The Lincoln Private Market Index (LPMI), which tracks changes in the enterprise value of privately held companies in the United States, 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.
Compared 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%, driven entirely by multiple contractions. This suggests that the private markets outpaced many public markets this quarter.
EBITDA purchase price multiples, which decreased from 11.5x in the second half of 2023 to 11.1x in the first half of 2024, remain well below the height of the market during the fourth quarter of 2021 of 13.2x.
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 granted access to cheaper borrowing rates and friendlier terms through proactive repricings. Conversely, while far smaller in number, weak performers cannot access the positive market trends prevalent in the first half of 2024 as demand for heightened risk and underperforming assets was absent.
Leveraged buyout volumes remained down from historical highs in Q2 2024, as did EBITDA purchase price multiples, which decreased from 11.5x in the second half of 2023 to 11.1x in the first half of 2024, remaining well below the height of the market during the fourth quarter of 2021 of 13.2x. Despite the decline in multiples, each industry tracked in the LPMI, besides consumer, experienced greater EBITDA growth in the first half of 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. Expressly, while aggregate buyout activity declined, in 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 sector. At the height of the market in Q4 2021, 33% of buyout transactions were in the TMT and healthcare industries, whereas in the first half of 2024, only 18% 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 demonstrated EBITDA growth, down from 62.7% in Q1, as slowing topline growth seeped 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 more than 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.
Original Issue Discounts (OIDs) continued to tighten, providing further evidence of fierce competition among lenders.
Of the industries tracked in Lincoln’s data, consumer showed the weakest growth trends, with 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, a University of Chicago Booth School of Business professor 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 contractions in the private markets.”
Competition Emerges as the Prevailing Theme for the Direct Lending Market in 1H 2024
The return of the broadly syndicated loan (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 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 proactively offers a tighter spread to the borrower before the repricing hits the open market. Notably, in the first half of 2024, Lincoln observed 137 amendments, resulting 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 suffered operationally due to sustained periods of elevated base rates, lingering impacts of inflation, and idiosyncratic missteps. Credit investors in these underperforming portfolio companies experienced significant mark-to-market write-downs, often suddenly, primarily due to 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 of over 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, a managing director and co-head of Lincoln’s valuations and 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 showed the greatest default increase.
Despite the small pockets of distress in the direct lending landscape, competition in the direct lending market could provide a much-needed jolt to buyout activity.
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 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 can pay more for portfolio companies,” said Mr. 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 a recent study 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,” concluded Mr. Kahn. “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.”
Lincoln International provides mergers and acquisitions advisory, private funds and capital markets advisory, and valuations and fairness opinions. The firm is headquartered in Chicago and has over 20 offices in 15 countries.
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© 2024 Private Equity Professional | August 13, 2024
