Private equity investors are holding off on big ticket leveraged buyouts until debt becomes affordable again. In the meantime, add-on strategies provide some relief.
Tasked with a challenging exit environment and a dwindling supply of affordable debt financing, PE managers are turning to add-ons, which are smaller-sized target acquisitions made through existing portfolio companies, to meet capital deployment mandates and keep portfolio company multiples afloat. In 2022, add-ons comprised 77% of US PE deals, an approximate jump of 3 percentage points from 2021, according to PitchBook data.
But it won’t last forever: The use of add-on deals is highly dependent on the market environment.
“When you’re in good economic times, organic growth is usually the preferred growth of the business over add-ons, but as things slow down, you kind of go back to the add-ons,” said Lee Gardella, head of PE in North America at Schroders Capital.
PE players are holding off on major deals. According to PitchBook’s Q1 2023 US PE Breakdown, the total PE deal count in Q4 2022 dropped to nearly half of what it was a year prior, and the average deal size shrank—a product of the IPO drought, misalignment between buyers and sellers and a dwindling supply of affordable leverage.
“Private equity funds are more reluctant to do platform deals when they feel they might need to overpay and it’s going to cost them more to do it,” said Matthew Simpson, co-chair of the PE practice at Mintz, a law firm that specializes in middle-market PE transactions. “That means they’ve turned inward.”
When the IPO market shut down last year, large firms lost access to their most profitable exit avenue, and by Q3, the largest PE funds in the world—those with over $1 billion—saw the weakest performance with a rolling one-year horizon IRR of 3.4%, according to PitchBook’s 2022 Global Fund Performance Report. Meanwhile, funds under $250 million generated an IRR of 12.7%.
In May, the Federal Reserve raised its key interest rate by a quarter of a percentage point, marking its 10th consecutive rate hike since the inception of its tightening policy in March 2022. Elevated interest rates leading to higher borrowing costs coupled with a series of regional bank collapses resulted in a dwindling supply of inexpensive debt for PE firms to use to finance deals.
Add-ons are a useful mechanism for GPs during tumultuous market environments because they add additional revenue and EBITDA—known as EBITDA expansion—to existing portfolio companies.
Last year, add-on deals reached historic levels. In 2022, the total global PE add-on deal value was $759.6 billion. That was a slight decrease from 2021’s outlying outperformance across all areas, but otherwise, it’s the highest mark over the past decade, PitchBook data shows.
In a typical add-on, a PE firm acquires a smaller company at a lower valuation and folds it into one of its portfolio companies. This immediately expands the primary portfolio company’s multiples. It can also offset some interest rate costs to portfolio companies.
For example, the largest PE add-ons in 2022 included KKR‘s $1.1 billion acquisition of drug delivery company MedAlliance, British Columbia Investment Management’s $1.1 billion agtech buyout of Gavilion and Saudi Arabian PIF’s $1 billion LBO of ESL FaceIt Group—all relatively small acquisitions for the massive asset managers with hundreds of billions of dollars in AUM.
“People are realizing that they have these platforms, and they need to juice EBITDA. They need to grow it,” Simpson said. “We’re just not seeing businesses grow at the same pace organically, and so a natural opportunity for a lot of these funds is to go out and target inorganic growth.”
Add-ons in a disrupted market
On the flip side, managers tend to shy away from strategies that deal in riskier assets—including add-ons—when there is a market disruption, like the collapse of Silicon Valley Bank.
Nicholas Tsafos, partner at accounting firm EisnerAmper, said that while he still sees acquisitive PE firms tacking on ever-smaller lower-middle-market assets, he’s also seen a slowdown in deals in this size bracket among clients.
“Since February and March of 2023, I have not heard of any deals in the lower-middle-market space being done with my clients,” Tsafos said.
Tsafos chalks the slowdown up to the rising cost of credit. Add-ons are typically touted for their low financing cost: An acquisition of a small company requires less debt than a large one. But Tsafos said in the high interest rate environment, credit alternatives like private credit are still too costly to managers.
Tsafos’ observation may also be a product of cautious sentiment following the collapse of Silicon Valley Bank and the regional banking crisis in the months after. The specter of an impending recession could be contributing to hesitancy in smaller acquisitions.
“The threat of a recession has been out there and it feels like it’s getting close, so you have to really be confident in the business that you’re buying—that it doesn’t add more problems in the near term,” Gardella said.
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