Private Equity’s Answer to a Frozen Deal Market

PE firms are flush with cash and kicking off a buying spree as they take creative approaches to deal-making.

Illustration by II

Illustration by II

Covid-19 isn’t stopping private equity firms from buying new businesses.

True, traditional deals are down dramatically. In the first half of the year, activity was down 63 percent in the Americas region, and 36 percent globally. The slowdown in deals was driven by buyers and sellers not being able to agree on a new price tag, the inability to easily travel and meet management, and scarce financing, according to EY’s newest quarterly report on private equity, infrastructure and private credit.

But private equity firms have just shifted their gears, taking more minority stakes in companies and buying non-core businesses carved out from large conglomerates, strategies they might have shunned a year ago. Minority stakes represented 23 percent of total deals in the first half of 2020, up from 11 percent last year, EY said in the study published Friday.

“Although investors are encountering challenges like deal pricing, difficulty in due diligence, and financing, analysts are seeing a shift toward a buyer’s market as firms employ creative deal structure,” the authors wrote.

Although it’s easier to have the upper hand when a firm owns a majority of a company, private equity can exert its will in other ways.

“PE has gotten more comfortable with minority stakes,” Pete Witte, global PE lead analyst, said in an interview. “PE firms are partnering with family owners, they are exerting influence without having outright control, and essentially providing capital to grow or stabilize businesses in the face of Covid.”

With revenue projections challenged by the pandemic, private equity firms are coming up with new deal provisions. “Creative structuring has become increasingly common, with mixes of equity, debt and convertibles,” EY said in the report. “The market is also seeing a surge in tranched transactions with provisions for follow-on investments upon reaching predetermined milestones.”

The pandemic also isn’t really crimping fundraising. Private equity firms raised $348 billion in the first half of the year, only 10 percent shy of what they took in during the same period in 2019, according to the report.

The largest firms, however, are the big winners as nervous investors are doing business with fewer fund managers. The number of funds that closed in the first six months of the year fell almost 30 percent. The funds’ average size grew to $816 million, up more than 20 percent. Buy-out funds represented 28 percent of the vehicles closed in the first six months, down from 40 percent in the same period last year.

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Not surprisingly, private equity firms haven’t gotten out of many of their investments during the pandemic. The value of M&A exits dropped by 50 percent in the first half of the year to $107 billion, according to the consulting firm, while the absolute number of transactions declined by 40 percent to 367 from 611 for the same period last year.

Only 16 private equity-backed initial public offerings have been priced so far, down 14 percent from 2019.

“PE firms have to think which companies are exit ready,” Witte said. “The equity story they were telling six months ago isn’t the story now. This means a longer holding period. But there was already a secular trend toward longer holding periods pre-Covid.”

Private credit had an even more robust fund raising period than PE. Private credit funds raised $57 billion in the first half of the year, a little above the $55 billion raised last year at this time. Still, 460 private credit funds are currently on the road and looking for $231 billion in commitments from investors. Distressed debt managers closed on $11 billion in 2020, an increase of 6 percent from the year before. But these managers want more: They’re currently looking to raise $63 billion from investors.