After a rather turbulent 2020, U.S. private equity deal-making looks as if it is finally falling back into place. Q1 resulted in deal values of $200B, being roughly in line with a red hot Q4 2020, which saw deal values of $203B. As the country continues to distribute vaccines, economic activity has picked up, and the environment for deal-making is currently quite healthy.
Rising yields are proving to be one of the key economic factors to watch in the near term. The 10-year Treasury yield has surged from just above 0.50% in August to eclipsing 1.5% in March. Although rates are still historically low, the climbing yield is a reflection on how the market views the upcoming recovery. Higher inflation is increasingly being priced into the markets even though inflation has lagged the Federal Reserve’s target for the last ten plus years. This view derives from unprecedented fiscal stimulus from Congress, which investors increasingly view as the factor which will once again spur inflation, and we see this risk being priced into Treasury yields.
Rising yields have the potential to level out the price multiples PE firms pay for businesses, which have trended upward in recent years, as future earnings of the business are discounted at increasingly higher rates when yields rise. Rising yields could also reduce the amount of leverage utilized in buyouts as debt financing becomes more expensive because of those rising interest rates. Despite the recent rise in yields, the Federal Reserve appears prepared to keep interest rates low well into the future. If the Fed can maintain low rates while keeping inflation relatively muted, we expect that we’ll continue to see high valuations and high leverage in future private equity deals.
Private equity firms are also weighing the possibility of a new Securities and Exchange Commission chairman and tax hikes. Gary Gensler, who headed the Commodity Futures Trading Commission under the Obama administration, has yet to be confirmed by the Senate; however, if he is confirmed, the industry is expecting increased fines, disclosures and enforcements in comparison to Jay Clayton, the previous chairman who was viewed favorably by the private equity industry.
While the national economy continues to rebound, IPOs are increasing drastically with a growing number of SPACs seeking merger targets leading the IPO wave. PE firms are looking at SPACs as a potential new avenue by which they can exit portfolio companies but also as potential competitors for deal flow.
Taxes are a common thought on everyone’s mind, and business owners are taking tax hikes seriously. Potential tax increases, specifically around capital gains rates, is in part driving the deal activity due to owners accelerating exit plans ahead of the potential changes.
Roll-up strategies remain very popular with add-on acquisitions eclipsing new platform acquisitions or growth equity investments as firms remain hesitant to expand full force into new markets given current economic conditions. Healthcare and IT deals are leading the way in deal growth while deal activity slower growth industries, such as materials and energy, have lagged. While growth equity investments are less common compared to buyouts, the prospects for the growth equity are promising, and firms closed on some big fundraising rounds in Q1. Given the economic stress of the past year, distressed deals are making a comeback as firms see opportunities for earning returns through turning around businesses in struggling sectors.
At Warren Averett, we’ve seen the increased activity in the add-on space firsthand as our work on the buy-side has mainly focused around advising on add-on acquisitions, which are particularly popular in the healthcare industry. We’ve seen a slowdown in new platform expansion while simultaneously seeing sell-side activity take off as business owners look to take advantage of favorable valuations and terms ahead of potential capital gains tax changes. As the hardest days of the pandemic fade out of the trailing 12-month time frame most private equity firms use as a basis for their valuations, we should start to see a more clear picture of what the “new normal” looks like for most businesses with regards to financial performance. This will likely give buyers and sellers more confidence in the data used as a basis for company valuation and other key deal considerations as COVID impact becomes less of a factor on recent performance.
Overall, our nation is rebuilding from the harsh year of the pandemic. With the economy rebounding, this year has the potential to surpass previous records for deal making. The private equity industry is closely watching interest rates, inflation, fiscal stimulus, tax policy and regulation as key factors which could define the year. Valuations are higher than ever, and competition for deals is fierce. The industry is evaluating risks and rewards resulting from the rise in SPACs and seeking out creative ways to put abundant capital to work in a competitive M&A market. Our focus remains the same on providing deep insightful analysis to help clients assess opportunities and potential risks associated with a proposed transaction so that they can make better, more informed decisions.
Source: Pitchbook US PE Report Q1