The turbulent state of the economy presents a unique opening for private equity (PE) investors to engage in profitable deal-making. With stubbornly high inflation, rising interest rates, and looming recession risks, a prevailing atmosphere of pessimism pervades numerous sectors. As we head into the new year, there are five key trends that PE firms and dealmakers should comprehend as they seek investment targets.
Reduced Competition Empowers PE Investors
The market's volatility and the inclination of public companies to finance acquisitions through share consideration have significantly slowed the pace of public deals. Consequently, private equity finds itself in the driver's seat due to diminished competition. Furthermore, the surge in regulatory scrutiny on special-purpose acquisition companies (SPACs) has led to a near cessation of SPAC activity. As many SPACs approach their expiration date in early to mid-2023, PE investors have an enhanced advantage.
Emergence of Public Company Carveouts and Take-Private Deals
The possibility of an impending recession has prompted companies to seek cash reserves to brace themselves for challenging times ahead. Consequently, large public companies are more willing than usual to divest non-core operations in exchange for liquidity. Moreover, an increasing number of public companies are considering take-private opportunities to distance themselves from a potentially volatile stock market.
Stabilizing Effects of Fading Tax Hike Concerns
The political climate in Washington has assuaged fears of immediate capital gains tax increases or new carried interest rules. The dissipating concerns surrounding these potential tax hikes have created a more stable environment for deal-making, allowing PE investors to operate with greater confidence.
Mitigating the Impact of Rising Interest Rates
The rise in interest rates poses a challenge, but private equity structures may provide a temporary remedy. In the past, persistently low interest rates granted easy access to low-cost capital for deals. However, the Federal Reserve's actions throughout the previous year offer a stark contrast, with seven rate hikes amounting to a total increase of 425 basis points in its benchmark interest rate. Additionally, beginning in tax year 2022, interest expense limitations are now computed at 30% of earnings before interest and taxes, rather than 30% of earnings before interest, taxes, depreciation, and amortization. This change may limit the deductibility of interest expense for some PE firms. As a result, some PE funds may opt to utilize their available funds to provide higher equity checks instead of relying on borrowing to fund transactions at the current market valuations.
Strong Fundraising Bolsters PE Investment Capacity
While there has been a decrease in fundraising for PE firms in 2022 compared to the previous year, the overall fundraising landscape remains robust. PitchBook data reveals that U.S. PE funds raised $258.8 billion through the third quarter of the current year, positioning them to surpass pre-pandemic fundraising levels. Although it may fall short of the $366.1 billion raised in 2021, this substantial amount of available capital indicates a wealth of funding ready to be deployed in PE deals.
In summary, the current economic climate, characterized by turbulence and uncertainty, presents private equity investors with a distinctive opportunity for deal-making. Diminished competition, public company divestments, fading tax hike concerns, strategic maneuvering around rising interest rates, and strong fundraising capacity collectively contribute to a favorable environment for PE investors to pursue lucrative investments.
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