Conversations with private equity and corporate partners in New York before March 2020 used to be predictable.
‘Busy?’
‘Oh yeah.’
‘Are you expecting to be less busy?’
‘Oh, no.’
‘Can anything stop you?’
‘I suppose the economy could collapse again.’
Of course, such confidence was briefly shaken by the Covid-19 pandemic, which stalled deals for a time, only for dry powder to be redeployed in the final quarter of 2020 and into 2021. Even as the Biden administration entered power, bringing with it fresh scrutiny on antitrust rules and the regulation of private equity houses, activity continued unabated, with firms at all levels of the market being kept busy.
However, since 2022, with all its well-documented reversals, the picture is much bleaker. Fears of a recession, the ratcheting up of interest rates to decades-high levels, and financial pressures on sponsors, lenders and law firms alike have aligned to suggest that the music has stopped at last.
Cutting through the plaintive noise, a trip to New York in October affords the opportunity to get the view from the ground with dealmakers and ask them what the market holds into 2024.
Losing momentum
At the top of partners’ minds when asked about the through-line of the last 18 months is, unsurprisingly, the state of the economy, most notably the Federal Reserve’s ongoing efforts to combat inflation via rate raises. With interest rates now at 5.4%, compared to the historic lows of 0.07% in 2021, fundraising and financing has been correspondingly more expensive, with an inevitable knock-on effect on M&A. For public companies, deals comprised of share equity have been a non-starter, while leveraged transactions are proving challenging following the withdrawal of bank lenders for much of 2022. Lenders started tentatively to come back to the table towards the end of last year, albeit term sheets are looking very different these days.
‘The continued increase of interest rates, making private and public debt more expensive, combined with a declining number of attractive targets, has resulted in an increase in prices and is limiting the impact of financial engineering,’ explains Lowell Dashefsky, co-head of Arnold & Porter’s life sciences and private equity groups.
Meanwhile, Katherine Krause, a partner in the corporate department of Simpson Thacher & Bartlett, reports that: ‘Sponsors, in particular, continue to have significant amounts of dry powder to put to work but have been electing to deploy it more opportunistically over the past few months.’
‘It’s no secret that PE deal flow over the last year and a half has been hamstrung by the condition of the credit markets,’ says Andrew Fadale, a partner in Milbank’s private equity team. His colleague John Franchini, co-head of the firm’s global infrastructure practice, echoes this sentiment: ‘Buyers, when they see uncertainty, sometimes move too far to the conservative position. For a pure PE model that runs on LBOs, they’re highly sensitive to the debt markets and they’re going to pause.’
‘Sponsors continue to have significant amounts of dry powder to put to work but have been electing to deploy it more opportunistically over the past few months.’
Katherine Krause, Simpson Thacher
‘The second half of 2022 was super-busy,’ explains Neil Torpey, a private equity partner at Baker Botts. ‘On the buy side, PE funds moved to finish acquisitions in time to take advantage of interest rates that, it was clear, were only going much higher in 2023. Early 2023 deal volumes benefited from the 2022 tailwinds, but in late Q1 investors seemed to take a breather to consider trends in geopolitics, energy markets, inflation and other factors impacting their strategies.’
The picture is slowly, if not improving, certainly stabilising, with many practitioners anticipating one final rate rise in 2024, before an increasingly positive macroeconomic picture sees rates hold steady, or even fall. ‘It appears that interest rate increases should be coming to an end with rates plateauing and perhaps beginning to trend downward in the second half of 2024,’ predicts Torpey.
The impact of this on transactions is the subject of some debate. While some see a deluge of dealmaking similar to the late-2021 boom on the horizon, others suggest a scenario of ‘higher for longer.’
‘Clients are finding many new industries and market segments in which to invest – from mega-takeovers, to roll-ups of mid-market companies in a variety of industries, to early-and growth-stage investments in the tech space,’ says Torpey, while Franchini identifies infrastructure as an ongoing area of activity. ‘A lot of infrastructure investors have flexibility to invest across the capital structure,’ he explains. ‘In infra, the credit and debt markets are still open for business and have been for some time. Therefore, people are able to consummate transactions because that debt is available.’
Many argue the need for the market to adapt to a new reality. The favourable valuations and ten-times returns of recent years are gone, but money is still there to be made once all parties accept the new terms.
‘As a seller, you have to pay the piper on valuation either way,’ reflects Fadale. ‘We’re seeing deals get done, even if they’re more esoteric and complex than before. There’s a limit to how long you can just sit idle. What I hear is that it’s going to continue to be choppy and deals will be difficult to be done, but that doesn’t mean deals won’t be done.’
The new way
One upside though is the entry of new direct lenders to the market, keeping transactions afloat when many felt interest rates and economic retrenchment would cause them to sink. Credit funds, including those operated by major private equity houses, have filled in for traditional banks and the syndicated structures previously relied upon.
‘Debt markets remain volatile due to the persistent rise of interest rates and ongoing economic uncertainty, with traditional banks essentially exiting the acquisition-related debt financing market completely,’ explains Katie Reaves, a partner in the corporate finance team at Cleary Gottlieb Steen & Hamilton.
Certainly, during late 2022 and early 2023, the period of the greatest rate rises and accompanying reluctance to finance, the role of credit funds and other direct lenders was crucial. Notes Torpey: ‘We have seen a steady and increasing presence in the funding of PE M&A activity, and financing of operations and follow-on investments involving PE fund portfolio companies, by non-bank lenders. These players have significant capital to put to work.’
