What comes after the PE dealmaking freeze?

Following a re-rating period that brought deals to a standstill, patient buyers could benefit in special situations, says PE expert

What comes after the PE dealmaking freeze?

After a challenging 18-month period of frozen dealmaking, some tiny pockets of the private equity space could prove lucrative for buyers and investors … but only if they have the patience to wait.

“Recently, we’ve seen a slowdown across three main segments of private equity: controlled buyouts, growth capital, and venture capital,” says Marcus New. New is the founder and CEO of InvestX, a leading private equity marketplace that empowers broker-dealers to invest in pre-IPO companies through single-issuer SPVs, multi-issuer funds and secondary market trading.

Part of the slowdown in deals, New says, can be explained by the policy tightening by central banks since last year. As interest rates rose, the cost of leverage has increased, which has put pressure on players in those sectors of PE to generate higher growth rates. That’s especially hard to pull off, New says, when investors across the world are exhibiting a “recessionary psychology” – taking a risk-off stance indicative of recession even before it has been proven out yet.

Across the marketplace for controlled buyouts, New says activity has been substantially frozen due to buyers and sellers’ inability to strike deals.

Because of the higher cost of debt, PE fund managers have to acquire companies or stakes in companies at lower prices to achieve their promised internal rate of return to investors. But even in the current challenging market climate, a majority of sellers are refusing to capitulate as they’ve anchored their pricing to eighteen months ago.

“We’re also seeing that in the growth capital markets, which is where we’re really investing,” New says. “Sellers in the secondary market are standing pat and don’t want to sell, and buyers have re-rated their prices. There’s a massive spread; in a lot of cases, that spread is between 20% and 30%.”

Amid the sluggish pace in dealmaking, New says PE fund managers are forced to hold a significant amount of capital on the sidelines. He’s also seen a slowdown in capital raises, with general partners looking for very little funding, assuming they’re trying at all.

“Because deal activity is slower, capital is not being deployed as quickly, and many PE funds aren’t seeing any liquidity either,” he says. “A lot of existing investors want to see their capital deployed before they commit any new dollars. Many others haven’t seen any distributions, which means there’s no return of capital for those investors to reinvest.”

With the risk-free rate now threatening to reach 5%, New says PE managers are under pressure to generate returns of up to 12% to stay compelling to investors. While those rates of return are hard to achieve in the more mainstream pockets of private equity, where long-term sustainable business growth of 5% a year are the benchmark, he says they’re more within reach in the growth capital space.

“You could describe companies in the growth capital space as late-stage ventures. They’re large private companies that haven’t gone public yet, and are taking on more capital to grow their business faster,” New says. “From a Canadian perspective, they’d be similar in size to large-cap tech stocks on the Toronto Stock Exchange.”

Given the current environment, New is seeing a potential play for investors and would-be buyers who are willing to be patient. Similar to a strategy his company used during the COVID-19 market downturn, he says there’s a marginal opportunity to put in low bids for high-quality companies – as low as half the value they’d trade for in the public markets – and wait for motivated sellers in need of immediate liquidity to take the offer.

“I think that the next three quarters, we’ll have a similar buying period to when COVID hit, but for very select situations,” he says. “A lot of people are still not willing to sell at these distressed prices. But once the IPO market opens up, which we expect will happen within the first half of next year, it will bring back all the hedge funds and crossover funds in the market … I think for very special situations, it’s going to be an incredible vintage in private equity investment.”