Lincoln Private Market Index Continued to Climb in the First Quarter on the Back of Steady Earnings Growth

May 2024

Despite solid portfolio company performance, buyout activity remains sluggish, but sponsors have deployed alternative strategies to distribute capital to investors

The Lincoln Private Market Index (LPMI), the only index that tracks changes in the enterprise value of U.S. privately held companies, increased by 1.4% during the first quarter of 2024, as the index climbed to yet another record high. For the 12th consecutive quarter, the index’s growth was primarily driven by positive financial performance rather than multiple expansion. Conversely, the S&P 500’s quarter-over-quarter enterprise value increase of 9.2%, or 7.8% excluding the “Magnificent Seven,” overshadowed the LPMI’s increase, but the S&P 500’s growth was largely multiple driven on the back of optimism of rate cuts throughout the remainder of 2024.

Along with the slowdown in buyout activity, for deals that closed in the first quarter, there was a modest decline in multiples from 11.6x in 2H 2023 to 11.4x in Q1 2024, which remained well below Q4 2021 levels of 13.2x. However, there is still an appetite for A+ companies with stable, high cash flow generation, which has led to competition among sponsors with ample dry powder to acquire such companies. Compounding this wealth of dry powder is the reopening of the broadly syndicated loan (BSL) market, which has led to less expensive financing sources relative to private credit, which dominated the limited buyout financing market in 2023. These two factors have led to outsized purchase price multiples for these A+ companies as sponsors look to add strong strategic fits to their portfolios amidst a dearth of attractive opportunities.

Despite a growing number of companies beginning to test the market, the number able to achieve closings remains small and sellers remain hesitant to part with their assets at what they believe to be discounted levels. All the while, limited partners (LPs) continue to press for returns of capital. To combat this, sellers have explored alternative ways to distribute capital back to investors including dividend recapitalizations, minority recapitalizations, continuation vehicles and NAV loans.

Despite the Scarcity in Private Company Buyouts, Private Company Growth Shows No Signs of Abating

The slowdown in buyout activity can be attributed to several factors, but underlying portfolio company performance is generally not one of them. For the fourth consecutive quarter, the percentage of companies achieving LTM EBITDA growth increased, with 63.0% of companies tracked by Lincoln demonstrating EBITDA growth in the first quarter. Year-over-year, LTM EBITDA growth of 5.6% in Q1 also represents a high watermark since Q2 2022. All of this is amid steady normalization of headline demand, as revenue growth has slowed every quarter since the fourth quarter of 2022; 67.5% of portfolio companies experienced year-over-year LTM revenue growth in the first quarter, down from market heights of 84.7% in 2022, but in line with the five-year average of 67.9%. The decrease in revenue growth relative to EBITDA is largely attributable to the cooling of inflation from elevated levels in 2022 when sales growth was largely attributed to increased prices across the economy.

“EBITDA growth is the highest it’s been in nearly two years, while revenue growth continues to normalize,” said Steve Kaplan, Neubauer Distinguished Service Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business, who assists and advises Lincoln on the LPMI. “The days of double-digit headline revenue growth appear to be behind us as inflation subsides, but EBITDA growth continues to be steady and the percentage of companies growing EBITDA was at the highest levels dating back to 2019. This also suggests that private equity-owned companies are weathering the storm from the large interest rate hikes.”

Private Market Conditions Call for Creativity

While portfolio company performance trends are encouraging, they have not led to a meaningful rebound in mergers and acquisitions (M&A) transaction activity. Meanwhile, LPs are becoming increasingly impatient to see capital distributions, particularly from older vintage funds. Two-thirds of private market participants surveyed by Lincoln International in Q1 2024 indicated an expectation that private company M&A activity would resume in the next six months. However, market participants have held this same belief for the last 18 months – hoping the next six months would be different than the last. While deal backlogs continue to be robust, through the first quarter of the year, closings continue to be delayed.

