Good businesses are exiting well — essentially the top 25 percent of companies in a private equity portfolio. But the bigger challenge, according to Lead Capital Partners Managing Partner Pryor Smartt, is for the remaining 75 percent of the portfolio, largely because of higher interest rates.
“It creates a lot of pressure on the business,” Smartt said at the Nashville Smart Business Dealmakers Conference. “And it just is slowing down the process for private equity firms to sell businesses — just the math gets a lot harder for them.”
Because interest rates are rising and valuations are coming down, he says private equity groups are electing to continue to operate the business to try to get earnings higher and drive the valuation they need at sale. But that, he says, is going to take a little bit more time.
“And so you're just seeing hold periods rise pretty substantially,” he says. “I think the latest number I saw was the 2023 private equity exit, the hold period was up to 6.4 years. Pre-COVID I think that number was under five. And so people are just having to grind a little bit more to generate the returns on the private equity side before they go exit.”
He says companies with an aggressive M&A strategy would go out and make a bunch of acquisitions when the cost of the debt was low. And now that it’s comparatively much higher, it creates a lot of hard math, leading to situations where the company is not in default, but they don't have money to pay the interest. That has contributed to slower processes.
“The good companies with great performance, those are doing well,” Smartt says. “But a lot of these different businesses, people are really having to roll up their sleeves and operate. And it's really hard to operate right now, with this labor environment, and with inflation and labor, and it's just put a lot of margin pressure. So, a lot of the assumptions that went into underwriting these deals in the last two to five years, the inputs have really changed. And so it's going to be really interesting to see what happens. That's why deal flow has slowed down materially, but people are really having to roll up their sleeves and operate really, really, really, really aggressively.”
Further complicating the matter, he says LPs have seen the pace of cash coming back to them slow down, so they're increasingly wanting to get cash back, which is creating an interesting dynamic.
“The PE firms aren't really ready to exit because of all these different dynamics — the inputs have changed, they've got to work through that,” he says. “And yet, the investors are ready for their cash to come back. So, it's an interesting time.”
Because private equity portfolios are struggling more than they were years ago and banks’ underwriting has become more restrictive, the investment underwriting from the buyer side is a lot more stringent than it was over the past two or three years. Comparatively, when underwriting criteria was getting loose during the period of easy money, it led to what he saw as kind of crazy deals. But that's changed. Those brining a company to market right now better be prepared with performance projections that are super tight, because buyers are going to poke holes in those plans much more than they had a few years back.
“People are going to peel the onion back and they're going to really know what's real and what's not real,” Smartt says. “And we certainly have seen that in a couple of exits that we've had. You can't just throw some numbers out there. They've got to be well thought out. They've got to be really backed up. And you got to get ready for that punch that's coming from the other side to really kind of say, ‘Well, no, this isn't going up here.’ And you got to say, ‘Yes, it is and this is why.’ It's got to be real and you've got to really stand behind it. And then having reasonable expectation as to what valuation would be given all that, and given this environment. You've got to be realistic and you've got to be able to really stand behind your investment and really support it. Underwriting standards are much more stringent today than they were in previous years.”
