PE Firms Pause Exits, Prioritize Financial Partners Amid Uncertainty

Middle-market private equity sponsors remain cautious in their investment strategy, focusing on initiatives that will carry themselves and their portfolios through uncertain times, and seeking partners that can support that objective.

Doug Farren, managing director of the National Center for the Middle Market at The Ohio State University, says company executives he’s spoken with who are part PE portfolios have been far more mindful of budget and capital expenditures.

“Middle-market companies have focused on preserving cash flow and making sure that they have strong working capital management processes in place,” Farren says, adding that PE firms and middle-market organizations alike are waiting for the right time to become more expansive in their investments.

According to a recent report from alternatives investor Apogem Capital, middle-market private equity firms have adjusted the focus of their investments as a result of a more fiscally conservative mindset.

More than 70% of executives and partners at middle-market PE firms plan to focus on operational improvements as the primary method of creating value, according to Apogem’s report, “Exploring the New Paradigm Shift: Middle Market Private Equity Research.”

The 100 partners and managers they surveyed are also investing in talent and human capital (69%), as well as buy-and-builds and business roll-ups (68%). Stable investments have become especially important as inflation rises, supply chain issues persist and the war in Europe rages.

Looking for an Exit

Although macroeconomic conditions are uncertain, Apogem found that exit activity is on track with long-term historical pace. But persistent volatility could slow M&A activity and put a pause on exit flow.

Farren says that he’s had a few conversations already where owners have looked to pull back from exits, waiting until they see the value rise in less volatile times. “It’s been coming up more and more as I talk to different folks at events and conferences,” he says.

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Louise Smith, managing director of private equity at Apogem Capital, says that sponsors have had to adjust their exit mindsets as a result of current market volatility.

“There seems to be recognition that the ability to create enterprise value by growing a company’s earnings versus expanding is going to be critical,” Smith says. “Moving forward, we think that the opportunity for multiple expansion is muted relative to what we’ve seen in past years. Many managers consistently benefited from multiple expansion when they would sell businesses, and we just don’t think that that’s quite as actionable of an opportunity today.”

There seems to be recognition that the ability to create enterprise value by growing a company’s earnings versus expanding is going to be critical.

Louise Smith

Apogem Capital

Financial Relationships

One the most important ways middle-market PE partners and managers are protecting against uncertainty are their relationships with financiers, Apogem said. A study participant told Apogem that the finance markets have been affected greatly by the volatility of the market, making it hard to execute deals.

This volatility has made it essential to find and keep strong, reliable partners who can step up during tough times. This has been especially true in the wake of the Silicon Valley Bank and Signature collapses, which Smith says has caused heightened scrutiny of PE sponsors’ cash management and treasury control at the level of both the firm and the portfolio company.

“In response to investor concern, many firms are revisiting their policies and procedures to assess ability to respond in another ‘doomsday’ scenario,” Smith says.

U.S. leveraged loan insurance for M&A reached a 10-year low in 2022, Smith says, as federal interest rates rose sharply and created even more economic uncertainty. This may result in even less credit issuance, increasing PE sponsors’ reliance on private lenders. McKinsey & Co. estimated that private lenders provided financing for more than 80% of private equity deals in 2022.

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“While some private lenders have grown hold sizes to a level where they can finance larger deals, most private lenders focus primarily on smaller deals,” Smith says. “We believe the ability to tap into the deep pool of dry powder available from private lenders, rather than relying solely on the syndicated loan market, can enhance the resilience of deal activity in the middle market relative to larger segments, even if credit available from traditional banks fails to recover or declines further.”

And when PE managers find these relationships, they’re valued highly. As one study participant told Apogem, their best capital partners are those who have communicated well even through volatile and uncertain times

“Relationships matter more today than ever,” Smith says. “You’re seeing private equity managers wanting to work with their most consistent partners to ensure continued access to capital, regardless of what’s going on in the market. We’re seeing private equity sponsors asking capital providers for partnership, flexibility, and speed. Those are the attributes that can make or break transactions in a volatile environment.”