingly examined whether they are able to bridge the gap until post-Completion to ensure that they can be the most competitive bidder in terms of speed (and, crucially, certainty) of delivery of a transaction. This gives PE funds a longer period of time to consider the third-party debt offerings that are on the table, and potentially also a few months for them to see whether either (a) the gap could be plugged by co-investment instead or (b) the interest rates move favourably so they can secure more competitive external financing in the coming months. From a legal perspective, it is important that we bear in mind the future third party debt requirement when carrying out diligence reporting, as there is limited scope (or appetite!) post-completion to revise diligence through the lens of the incoming bank.
Will these financing difficulties continue into 2024? In the first few days of the year, we have already seen banks reducing the interest rates on residential mortgage deals and the predications in the UK are that there will be a series of rate cuts in the coming year, due to lower-than-expected inflation- albeit these are expected in Q3 and Q4. Therefore, we may see a resurrection of third-party lending and reduction in bridge financing going forward, should the predictions of economists prevail.