Goldman Sachs’ chief credit strategist anticipates a return to the leveraged buyout in 2024.
Lotfi Karoui said the record amounts of dry powder paired with more deals financed with equity and cash will stimulate a return to a traditional LBO structure. At this inflection point in transaction financing, Karoui expects PE investors to target cash-generating businesses, improve operations during the holding period and flip them in a series of exits—the textbook buyout.
Still, these transactions may look slightly different than the behemoth debt-heavy transactions more typical of the PE game. Instead, the perpetuating high cost of leverage means that deals will likely be structured with less debt, Karoui said.
“We’re coming back to what an LBO has always been about, which is, you take a mature business, you make sure it’s efficient and then you IPO it after five-to-seven years,” he said.
Karoui sat down with PitchBook to discuss the outlook for the private credit market, its impact on deal flow in the coming months and his expectations about the future of the asset class. The following interview has been edited for length and clarity.
PitchBook: With higher-for-longer funding costs and financial distress in the broader market, how will private markets fare vs. public debt markets over the next few years?
Karoui: I’ll make a macro point first. Everything that’s happened the last five or six weeks seems to suggest that 2024 is shaping up as another year of elevated cost of capital. You’re not getting any funding relief for the next four quarters at least, maybe longer. This means that the ability of companies across the board to offset those elevated funding costs via strong earnings growth is going to remain greatly constrained.
Basically, you have a 5 ½-point increase in interest expenses over a very short period of time, and that—combined with what we know is a very sluggish earnings growth environment—means there’s no question that the higher-for-longer cost of capital environment is going to test the asset class in a way that the COVID-19 crisis did not.
But it still seems like there’s a lot of interest in private debt from institutional investors. What is attractive to them about the asset class?
Totally, I mean it’s pretty interesting. The narrative two years ago was that you had a decade or so of very depressed levels on the public side and that basically forced a lot of investors to seek alternatives and get better yields. Private credit offered that.
Over the last few years, we saw two things: One, public yields have reset to historically high levels. Yields are attractive today. Two, the extra premium you’re getting in the private debt markets vs. the public markets has also compressed quite dramatically.
And yet, as you said, the appetite is still there, so there’s something else that’s driving it. We think that investors need the ability of private credit to deliver better risk-adjusted returns or smooth returns relative to public markets.
And that makes sense when you look at the ownership structure of the private debt markets, like who’s the end user? Who’s on the other side? Typically, it’s insurance companies, pension plans, foundations, family offices—basically buy-and-hold investors that, in some ways, don’t need the liquidity of the public markets because they buy and then hold it until it matures.
The private debt market has grown exponentially over the past few years (exceeding $1.5 trillion in 2022 with $434.4 billion in dry powder, according to PitchBook data). Do you expect this dry powder to be deployed next year, perhaps through LBOs and M&A?
Since Q2 2023, there’s been broader acceptance that the [Federal Reserve] will be able to engineer a soft landing, so that should bring back confidence into the boardrooms, and you should expect to see some recovery on the M&A front. On the LBO front, you should get a little bit of recovery, but it won’t be spectacular.
Still, we are at an inflection point in terms of strategic and sponsor activity. The financing structures will, however, look different, because the cost of leverage is higher, the cost of capital is higher, so deals will likely involve more equity, more cash and less debt.
The business models, I think, will also look different. We’ll see traditional cash-flow rich businesses being PE targets, as opposed to some of the growth-y stuff in biotech or tech.
Private debt fundraising is tracking well ahead of last year and is likely to exceed $200 billion for the fourth consecutive year, now second only to PE. Do you expect this momentum to continue?
It’s reflective of strong investor appetite. I also think it’s interesting to draw the contrast between fundraising activity on the PE side, because you’re not seeing this. There’s definitely more appetite for private debt than PE. Part of it on the PE side is because the IPO market has been closed for over a year. It’s coming back gradually, but you had a year and a half with very muted activity and therefore limited assets for PE.
There’s no analogue to that on the debt side. Stuff matures, basically. And then you replace it with new debt.
Any concerns of a bubble with this rapid growth?
You always have to be concerned about that, whether growth is happening too quickly. And if that’s the case, then if you’re going to see capital getting misallocated. In this case, I’m not seeing it. The fact that there’s so much dry powder means that GPs are being conservative and only going after the opportunities that make sense. So we’re not there yet, but it’s a risk I will keep my eye on.
The other concern we hear all the time is, is this a sort of shadow banking? It’s been a natural substitution away from traditional bank lending into this disintermediated model. Are we supposed to look at that as shadow banking and as a potential threat to financial stability?
Some asset managers may face financial distress because the cost of leverage is higher and because they face margin calls. We can never rule that out. But I think the risks for the broader financial system should be manageable. In my opinion, the analogy to the global financial crisis is misguided.
I do think the ability of asset managers to deal with financial distress is just better; they have more flexibility than on the public side. But we’ll see.
Featured image of Goldman Sachs’ New York headquarters by JayLazarin/Getty Images
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