Despite lower deal flow, credit markets saw spread compression beginning in the fourth quarter
The Lincoln Private Market Index (LPMI), the only index that tracks changes in the enterprise value of U.S. privately held companies, increased by 0.6% during the fourth quarter of 2023, resulting in the index ending 2023 at another record high. The LPMI’s increase was directionally in line with the movement of the S&P 500, which increased 9.1% since the third quarter. During 2023, the S&P 500 soared by 22.7%, while the LPMI climbed only 5.5% but demonstrated greater stability over the year. The public index was buoyed by multiple expansion in its seven largest companies whereas the engine behind the LPMI’s growth was strong operating performance, as multiples declined for the third consecutive quarter.
While publicly traded companies, which generally have lower leverage than private companies, have benefitted from multiple expansion, private equity-owned business valuations continue to face downward pressure from high-interest rates as investors attempt to offset elevated acquisition financing costs against sustainable leverage and internal return hurdles. The average EBITDA multiple of new buyout transactions that closed in the second half of 2023 was 11.8x (for transactions tracked in Lincoln International’s proprietary private market database), which remains a far cry from the peak average multiple of 13.4x which occurred in Q4 2021.
Leveraged buyout (LBO) volumes in 2023 were depressed as sellers and buyers remained locked in a tug-of-war. Sellers remain reluctant to part with their investments at lower valuations than those seen at the height of the market in 2021 and early 2022, and buyers have held out for investment opportunities that reconcile their return requirements with the burden of high financing costs. In the absence of larger platform acquisitions, dealmakers are instead focusing their efforts on add-on acquisitions, which represented 35% of all transactions observed by Lincoln in the second half of 2023, an increase from 21% at the end of 2021.
While Revenue Growth Moderated, EBITDA Growth Persevered
For the fourth consecutive quarter, revenue growth declined slightly for private companies tracked in Lincoln's database, although roughly 70% of all companies experienced revenue growth, approximating the three-year trailing average. Margins, however, have held up despite pressure on the top line. EBITDA growth for the same group was 4.8% year-over-year in the fourth quarter, compared to 4.2% in the third quarter. While revenue growth in the aggregate has slowed, portfolio companies are stemming the tide by cutting costs and focusing on strengthening profitability. In the fourth quarter, revenue growth exceeded EBITDA growth by 3.0%, the slimmest gap since 2021, as companies found creative ways to keep EBITDA afloat while addressing contracting demand.
“Revenue growth has declined, but interestingly EBITDA growth has been strong as businesses took measures to protect and even grow their profitability,” said Steve Kaplan, Neubauer Distinguished Service Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business, who assists and advises Lincoln on the LPMI. “Businesses were able to stave off numerous headwinds since the beginning of 2023, and the resiliency they exhibited is evidenced by the LPMI’s growth despite multiple contraction in the private markets.”
Competition in Private Credit Kicks Up
The Lincoln Senior Debt Index (LSDI) ended the year flat from the third quarter at an average fair value of 97.9% and was modestly elevated from 96.3% at the end of 2022. Interestingly the index’s stable median loan-to-value (LTV) of approximately 40% since 2021 contrasted with the index’s increase in yield from 8.0% to 11.4% over the same period, which might suggest lenders are getting a higher return for the same level of risk thanks to rising reference rates. Investors, however, are taking these higher returns with a grain of salt as they attempt to balance higher returns with slimmer-than-ever portfolio company fixed charge coverage. At the end of 2023, the constituent population’s weighted-average fixed charge coverage ratio was 1.07x, which has crumbled from 1.57x at the end of 2021.
Between the third and the fourth quarter, Lincoln observed approximately 25 basis points (bps) of tightening in unitranche credit facilities, while competition also manifested itself through tighter original issue discount requirements and looser covenants. Whereas in the third quarter, spread tightening was mostly observed for transactions involving businesses with greater than $40.0 million of EBITDA, tighter spreads seeped into transactions for smaller businesses in the fourth quarter. As the broadly syndicated loan (BSL) market, which generally offers lower-yielding loans than private credit, starts to open, stiff competition has surfaced as larger lenders are forced to hunt for smaller, higher-yielding credits to deploy capital.
“Competition has increased, and lenders are being forced to sharpen their pencils,” said Ron Kahn, Managing Director and co-head of Lincoln’s Valuations & Opinions Group. “But with so few high-quality assets and the re-opening of the BSL market, where lenders deploy the plethora of capital they have at their disposal remains the biggest challenge.
“While default rates remain relatively low at 3.4%, fixed charge coverage remains slim and there is an expectation for more defaults and stress on the system,” Kahn continued. “To properly assess where the credit markets are today, you need to look at fixed charge coverage relative to LTV and returns.”
