Despite higher interest rates and subdued private equity deal activity, the enterprise values of private-equity-owned companies increased in the first quarter of 2023, according to global investment bank Lincoln International. 

Lincoln’s tracking of quarterly changes in the enterprise values of 825 private companies found valuations rose 1.5% in the first quarter after rising 1.6% in the final quarter of 2022. Last quarter’s rise was driven mainly by modest improvements in EBITDA performance, according to Lincoln's Private Market Index report. Multiples contracted by a negligible amount.

“The fundamentals — despite everybody's thinking that things were going to deteriorate — have continued to do fairly well,” said Ron Kahn, managing director and co-head of Lincoln's valuations and opinions group.

Private market multiples tend to be less volatile than those of publicly held companies because the market is not as subject to short-term fluctuations in money flows. But a lack of PE deal activity also has affected valuations.

Losing Leverage

Ron Kahn

Very few private equity investment deals are getting done this year. The culprit is the reduced ability of PE firms to leverage a company. Kahn said that higher interest rates and spreads (6%-6.5%) are the main causes. Nervous lenders are also pushing for a 50% equity requirement on new deals, up from 40%-45%.

The only deals getting done are [for] the best, most pristine companies — Ron Kahn, Lincoln International

At current rates, which usually consist of the secured overnight financing rate (SOFR) plus a spread, to earn an 18% return on a deal a private equity firm would need the purchase price to fall 15% to 20%, said Kahn.

Sellers reject those offer prices, and buyers will not take subpar investment returns, so deal-making is at a standstill.

“The only deals getting done are [for] the best, most pristine companies,” Kahn said. “And they’re still going for really good prices.”

Coverage Ratios

Higher interest rates also threaten the ability of portfolio companies to service interest payments and other fixed charges.

Among the group of companies Lincoln tracks, about one-fifth had a fixed-charge coverage ratio of less than 1x, signaling an inability to pay back current debt and interest. Surprisingly, overall the ratio did not change in the first quarter despite rising interest rates, “primarily due to reduced capital expenditures as companies reined in their spending,” said Lincoln's report.

A revival of PE investing depends on the Federal Reserve, said Kahn. Conventional wisdom says the forward SOFR curve will come down as the Fed starts reducing benchmark interest rates, alleviating the fixed charge coverage ratio issue. But it's not at all certain rate cuts are in the cards in 2023.

Default rates for PE-owned firms ticked slightly in the first quarter to 4.5%, said Lincoln, still well below the peak of 9.4% observed during the pandemic. (The Lincoln PMI was started in 2014.)

Bridge Layer

Companies that are over-leveraged and have trouble refinancing can be aided by PE firms interested in bridging the gap between debt and common equity. This bridge layer of capital is known as “structured equity.” The financing is usually done at a multiple on invested capital (MOIC), said Kahn, where the investor gets a minimum payback on their investment.

Private equity firms are “seizing on this opportunity and getting very nice rates of return,” said Kahn. “If you put money in and you're guaranteed to get two times your investment back before the common equity gets a penny — [assuming] you've done your homework and it's a good company — that's a very attractive [internal rate of return].”

The Lincoln Private Market Index measures quarterly changes in enterprise values based on data from 4,000 companies primarily owned by private equity firms.

To construct the index, Lincoln selects a subsection of the companies valued each quarter, including private companies each generating earnings before interest, taxes, depreciation, and amortization of less than $100 million. It excludes venture-stage businesses.