While the Lincoln Private Market Index Increased in the Second Quarter, Private Company Earnings Growth Slowed

Aug 2024

Enterprise values continued to increase, and private markets showed signs of momentum for future M&A activity due to lower spreads and potentially tightening equity cushions.

The Lincoln Private Market Index (LPMI), the only index that tracks changes in the enterprise value of U.S. privately held companies, increased by 1.9% during the second quarter of 2024 as the index reached a new high. As has been the case in most quarters since the index’s inception, the index’s growth was primarily driven by positive financial performance rather than multiple expansion.

When comparing the LPMI to the public markets, the S&P 500’s quarter-over-quarter enterprise value increase of 4.5% outpaced the LPMI. However, the S&P 500 excluding the “Magnificent Seven” actually contracted in enterprise value by 0.7%, which was driven entirely by multiple contraction, suggesting the private markets outpaced much of the public markets this quarter.

Broadly speaking, private market behavior in 2024 has been a tale of two cities, with strong performers reaping benefits and a smaller subset of underperformers facing the consequences. Loan spreads, defaults, liquidity and sponsor support looked markedly different between the haves and the have-nots. Strong operators looked more attractive as their favorable performance trends, ample liquidity and sponsor support grant access to cheaper borrowing rates and friendlier terms in the form of proactive repricings. Conversely, weak performers, while far smaller in number, are unable to access the positive market trends prevalent in the first half of 2024 as demand for heightened risk and underperforming assets was not present.

Leveraged buyout volumes remained down from historical highs in Q2 2024, as did EBITDA purchase price multiples, which decreased from 11.5x in 2H 2023 to 11.1x in 1H 2024, remaining well below the height of the market in Q4 2021 of 13.2x. Despite the decline in multiples, each industry tracked in the LPMI, besides consumer, experienced greater EBITDA growth in 1H 2024 relative to 2021, indicating that the current stagnation in deal volume is not performance-driven, but likely reflective of a more uncertain macroeconomic climate.

Examining the change in purchase price multiples further, the decrease may be related to the industry mix of new deals. Specifically, while aggregate buyout activity declined; technology, media and telecom (TMT) and healthcare – which are historically higher multiple industries – buyout activity declined at a greater rate than buyout activity in industrials, a generally lower multiple industry. At the height of the market in Q4 2021, 33% of buyout transactions were in TMT and healthcare whereas in the first half of 2024, only 18% of transactions were in these industries.

Slowing Growth Still Clocks in Ahead of Historical Averages

For the first time since Q3 2023, the percentage of companies achieving LTM EBITDA growth decreased from the previous quarter. In the second quarter, 61.3% of companies tracked by Lincoln International demonstrated EBITDA growth, down from 62.7% in Q1, as slowing topline growth seeped down into EBITDA. Despite the decrease, this still compares favorably to the average dating back to 2019 of 58.7%, indicating aggregate growth remains strong. Year-over-year, LTM EBITDA grew 5.3% in Q2 2024 relative to 5.6% in Q1 2024; however, this growth remains in excess of the historical average since 2019 of 3.9%. Revenue trends were more stable, as the percentage of companies growing revenue and the magnitude of their growth was consistent quarter over quarter.

Of the industries tracked in Lincoln’s data, consumer showed the weakest growth trends of the set, with both revenue and EBITDA growth clocking in lower than the averages stated above at 3.1% and 2.7%, respectively.

“While we observed slowing revenue growth dating back to 2022, EBITDA continues to steadily grow on the back of margin improvements,” 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. “While revenue growth may have slowed, businesses’ fundamental performance has weathered the storm so far, as shown in the LPMI’s growth despite multiple contraction in the private markets.”

Competition Emerges as the Prevailing Theme for the Direct Lending Market in 1H 2024

The return of the BSL market, record levels of dry powder in direct lending funds and a lack of new buyout activity continued to create increased competition among direct lenders in Q2 2024. Spread tightening on new originations in the direct lending market persisted in Q2 2024, with unitranche spreads tightening between 25 and 50 bps for companies between $40 million and $100 million of EBITDA, totaling 75-100 bps since the dislocation to end 2022. Original issue discounts (OIDs) continued to tighten, providing further evidence of fierce competition among lenders. The spread tightening and overall positive performance trends from strong credits caused the average senior credit mark in the Lincoln Senior Debt Index (LSDI) to increase from 98.4% to 98.6% quarter-over-quarter.

