As we approach the December holiday season and investors look ahead to 2023, it’s important to take a step back and realize how historic 2022 has been for the broader market. The S&P 500 and the NASDAQ began the year at 4,796 and 15,644, respectively, which were all-time highs for those indexes at the time.1 Companies in 2022 were expecting to outperform 2021 financial results as COVID-19 disruptions were starting to fade, supply chains were somewhat normalizing, and the economy was humming along, with markets making new all-time highs seemingly every other day.
The Federal Reserve (Fed) believed that inflation was transitory, while investors continued to bid up the valuations of fast-growing companies to extremely outlandish levels. As the market began to realize that inflation was stickier than originally anticipated, the Fed rushed to raise rates. Now, the economy is on the verge of a recession. Numerous publicly traded companies have revised their guidance for 2022 and some management teams are struggling to forecast what 2023 will look like. In addition, the Fed has communicated that it will continue to raise the terminal rate, which will stay high (relative to recent history) for the balance of 2023 until inflation is under control.
The public market turmoil of 2022 has also impacted private market valuations, as evidenced in this week’s Chart of the Week, which shows that the median EV/EBITDA purchase price multiple (green line) is now below levels last seen in the fourth quarter of 2019. As the cost of capital has increased, private equity (PE) firms have reevaluated what businesses may be worth in this environment, in addition to reconsidering what margin expansion could look like over the next few years.
In relative terms, purchase price multiples are roughly 50% higher than they were in 2012, which can be attributed to the amount of dry powder in the space as well as the bull market we experienced post-2008. These multiples are just a snapshot of what general partners (GP) are paying in the market, as some firms are comfortable paying up for a business if they strongly believe in the management team, business, sector and ability to drive operational efficiencies moving forward — ultimately driving up valuation, coupled with sustainable growth.
In private equity, deals are normally financed with a combination of debt and equity, as debt financing can ultimately drive higher returns if a company performs well. Over the past 10 years or so, GPs have been able to find relatively cheap financing for their businesses as interest rates were close to zero.
Ultimately, the interest expense that portfolio companies were paying was relatively low and GPs were able to drive more dollars to the bottom line, generating higher net income and free cash flow. Moving forward, GPs will need to be more strategic in how portfolio companies are managed and operated, given these businesses will have to pay higher interest expense considering the move in rates, as well as the financing provided by private credit markets.
2022 has been a historic year for the broader market given the inflation picture, Fed rate increases, supply chain disruption and fears of a recession on the horizon. The turmoil investors have experienced in the public markets this year has trickled into the private markets as well, with private equity firms buying businesses at multiples last seen in 2019.
Multiples being paid by PE firms today are roughly 50% higher than in 2012, which can be credited to the number of funds in the space as well as the amount of dry powder these firms have to deploy. With purchase multiples remaining elevated versus historical levels, it will be important for GPs moving forward to closely manage companies and efficiently grow margins, in order to offset higher interest expense while still growing the bottom line.
1Source: CNBC- U.S. Markets; as of 11/30/22
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