The two leading factors that market participants believe will spur M&A activity are reductions in interest rates (38% of participants) and valuation expectation alignment (37% of participants). These two factors are ultimately interrelated as elevated rates have led to pressures on valuations given the difficulty obtaining greater leverage, as levels over 6.5x of leverage that were ubiquitous in 2021 are almost entirely absent in today’s market. While at the beginning of 2024, it looked like rate reductions may be coming, recent posturing by the Fed has suggested the potential for a change in course and rates may continue to remain higher for longer. Should the rate environment improve and allow access to greater leverage, and buyers and sellers more closely align on valuations, the record backlog of deals could lead to a strong return of M&A activity.

In the interim, with rate uncertainty enduring, private equity professionals have resorted to alternative strategies to return capital to investors. Given the extended hold period of many portfolio companies, the focus for both sponsors and investors has often shifted from internal rate of return (IRR) to distributed to paid-in capital (DPI), which measures actual distributions to investors compared to paid-in-capital and is not necessarily limited to the full exit of a portfolio company.

The rate environment has not only hampered dealmaking mechanics but is simultaneously keeping private equity sponsors and private company management up at night, as they focus on reducing the cash interest burden their companies have faced over the last 18 months. Between the decrease in spread and increased competition within the BSL market, sponsors now have an opportunity to lower the interest burden by amending and extending loans at lower pricing or refinancing the existing loans. Even a 100 bps decrease in spread at current base rate levels could save businesses approximately 10% from of their current interest burdens.

On the flip side, lenders with dry powder have been accommodating by proactively amending and extending facilities with existing borrowers – effectively lowering the interest burden of portfolio companies, while maintaining stronger assets in lenders’ portfolios and even allowing dividend recapitalizations or partial distributions. For these refinancing transactions, Lincoln observed decreased spread levels of up to 50 bps.

“We are seeing outsized multiples being paid for A+ businesses, but for the rest of the portfolio company universe, selling at a discount to the going in multiple is not an attractive option since it results in a suboptimal IRR. As a result, general partners are in the difficult position of wanting to give investors the distributions they deserve, while preserving IRRs,” said Ron Kahn, Managing Director and co-head of Lincoln’s Valuations & Opinions Group. “So, creativity and alternative transaction solutions such as continuation vehicles, NAV loans and recapitalizations are the name of the game in returning capital until M&A activity fully rebounds.”

Reopening of BSL Market Puts Pressure on Private Credit

BSL market activity meaningfully dried up in 2023, while private credit issuances charged on and financed much of the buyout activity in 2023. However, as the calendar turned to 2024, the script flipped and BSL activity has charged back. BSL lenders have been able to pry away deals from direct lenders primarily through ~200 bps lower spreads relative to private credit loans, often with fewer covenant protections, making the loans more favorable to borrowers and their sponsors. This competition has led to direct lenders needing to reduce spreads on new issuances, albeit not to the levels that are offered in the BSL. More specifically, new issuance spreads on larger deals in Q1 2024 clocked in approximately 25-50 bps lower than Q4 2023. Additionally, original issue discounts (OID) have also tightened in the first quarter of 2024, coming in at an average of 98.5% on new deals compared to 98.0% for Q4 2023.

While this competition has led to tighter spreads as private credit strives to maintain market share, particularly on the upper end of the market, all-in yields remain well above historical averages primarily driven by the elevated rate environment, allowing direct lenders to continue delivering returns above historical averages. Notably, the Lincoln Senior Debt Index (LSDI) increased to 98.4% from 97.9% at the end of 2023 reflecting these trends. Additionally, the average yield of the LSDI in Q1 was 11.3%, which remains well above the historical average of 9.8%. Alongside this, default rates continued to tick down from 3.4% in Q4 2023 to 2.7% in Q1 2024.