While cash flow and cash interest remain paramount, borrowers and lenders agreed to forego cash interest in lieu of paid-in-kind (PIK) interest at a higher clip in the fourth quarter, as approximately 10% of new private credit issuances in 2023 included a PIK component, nearly doubled from the end of 2021. PIK interest can often have a negative connotation, and is sometimes viewed as indicative of borrowers being unable to service cash interest; however, the reasons for using PIK interest are more nuanced. Lenders are now offering PIK interest as a competitive edge in the pricing process, emblematic of broader pricing competition in the market. As lenders get ready to duel for deals, one of the tools in their arsenal includes offering prospective issuers a portion of their interest in PIK.
Incremental Facility Pricing Tightens in the Fourth Quarter
Private lenders thrive on a strong LBO market, and the decline in buyout volume has hampered private credit’s fastball to an extent, but add-on acquisitions have remained robust. As incumbent lenders offer financing for these add-ons, market competition is beginning to manifest itself as incremental facilities are issued at lower pricing, deeper in the capital structure. In the fourth quarter, Lincoln observed an increase in incremental senior and unitranche issuances to existing structures, and pricing was approximately 50 bps lower than the existing facility, on average.
Investors Eye Prospective Deal Resurgence in Second Half of 2024
The prospect of higher levels of mergers and acquisitions activity in 2024 may hinge upon the future of interest rates. Managing debt service costs while investing in future growth has been top of mind for portfolio companies and will continue to be a focal point for businesses in 2024 as rates remain elevated. The recent hint of rate cuts indicates that lower cost of debt could be on the horizon, but lenders remain skeptical that the downward-sloping yield curve declines observed in 2023 will be realized. Underwriting professionals have not been considering expected declines in the curve and have continued to assume higher interest rates in their models.
Based on a recent survey of more than 100 private market professionals conducted by Lincoln International, over 84% of survey respondents are anticipating transaction volume to tick up by the end of 2024, with more than half indicating a realignment between buyer and seller valuation expectations will drive deal flow. Conversely, 78% of respondents believed that covenant default rates would increase in 2024. While lenders, sponsors and businesses will need to grapple with more adversity, many left 2023 with newfound optimism.
“Amidst a sluggish deal environment in 2023, private companies demonstrated resiliency,” noted Kahn. “With performance holding up, the biggest hurdle to surmount in 2024 for ramped-up dealmaking will be the alignment of buyer and seller expectations. Limited partners expect a return on their capital, and general partners need to deploy capital.”
About the Lincoln Private Market Index & Lincoln Senior Debt Index
The LPMI is the only index that tracks changes in the enterprise value of U.S. privately held companies—primarily those owned by PE firms. With the LPMI, private equity (PE) firms and other investors can benchmark private companies’ performance against their peers and the public markets.
This index is differentiated from other indices as it (1) tracks enterprise values of private companies over time, (2) is based on valuations rather than executive surveys and (3) covers a wide sampling of companies across a range of PE firms’ portfolios.
The LPMI seeks to measure the variation in private companies’ enterprise values by analyzing the aggregate change in company earnings as well as the prevailing market multiples for approximately 1,500 private companies of the more than 5,000, the firm values quarterly. The index is calculated using anonymized data on an aggregated basis by Lincoln’s Valuations & Opinions Group, which has distinctive insights into the financial performance of thousands of portfolio investments of financial sponsors, business development companies and private debt funds.
The methodology was determined by Lincoln in collaboration with Professors Steven Kaplan and Michael Minnis of the University of Chicago Booth School of Business. While other indices track changes to a company’s revenue or earnings, the LPMI is different in that it tracks the total value of these companies. Significantly, the large number of private companies used to create the LPMI helps ensure that the confidentiality of all company-specific information used in the index is maintained.
Further, in 2020, Lincoln launched the LSDI which provides insight into the direct lending market as a fair value index tracking the total return, price, spread and yield to maturity of direct lending securities. The index is developed using much of the same data as the LPMI and the methodology was determined by Lincoln in collaboration with Professor Pietro Veronesi of the University of Chicago Booth School of Business.
Important Disclosure
The Lincoln Private Market Index is an informational indicator only and does not constitute investment advice or an offer to sell or a solicitation to buy any security. It is not possible to directly invest in the Lincoln Private Market Index. Some of the statements above contain opinions based upon certain assumptions regarding the data used to create the Lincoln Private Market Index, and these opinions and assumptions may prove incorrect. Actual results could vary materially from those implied or expressed in such statements for any reason. The Lincoln Private Market Index has been created on the basis of information provided by third-party sources that are believed to be reliable, but Lincoln International has not conducted an independent verification of such information. Lincoln International makes no warranty or representation as to the accuracy or completeness of such third-party information.
About Lincoln International
We are trusted investment banking advisors to business owners and senior executives of leading private equity firms and their portfolio companies and to public and privately held companies around the world. Our services include mergers and acquisitions advisory, private funds and capital markets advisory, and valuations and fairness opinions. As one tightly integrated team of more than 950 professionals in more than 20 offices in 15 countries, we offer an unobstructed perspective on the global private capital markets, backed by superb execution and a deep commitment to client success. With extensive industry knowledge and relationships, timely market intelligence and strategic insights, we forge deep, productive client relationships that endure for decades. Connect with us to learn more at www.lincolninternational.com.
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