Privately held U.S. companies in the middle market saw their enterprise values increase by a smaller amount in the third quarter as lower earnings multiples partially offset earnings growth.
The Lincoln Private Market Index, a measure of private company enterprise values (EV), increased by 0.8% last quarter, down from a 2.3% increase in the second quarter and a 1.7% increase in the third.
The growth of earnings before interest taxes and depreciation and amortization (EBITDA) for the roughly 4,500 companies tracked— almost all private-equity owned — remained relatively stable in the third quarter at 2.7%. But slowing revenue growth and higher interest rates on debt mean these companies don’t warrant as high an earnings multiple.
Multiples for leverage buyout transactions that closed in the last two quarters have fallen 1.5 times since the beginning of 2023, said Lincoln International. Even higher-multiple industries such as healthcare and technology, media, and communications have been dragged down. Prevailing multiples for all the companies in the PMI fell 1.9%.
“The third quarter painted a picture of the resilience of the private markets,” said Ron Kahn, managing director and co-head of Lincoln’s valuations & opinions group. “Over the last year, many predicted a decrease in enterprise value multiples, but it is only now that we are seeing that decrease in valuations for deals getting done.”
According to the report accompanying the Lincoln PMI data, “The lower multiples may reflect, among other factors, [private equity] buyers’ need to lower valuations to offset higher interest costs and lower debt capacity to still meet their targeted returns.”
Thinner Coverage Ratios
The high debt service costs “are plaguing portfolio companies,” according to Lincoln International.
Sponsors and businesses are trying to increase cash flow coverage by strengthening EBITDA and “peeling away capital expenditures, which have fallen by approximately 6% since the beginning of 2023."
Lincoln International, Private Market Index Q3
The fixed charge coverage ratio of the private market companies— a measure of how well a company can pay its interest expense and debt payments out of earnings — declined to an average of 1.10 times in the third quarter, compared with 1.13 times in the second quarter. (A larger fixed charge cover ratio is better.)
Sponsors and businesses are trying to increase cash flow coverage by strengthening EBITDA and “peeling away capital expenditures, which have fallen by approximately 6% since the beginning of 2023,” said Lincoln.
But covenant default rates declined last quarter — to 3.9% from 4.2% in the second quarter.
Higher default rates were prevented by lenders and borrowers proactively working through impending covenant defaults, said the investment bank. Lincoln International recorded 675 loan covenant amendments in the first nine months of 2023 —about 15% of the companies PMI tracks. A significant number of the amendments included coupon increases coupled with equity infusions from the sponsor.
Most amendments in the third quarter were executed for deals that originated in or before 2021, said Lincoln. “These transactions were printed while market conditions allowed lower equity cushions,” the Lincoln report noted. “Liquidity and cash flow challenges are now hitting these [2021 vintage] businesses the hardest,” Lincoln added, as many required multiple adjustments to loan covenants over the year.
Enterprise Value Disparity
The lower revenue growth that the private companies posted in the third quarter, the first single-digit growth rate since the fourth quarter of 2021, could cause problems if it’s the beginning of a trend.
“Should slowing demand persist, private company enterprise values could start to see a decline,” according to Lincoln’s report.
Smaller companies tracked by Lincoln (those with less than $20 million in EBITDA) have already seen their enterprise values drop — 1.4% in the third quarter. Their multiples contracted more than large companies ($50 million to $250 million in EBITDA), which saw their enterprise values increase by 1.3%.
“This disparity is likely a result of an increased likelihood of customer concentration, difficulties in passing along rising costs, and less product/service offering diversification” at smaller companies, according to Lincoln.
Every quarter, Lincoln International measures the enterprise fair value of over 4,500 portfolio companies for over 140 sponsors (i.e., private equity groups and lenders to private equity groups). These portfolio companies report quarterly financial results to the sponsor or lender.