Collaboration Between Sponsors and Lenders Remains a Key Differentiator

One advantage that direct lenders continue to hold over the BSL market is the benefit of stronger relationships in private credit deals. Whereas BSLs may have a large pool of lenders with different strategies, entry prices and return requirements, which often leads to differences of opinion particularly in times of stress, private credit deals are largely done amongst a small group of lenders who place a high degree of importance on their relationship with the sponsor. As we have witnessed acutely in the last 18 months, these relationships have led to proactive management of portfolio companies ahead of potential defaults and allowed for flexibility that is often not available in the BSL market.

A primary example of the benefit of these relationships comes in the form of preemptive amendments ahead of covenant defaults. Covenants are a key piece of the lender and sponsor relationship. While on its face a covenant default may seem a negative event, the presence of covenants leads to lenders and sponsors getting to the table before a situation worsens, as opposed to the largely covenant-lite or covenant-wide structures found in most BSLs. In the last 12 months, Lincoln observed amendments for 16% of all portfolio companies valued. Of those amendments in Q1 2024, 58% included pricing changes with a median increase of ~75 bps, and one-third included a sponsor infusion. Often accompanying those pricing increases is a paid-in-kind (PIK) interest component. While PIK interest is often viewed as a negative sign, it affords flexibility to a borrower that often cannot be achieved in the BSL market as such loans typically do not have a PIK component. These types of amendments are mutually beneficial as the lender receives a higher return and the borrower receives relief from reduced debt service requirements.

Despite the competitive nature of the market and decreased spreads, fixed charge coverage continues to be the threshold issue for obtaining debt capital. As of the first quarter, the average fixed charge coverage ratio for portfolio companies tracked by Lincoln was 1.04x, a significant decrease from 1.23x in the first quarter of 2023, on the heels of a full year of elevated base rates. The increased interest expense is siphoning funds that could have been used to grow portfolio companies or repay their debt.

“Even though there are a number of tailwinds, interest rates hold the key to a paradigm shift in the private markets,” said Kahn. “As a result of the higher cash interest paid by portfolio companies, their cash flow profiles have materially diminished. Take a $75.0 million EBITDA business with 6x leverage – all-in rates may have increased from 6.5% to 11% over the past two years. As a result, the company is now spending an additional $20 million, or 26% of EBITDA, each year in interest, and has less money for capital expenditures, funding growth initiatives and paying down principal. It all comes full circle – higher interest rates will continue to have a negative impact on a company’s cash flow resulting in reduced IRRs for sponsors.”

About the Lincoln Private Market Index & Lincoln Senior Debt Index

The LPMI is the only index that tracks changes in the enterprise value of U.S. privately held companies—primarily those owned by PE firms. With the LPMI, private equity firms and other investors can benchmark private companies’ performance against their peers and the public markets.

This index is differentiated from other indices as it (1) tracks enterprise values of private companies over time, (2) is based on valuations rather than executive surveys and (3) covers a wide sampling of companies across a range of PE firms’ portfolios.

The LPMI seeks to measure the variation in private companies’ enterprise values by analyzing the aggregate change in company earnings as well as the prevailing market multiples for approximately 1,400 private companies, each generating less than $250 million in annual earnings. The index is calculated using anonymized data on an aggregated basis by Lincoln’s Valuations & Opinions Group, which has distinctive insights into the financial performance of thousands of portfolio investments of financial sponsors, business development companies and private debt funds.

The methodology was determined by Lincoln in collaboration with Professors Steven Kaplan and Michael Minnis of the University of Chicago Booth School of Business. While other indices track changes to a company’s revenue or earnings, the LPMI is different in that it tracks the total value of these companies. Significantly, the large number of private companies used to create the LPMI helps ensure that the confidentiality of all company-specific information used in the index is maintained.

Further, in 2020, Lincoln launched the LSDI which provides insight into the private credit market as a fair value index tracking the total return, price, spread and yield to maturity of private credit securities. The index is developed using much of the same data as the LPMI and the methodology was determined by Lincoln in collaboration with Professor Pietro Veronesi of the University of Chicago Booth School of Business.