Breakingviews: Private equity bites off mostly what it can chew

Buyout barons are nibbling their way back. Smaller transactions are a sensible way to stay active, and there are growing reasons to think mega-buyouts won’t come roaring back anytime soon. Hoards of capital can’t sit unspent indefinitely, however.

Private equity firms notched nearly $300 billion of acquisitions worldwide through Aug. 15, according to Dealogic data. The figure is less than half last year’s pace and only 6% higher than the pandemic-era nadir in 2020.

Relative minnows are the catch of the day. KKR is snapping up book publisher Simon & Schuster for $1.6 billion; STG agreed to pay $1.4 billion for software developer Avid Technology; and GTCR Capital will buy ADT’s fire and security arm for $1.6 billion. Deals in the $1 billion to $5 billion range are running closest to the same pace as 2022.

Some of the structures even look normal-ish. STG, for example, secured a loan to value of more than 40% from private lenders. Clayton, Dubilier & Rice enlisted five banks to finance its $2.3 billion acquisition of packaging provider Veritiv.

Debt availability remains far from its heady 2021 peak, though. Banks are backing deals with lower multiples of borrowing to EBITDA. Last quarter, nonbank lender Ares Capital’s average loan size and total lending both fell by about 60% from a year earlier. With capital tighter, it’s easy to understand why buyout firms are pursuing humbler deals more likely to exceed the minimum returns investors expect.

High interest rates make the task even harder. Cautious lenders typically want companies to generate enough operating profit to cover interest payments nearly twice over. This standard means paying with proportionally less debt, which can eat into returns. GTCR’s plan to buy 55% of Worldpay at a $17.5 billion valuation requires an equity check equivalent to 15% of the buyout firm’s assets. The risky decision suggests a perception that rates won’t be falling anytime soon.

Takeover targets, especially smaller ones, are also adjusting slowly to clipped valuations. The S&P SmallCap 600 Index hasn’t rebounded as quickly this year as a mid-cap benchmark, which in turn lags the S&P 500 Index. Deteriorating financial results should help narrow the price gap between buyers and sellers, a sticking point that torpedoed software developer New Relic’s early talks with TPG and Francisco Partners until the seller later capitulated, according to Reuters.

Big buyouts have been an increasingly important component of private equity’s gigantism. The industry ended 2022 with $1.1 trillion of so-called dry powder, according to Bain Consulting. More of the action is moving to the middle market, though, which accounted for nearly 90%of funds raised early this year, per research outfit PitchBook. Some flagship funds are contracting. That larger firms are now choosing to talk up their lending capabilities and other forms of investment is yet another sign of the shrinking expectations for mega-deals.