Alan Glantz, a partner in Arnold & Porter’s corporate finance team, argues that while direct lending is not a new trend, it has certainly expanded its reach. ‘Private credit funds have been capitalising on the financing opportunities that do exist, and have been expanding their market share of lending activity,’ he explains. ‘While direct lenders traditionally have been an important source of financing in just middle market transactions, the rapid growth of direct lending has led to many direct lenders being able to provide commitments that are greater in size to support large-cap transactions as well.’
‘The private credit market has got a lot more robust, especially in the US,’ agrees Fadale. ‘You see this move towards more and more private funds raising private credit funds, not just to fill the gaps in the acquisition financing markets, but to adjust and effectively deploy capital in a more flexible manner.’
‘Debt markets remain volatile due to the persistent rise of interest rates and ongoing economic uncertainty.’
Katie Reaves, Cleary Gottlieb
Reaves echoes the point: ‘Non-traditional lenders, including private credit (direct) lenders and fintech firms are filling the void left by traditional banks, shouldering more risk than the traditional banks in order to stay competitive and allowing borrowers to continue to secure favourable, borrower-friendly terms reminiscent of the lower-interest rate era – a risk-tolerance that is likely to be tested as interest rates continue to rise.’
Seller financing is also increasingly popular among private equity investors, according to the Milbank team: ‘Seller financing right now is serving to bridge that value gap – when there are adjustments and dislocation in the market, you have to wait for seller and buyer expectations to align,’ says Franchini.
Fadale agrees: ‘One of the key things we see is seller financing and seller rollovers taking the place of some acquisition debt financing. Sellers are more willing to sell 51% or more, but rolling over significant stakes to get a deal done.’
Despite a gloomy outlook from many, others take the glass half full view. ‘Overall the markets (including the syndicated market) have recovered to the point where the price of credit rather than the availability of credit seems to be the bigger issue impeding deal flow in terms of financing,’ says Patrick Ryan, global head of Simpson Thacher & Bartlett’s banking and credit practice.
Hedging your bets
A key question, then, is how firms are adapting to new market realities. The US legal market is heavily concentrated in the middle, with seemingly no consolidation in sight. Mid-market and bulge-bracket firms alike continue to see new workflows, though the heavy deal volume provided by lower-cap funds raised by the likes of KKR, Blackstone or Apollo has receded as leveraged finance deals became harder to execute.
Being able to manage evolving regulatory pressures is also key, says Dashefsky: ‘The enhanced regulatory environment has resulted in the M&A market being more complex to navigate. Firms with antitrust and regulated industry expertise, along with strong transactional practices, will be sought out by clients.’
The situation has led to a ‘flight to quality’ in many cases, lawyers argue, with clients willing to soften past demands on everything from fees to firm culture in favour of ensuring business-critical deals get done. When work was widely available, a buyers’ market on the client side meant they were willing to shop around and consider different counsel. However, with deals taking longer and being more expensive, the idea of in-house teams doing ‘more with less’ in terms of legal spend is far less prevalent.
‘In a crowded field, identifying a firm’s strengths and applying them to the evolving markets is critical,’ reflects Torpey.
Where firms are struggling, some claim, the cause is usually uneven investment, either into new practice areas where the firm lacks traditional strength, or high-profile lateral moves that create unrest among existing partner ranks and fail to translate into increased revenue.
‘There are a lot of firms where people come in, punch in the clock. They’re not making decisions, they’re not voting on anything, they feel like a person in a big organisation and they make good money,’ argues one New York private equity partner. ‘Are they really rolling up their sleeves to double down on client service, to bring in the new and keep the old?’
‘The enhanced regulatory environment has resulted in the M&A market being more complex to navigate.’
Lowell Dashefsky, Arnold & Porter
And then there is the question of firm culture and strategy. For years, arguments have raged over the white-shoe lockstep model versus eat-what-you-kill, stoked by newer debates over internal firm culture, working from home versus time in the office, and associated demands on working hours, flexibility, and diversity, as well as demands from clients.
Reaves identifies growing pressures from new lenders as one such issue: ‘Many of these non-traditional lenders are requiring borrowers to meet ESG standards, emphasising sustainability and a commitment to the environment and social responsibility in their loan criteria, often insisting on transparency through reporting and sustainable practices.’
‘Calibrating (these demands) is the key to outperforming in difficult times. Culture and comp are very intertwined,’ notes one partner. ‘The firms that are going to succeed are the ones able to adapt best to changes in the market.’
What next?
The outlook fluctuates between ‘full steam ahead,’ and ‘trouble on the horizon.’ Most firms are cautiously optimistic about the future, and see a period of stability, if not explosive growth. For dealmakers, a general acceptance that transactions will take longer and cost more is a given.
‘We are having more conversations with clients about potential deals and there are signs that the dealmaking environment is picking up. If inflation eases, interest rates stabilise and the global unrest subsides, given the amount of dry powder on the sidelines, dealmaking can potentially see a meaningful recovery in 2024,’ says Dashefsky.
Torpey also predicts an uptick. ‘It appears that interest rate increases should be coming to an end with rates plateauing and perhaps beginning to trend downward in the second half of 2024,’ he says, adding that ‘Many PE funds have significant capital to deploy from prior years’ fund-raising, so we expect to see M&A volumes increase as 2024 progresses, and also to see a larger number of financings across the year as the cost of debt gets lower.’
While a number of longer-term questions about strategy and culture remain in the back of firms’ minds, the priority for private equity and M&A teams at the moment remains adapting to a more challenging market, resourceful ways of financing deals, and an uncertain economic environment, as well as continuing to deliver for an increasingly sophisticated and discerning client base. LB