Considerations for a Successful Private Equity Exit

 

After a period of slower deal activity, middle market mergers and acquisitions (M&A) are showing signs of resurgence, with data from PitchBook’s Q2 US PE Middle Market Report indicating a 12% increase in the first half of 2024 compared to the same period in 2023.

This momentum is likely to continue — following a change in administration after the U.S. presidential election and the Federal Reserve’s November decision to lower the benchmark federal funds rate another quarter point to a range of 4.50 – 4.75%.

Lower interest rates are already impacting the broader market. In its Q3 US PE Breakdown, which covers all US PE deal activity, PitchBook reported its highest level of estimated exits (394) since Q1 2022. The Russell 2000 Index — often viewed as a bellwether for private company valuations — rose 1.8% immediately following the rate cut and is up nearly 9% year-to-date.

These tailwinds should ripple into the portfolio companies of private equity (PE) firms, as these funds look to increase exit activity, which has remained flat year-over-year.

Middle Market Dealmaking: What We’re Seeing

Although deal activity is expected to increase, PE exits in the middle-market have stabilized as noted below but not meaningfully improved.

Exit backlog should inspire more M&A

Due to the exit backlog, many PE funds are facing increasing pressure to sell portfolio companies (portcos) after historically long holding periods. U.S. general partners (GPs) have been waiting for more favorable exit market conditions, extending the median holding period for middle-market PE investments to a record 6.4 years in 2023, according to PitchBook.

Given the recent increase in the Russell 2000 Index noted previously, as well as the rise in middle-market deal multiples, which have recovered to 12.9x EV/ EBITDA from a bottom of 11.0x in 2023, we believe the exit market conditions have become more favorable. Anecdotally, we’ve seen earnings of private companies steadily improve which should also help bolster their valuations.

These two factors should set the stage for renewed deal activity. We expect that a rebound in exits will power PE M&A activity in the middle market, as more funds kick off sales processes for the portcos they have been holding onto for an extended period of time.

Strategics play important role in middle market exit activity

As they kick off their expected sales processes, PE funds operating in the middle market are likely to look at other sponsors and strategic buyers.

Since Q1 2023, sponsor-to-sponsor exits have consistently outpaced exits to corporate strategics, making up over 55% of exit activity in Q1 and Q2 of 2024, excluding public listings according to PitchBook.

But strategic buyers remain highly competitive in the middle market. In fact, 69% of fund managers and operating partners in BDO’s 2024 Private Equity Survey reported strategic investors as their top competition for deals, indicating that strategics are still highly engaged and poised to capitalize on opportunities. Moreover, 57% of respondents said they will pursue a sale to a strategic for their exits compared with 37% who cited a sale to a financial sponsor.