Analysis | Private Equity’s Woes Go Beyond the Deal Freeze

Pharmacist Walgreens Boots Alliance Inc. scrapped the £5 billion ($6.1 billion) sale of its UK Boots subsidiary last month. Consumer products firm Reckitt Benckiser Group Plc has likewise considered shelving plans to dispose of its remaining infant-nutrition business, a potential $7 billion deal, with private equity the obvious buyer.

True, some transactions are still live or being attempted. But they are usually infrastructure-like, such as Deutsche Telekom AG’s cellphone-towers business, or small, like publisher Euromoney Institutional Investor Plc in the UK, or special situations, like software firm Zendesk Inc. in the US.

Frozen financing strikes at the core of the private equity model. And the industry still has a lot of unspent dry powder. But there’ll be a thaw in time and the bright side for acquirers is that purchase prices will likely decline.

The big unknown is how long until buyers and sellers find common ground on valuation, and whether lower asset values will fully compensate for having to fund transactions with more expensive debt. The industry may need to compromise on return hurdles exceeding 20%.

The more fundamental problems relate to past deals not new ones. 

Buyouts done in the last two years or so, struck as markets peaked, could become a millstone.

The valuation of the average US leveraged buyout relative to profit as conventionally measured rose 1.8 times between 2000 and 2021, according to consultancy Bain & Co. Increasing valuations in the public and private markets have enabled private-equity firms to exit investments at higher multiples of profit than they they paid. Repeating that trick is going to be tough, making efficiency and revenue gains more urgent priorities to increase the worth of the enterprise on sale. But macroeconomic pressures are undermining both levers.

Moreover, many private equity portfolio companies will be facing cost pressures they can’t pass on to customers. Leverage can push sickly businesses into a critical condition. Where debt has been provided with loose covenants, lenders may be powerless to intervene until the problems are severe. A high-profile blowup would remind investors that leverage cuts both ways.

Which brings us to fundraising. Investors’ enthusiasm for private assets has enabled firms to raise ever bigger funds, in turn expanding the management-fee pool and enabling them to expand their own businesses. It could be a while before new records are set. As private market valuations catch up with the decline in stock markets, the limited partners who invest in buyout funds must brace for disappointment.

A sudden slowdown in allocations to private equity would hit smaller and mid-market buyout shops particularly hard. They were already on the wrong side of a trend that was seeing investors make larger commitments to fewer but bigger firms. Now the battle will be over a shrinking pie.

So don’t worry about the deals private equity can’t do today. Worry about the performance of the deals they’ve done, and where the next round of fees is coming from.

More From Bloomberg Opinion:

• Don’t Let Private Equity Make a Fool of You: Chris Hughes

• Kellogg Is Serving Hungry Investors a Snack: Andrea Felsted

• Paulson Hits Paydirt Again With Porsche of Pianos: Chris Bryant

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Chris Hughes is a Bloomberg Opinion columnist covering deals. Previously, he worked for Reuters Breakingviews, the Financial Times and the Independent newspaper.

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