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Leveraged Loans

European private equity funds shift to value investing to counter volatility

The euphoria experienced by Europe’s private equity markets over recent years may be wearing off, as players facing a multitude of challenges are forced to downsize their ambitions amid falling LBO deal volume.

Europe’s private equity funds have largely been able to stay committed over the past few years amid volatile markets, but having faced the pandemic, geopolitical crises including war in Europe, rising inflation and interest rates, a lack of available financing and now turbulence in the banking sector, funds may be forced to downsize their ambitions.

When interest rates were low, it was easier to pursue a growth strategy, but now PE funds must be more concentrated on creating value from their existing portfolios. Many deals are now add-ons, rather than new acquisitions, and deal-making is approached with added caution, sources say.

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Volume dial
European LBO transaction volume dropped significantly in 2022, to €38.1 billion from a chunky €96 billion in 2021, according to LCD. The LTM (to Feb. 28) figure is €23.2 billion, which — while quite low — represents 61% of the total transaction volume in full-year 2022, and could suggest some recovery for the rest of this year.

But deal volume is likely to be muted for some time yet. “There is not much going on in the pipeline, and I don’t think the economic backdrop is the main reason for this,” one M&A banker explained.

So, why is the pipeline looking so thin? First, it is difficult to find financing, especially in the capital markets. Supply chain restrictions have limited some sectors. These factors impact M&A activity in general, and not just LBOs. That said, the deal boom of the past few years allowed private equity to put money to work and portfolios at most funds are relatively young, the same banker said.

After buying assets backed by high leverage, PE funds are concentrating on smaller buy-and-builds in an attempt to create to “sector champions” stemming from that first “expensive” company. “From the first brick, then they build a house” in one particular sector and consolidate a fragmented market, one lender explained. “There have been a lot of those deals, for example in the dental, veterinary and building-management sectors.”

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Source code
Drilling into sources of proceeds for European LBOs, for the LTM to the end of February senior debt accounted for 36.5% of the European LBO total, according to LCD, while high-yield bonds took a 9.9% slice, second lien 12.5% and equity 38.6%. These figures illustrate how sponsors are increasingly drawing on equity to support deals: “We see PE funds getting more and more involved with equity as they want to make the investments work and participate in any cashflow requirement they have,” one private debt lender said.

The share of total equity for the LTM to Feb. 28 is 42.2%, which is roughly in line with the full-year 2022 reading of 43.7%. On average, between 2013 and 2022, the total equity contribution was 45.7%.

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Common denominator
Meanwhile, fundraising activity has slowed. Private equity buyout fundraising had been rising since 2010, according to PitchBook Data, reaching a peak in 2017 at €92.1 billion raised for 174 funds. The 2021 totals were €89 billion for 142 funds, and in 2022 they fell to €40.6 billion for 65 funds, reflecting caution among LPs.

Sponsor exits are decreasing due to macro headwinds, impacting distributions to LPs, which will in turn reduce the amount of money recycled into future commitments.

In addition, given the economic backdrop there is a fear of the so-called “denominator effect,” which occurs when the value of one portion of a portfolio falls drastically, pulling down the overall value.

According to PitchBook Data, the cumulative private equity buyout dry powder total for 2022 is €259.5 billion. The dry powder is still very strong as a result of the healthier fundraising processes until recently, but there are fewer opportunities — mostly because of the challenging macroeconomic and geopolitical situation.

In 2022 the average purchase price multiple for European LBOs was 10.66x, while the average multiple for the previous five years is 11.19x. For the LTM to Feb. 28, the same measure stands at 10.09x.

Given the economic turmoil in play it does not come as a surprise that enterprise-value multiples have decreased, as PE funds are less willing to fork out crazy amounts to beat the market, while amid difficult financing conditions and scarcer funding, more transactions need to rely on direct-lending financing routes, and unitranches in particular. Unitranche providers — although known for their flexibility — are also putting a brake on high leverage, which has an inevitable impact on LBO valuation capacity.

Though only a snapshot of the first two months of this year, LCD’s industry diversification data shows the previously most favored sectors — namely healthcare and computers & electronics — no longer top the chart for European sponsored loan volume. Services & leasing leads with a 26.8% share of the total, while food & beverage comes second with 16.5%. Computers & electronics is third with a 12.6% slice, while healthcare languishes in tenth position with just 1.4%.

The collapse of Silicon Valley Bank is expected to put further pressure on the technology industry, as the bank specialized in high-growth start-ups and technology companies. Indeed, this is a sector that PE funds and lenders alike grew extremely fond of in recent years, attracted by strong recurring revenue and low capex. While SVB was a lender and venture capital provider to technology start-ups, it seems those companies that made perfect “buy and build” targets are now potentially incapacitated.

Geography lessons
As for sponsored loan volume by geography, the UK is no longer at the top of this table — largely due to weak economic performance over the past few years, coupled with inflation woes and fears of an impending recession. It is also the only country among the G7 economies that is yet to fully recover its lost output during the Covid-19 pandemic.

But with the country so far narrowly avoiding recession and showing signs of growth — albeit at just 0.3% in January, according to data from the Office for National Statistics — the UK is expected to bounce back, investors say. “There is no doubt that the UK has significant structural headwinds from the macro standpoint,” said Ross Morrison, partner at Adams Street, who focuses on the primary portfolio within the UK, Nordic Region, and France.

“The reality is that deal volumes are down significantly — by around 30-40% compared to 2021, which saw record deals,” Morrison added, while still noting that the UK is the most attractive buy in Europe right now for a pan-European investor. “What you have now are professional businesses at arguably discounted prices, so the UK not being hot creates an attractive buy opportunity,” he concludes.

Featured image by alexkich/Shutterstock

  • Francesca Ficai
    Written by Francesca Ficai
    Francesca Ficai is a managing editor overseeing private credit in Europe. She joined LCD in January 2020 after working for Debtwire and Mergermarket. She started her career in policy, working for the European Commission and the House of Parliament, and is fluent in four languages.
  • nishant.jpg
    Written by Nishant Sharma
    Nishant reports on the European private credit market for LCD in London. He joined from With Intelligence, where he covered private equity, focusing on the EMEA and US regions. Prior to that, he was with Bloomberg’s erstwhile India partner BloombergQuint, now BQ Prime, as a special correspondent covering the mobility sector and startups/tech in the venture capital ecosystem.
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