Because of the aforementioned competition, lenders are eager to keep performing credits on their books by any means necessary. In many instances, for strong credits with above-market pricing by today’s standards, the existing lender group is proactively offering a tighter spread to the borrower before the repricing hits the open market. Notably, in the first half of 2024, Lincoln observed 137 amendments which resulted in reduced cash pricing on an existing facility, with the average reduction clocking in at ~75 bps.

Sponsor Support is Key in the Direct Lending Market

While still a minority of the broader population, poor performing companies continued to suffer operationally due to sustained periods of elevated base rates, lingering impacts of inflation and idiosyncratic missteps. Credit investors in these underperforming portfolio companies experienced large mark-to-market write-downs, often suddenly, primarily as a result of evaporating sponsor support. Notably, in the first half of 2024, 7.3% of loans of the credits that decreased in value in Lincoln’s database experienced write-downs in excess of 10%, compared to only 5.5% in the second half of 2023, which demonstrates how quickly a situation can take a turn for the worse.

“Sponsor support can make or break a weakly-performing portfolio company in today’s environment,” said Ron Kahn, Managing Director and co-head of Lincoln’s Valuations & Opinions Group. “With average fixed charge coverage ratios hovering close to 1.0x, there is little room for error. For borrowers short on liquidity, a supportive sponsor is often the only way to stem the tide.”

Amendment activity likewise varied between strong and weak performers. While healthy portfolio companies experienced proactive repricings, amendment activity for poor performers focused on addressing covenant defaults, maturity extensions and waivers on missed principal and interest payments. Interestingly, Lincoln’s size-weighted default rate contracted quarter on quarter from 2.7% in Q1 2024 to 2.6% in Q2 2024. However, Lincoln observed an increase in the instance-weighted default rate among companies in its database, which rose from 6.0% in Q1 2024 to 7.5% in Q2 2024. Digging deeper, the size-weighted default rate for companies below $10.0 million in EBITDA had the greatest increase in defaults.

One reason for the elevated default rates for small operators could stem from more restrictive covenants. Per Lincoln’s observations, there is an inverse relationship between EBITDA size and covenant headroom. At the time of the first net leverage compliance test for observed portfolio companies, those between $0 and $10 million of EBITDA had the least cushion, with an average gap between actual leverage and the compliance leverage threshold of just 1.4x. This compared to an average 3.0x leverage cushion for companies generating over $100 million of EBITDA, indicating covenants at close were set tighter for these smaller businesses. Problems for weakly-performing portfolio companies were apparent through sponsor support activity, as 50.0% of amendments observed (regardless of company size) contained sponsor capital injections to address liquidity shortfalls compared to 43.3% in Q1 2024.

Despite the small pockets of distress in the direct lending landscape, competition in the direct lending market could perhaps provide a much-needed jolt to buyout activity.

“While higher SOFR and resulting higher borrowing costs contributed to the slower M&A environment, ironically, decreased spreads and reduced equity cushions could be the catalyst for renewed buyout activity as buyers now have the ability to pay more for portfolio companies,” said Kahn. “All of these tailwinds beg the question on everyone’s mind: has the M&A tide finally started to shift for the second half of 2024?”

Lincoln’s Database Independently Verified

According to the findings of a recent study led by an Assistant Professor of Finance at Penn State University’s Smeal College of Business, Lincoln’s private company database includes reliable, statistically significant data not found in other major United States private debt databases.

“Year over year, Lincoln’s Private Market Index and proprietary database has provided private market participants with critical benchmarking intelligence to inform their decision making,” Kahn said. “We are proud that the firm’s data has once again been recognized as a consistent resource that is relied upon by some of the world’s largest asset managers, research analysts, limited partners and institutional investors each quarter.”

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 1,500 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.