Optimism and the new normal in valuations

Things are looking up for valuations, after a tough period of adjustment to higher interest rates, increased costs and a stifled deal market.

With the Fed signaling a drop in interest rates in the second half of the year should inflation numbers keep trending down, managers eager to deploy dry powder and to sell assets they have held beyond their target dates, and things looking brighter for the IPO market, the gloomy conditions underlying the industry since around March 2022 may be coming to an end.

“I think part of the optimism heading into the Q2 is that everyone simply can’t wait for the drought of deal activity we saw last year to be over,” says Peter Tang, CFO of Butterfly Equity.

“I do think that if the Fed does start cutting rates in 2024, that will have an immediate impact that’s going to further fuel this optimism and things opening back up.”

Stable, but yet to recover

Tang notes that private equity valuations recently have not, and are not expected to, come down significantly on the back of higher interest rates, simply because assets generally were not overvalued to begin with.

“Valuations haven’t really been as sensitive to interest rate changes as the broader market has been, simply because private equity valuations consider a lot of different factors, not just the interest rate,” he says, adding that private markets valuations tend to be more rational than public market assets.

“Everyone simply can’t wait for the drought of deal activity we saw last year to be over”

Peter Tang
Butterfly Equity

Of course, higher interest rates mean higher borrowing costs and debt interest expense, which does suppress equity values, says Nick Tsafos, a partner at EisnerAmper. But it has been small- and mid-market PE firms’ assets that have been most impacted, since smaller companies spend more of their limited cash to fund their debt when rates are high. That leaves them unable to invest in technologies or make capital improvements that would make the company more efficient, and more valuable.

And higher interest rates also mean buyers want more for their money, adds David Acharya, managing partner at Acharya Capital Partners. “The higher interest rates that we’ve seen means it will cost more to fund acquisitions, so to get the returns that managers and investors want, valuations will have to be compressed.”

All that has caused more PE managers to stay on the sidelines as they adjust and wait for a more stable environment, says Tom Angell, a partner and practice leader of Withum’s Financial Services Group.

“Private equity funds are holding on to their assets a little longer. They’re not out buying unless they can find something they think is reasonable, because with higher interest rates, your cost of equity goes up, and that means you need a better return on the asset you’re going to purchase. And, right now, buyers and sellers have different views of the market and deal activity is down,” he says.

Lower deal volume

US private equity deal volume in 2023 was down 27 percent from the peak activity seen in 2021, and down 19 percent versus 2022, according to the EY-Parthenon Deal Barometer.

But activity is starting to tick upward, in part due to anticipated Fed rate cuts in the second half of the year and a desire to put capital to work.

“Everyone has been waiting for prices to be more reasonable,” says Angell. “But the lower deal volume won’t last much longer. PE managers and investors want returns and there’s a lot of dry powder sitting there that hasn’t been spent. You’re starting to see some larger scale M&A activity, the IPO market is starting to open up a bit.

“People have been a bit gun shy waiting for things to stabilize and normalize but that won’t last much longer.”

“The lower deal volume won’t last much longer”

Tom Angell
Withum

Tsafos points out: “The private equity industry, I think, is very positive looking ahead.”

The combination of lower potential interest rates, continued recovery from supply chain issues resulting from the covid pandemic, and improved operational efficiencies made to portfolio companies all contribute to a bright outlook for the next 12-18 months.

Rates not the only risk

Geopolitical and environmental threats can also impact valuations, of course. After rebounding from covid supply chain disruptions, recent Houthi rebel attacks on vessels navigating the Red Sea – a vital shipping passageway – present a threat to further disruptions.

Environmental concerns, such as wildfires in Texas, California and Hawaii, can present threats.

Tsafos says valuation experts need to reflect upon the whole environment when determining values.

“Just looking at the current interest rates, infrastructure spending and other global risks, you have to consider whether your initial investment thesis is still warranted or if the valuation has been impacted. If the environment has changed how your business can operate, then you have to make changes to your valuation model to take all of that into consideration,” Tsafos explains.

Acharya says he takes all risks into consideration when determining valuations.

“I’m thinking about how those risks are going to start affecting the total valuation. When you look at different conflicts overseas, many of our products and services come from elsewhere, so that factor has to be taken into consideration in your valuations because you cannot view one company and one country in isolation.

“You have to think about specific company risk and market risk, and right now things have changed, multiples have been compressed, so your assumptions have to reflect that.”

Tang agrees, and adds that any changes in valuation assumptions will depend on the company, its location and its industry. Some business may be more impacted by geopolitical risks, disruptions in the supply chain or the results of the US presidential election, but these things must be taken into consideration along with financial factors.

But current market challenges shouldn’t change established valuation methodologies.

“Assumptions will fluctuate based on what’s going on in the market and what’s happening with our companies,” Tang says.

“Just looking at a company’s cashflow forecast and looking at the multiple of the most comparable public companies and transactions, those have changed recently since cost of capital is higher and deal volume is down.

“We haven’t seen a change in the methodology, but we’re certainly seeing the impact of changing variables, with interest rates and less deal activity being among the most sensitive.”