Post-pandemic, the resurgence of consumer demand, pent-up supply chains, and near-shoring have supported demand resilience during the Fed's attack on inflation. Year to date, the consumption and inventory rebounds have discredited the bond market's fierce reputation as a discounting mechanism. Pricing power and robust consumer activity have deflected some of the rate-inflicted pain. Meanwhile, as the unsteady investment climate finds its footing and the IPO window slowly re-opens, the follow-on effects are starting to show.
Included This Quarter.
- Increasing Capital Velocity
- Middle Market – A Defensive Haven
- Sector Themes
- Notable Events
- What We’re Reading
Increasing Capital Velocity.
AI (Artificial Intelligence) may be this year's theme, but its application within technology infrastructure extends far beyond solely tech companies. Tech-enabling, a cornerstone of private equity's value-added playbooks, propels competitive advantages across many sector specialties. Healthcare and consumer goods companies with large and complex datasets benefit from better management of user interface profiles, with details right down to cellular-level data captured during drug discovery. AI-enabled companies are responsible for igniting public equity returns earlier in the quarter. This portends an extension of the already robust public secondary offerings into an increasing IPO queue with the potential to improve capital velocity with distributions.
Larger buyout managers with prolonged hold periods have used the longer runway to increase add-on acquisition, turning to the Middle Market for accretive deals that can close quickly. Over the last two years, deal sizes have decreased, supporting Middle Market valuations and exits. Consumer IPOs, like Cava and Kenvue, belied the worries that an inverted yield curve raises. Among near-term demand for IPO candidates, NYSE President Lynn Martin sees investor demand for industrial transformation, clean energy, and consumer companies. She believes that it will be a while until the large tech companies are welcomed back into the market. With large private equity managers overweight the tech sector, we expect a slow recovery.
Middle Market – A Defensive Haven.
Middle Market private equity has been a defensive haven with steadier valuations and a more stable exit environment. Business fundamentals are among the key drivers of this resilience. In the recent RSM survey, 57% of Middle Market executives expect revenues and gross margins to increase, as illustrated by inventory rebuilding. This has been supported by the ability of society-critical businesses to pass along inflationary price increases.
A deal culmination mindset is growing among Middle Market business founders. As lending costs have increased and working capital needs have accelerated, they are inclined to cultivate private equity investors. There is concurrent reluctance to fully exit at current valuations, thus maintaining more aligned partnerships with rising percentages of roll-over equity. These partnerships can propel competitive leaps when backed by fresh capital and a strategic sector-specialist equity partner.
Of late, for allocators, it was as if the hourglass was flipped prematurely when both assets and liabilities moved in opposite directions. Valuations are in transition. As leverage drops and rates increase, net-net strategic equity providers in the Middle Market are more valuable today than ever.
While the overall debt market has been disrupted, debt availability has been more stable for small and medium companies because of the disproportionate growth in private credit. Going forward, private credit's consistency and familiarity with the Middle Market is expected to provide a reasonable degree of stability.
Finally, lower entry valuations provide inherent downside protection to the Middle Market. Bain reports that, in the past decade, the average entry valuation is under 9x EV/EBITDA for companies less than $250 million rising to over 12x EV/EBITDA as the target deal size reaches $1 billion. The scale-driven valuation gains and multiple expansion serve as a double reward as companies increase in size and move into the more competitive large buyout universe. This difference in valuation multiples is reinforced by the propensity for Middle Market companies to exit through a financial buyer or strategic acquisition, thereby obviating the need for a healthy IPO market – a distinct benefit in the last 18 months.
Even though Middle Market investing fundamentals have been more stable, it is still a buyer's market. Valuations remain reasonable, creating what we believe to be an attractive decade-long opportunity ahead.