While private company performance has been stronger than expected, are cracks starting to form?

The Lincoln Private Market Index (LPMI), the only index that tracks changes in the enterprise value of U.S. privately held companies, increased by 1.5% during the first quarter of 2023. As has been the case for the past two years, growth in the LPMI was driven by fundamental performance rather than multiple expansion as private company performance has held up well, particularly in the presence of the persistent inflationary pressures impacting the broader economy.

While the LPMI increased, the rise was mild in comparison to the S&P 500, which grew 8.2% during the first quarter. Both indices grew despite macroeconomic headwinds, including the collapse of Silicon Valley Bank (SVB) in March, which led to a modest pullback in the S&P 500. Since Q1, however, the S&P 500 has rebounded to levels seen in February before the pullback.

From the inception of the LPMI in 2014 to today, changes in the index have directionally conformed with changes in the S&P 500. While the changes in the LPMI have been less volatile, the two indices have converged in multiple quarters, including Q1 2023. As of Q1 2023, the LPMI and S&P 500 sat nearly on top of each other, with the LPMI growing 52% since inception and the S&P 500 growing 51% over that period. Further, as highlighted in a recent perspective published by Lincoln International titled “Private Equity and Private Credit Resiliency is Not an Illusion,” some of the reasons for these less volatile movements in the private markets, as compared to the public markets, can be attributed to the dissonance between public market and private market portfolio composition and a lesser influence of capital flows in the private markets.

“Fundamental performance, rather than multiple volatility, is the primary driver of value in the private markets, and private equity appears to have done a good job of navigating the current inflationary and recessionary pressures,” said Steve Kaplan, Neubauer Distinguished Service Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business, who assists and advises Lincoln International on the LPMI.

Amid Growing Market Share, Direct Lending Remains in a Period of Price Discovery

While 2023 has been off to a slow start from an M&A and lending perspective, there has been a stark contrast between activity in the Broadly Syndicated Loan (BSL) market and the direct lending market. Nearly all M&A financing in 2023 has been done through the direct lending market rather than the BSL market, including deals that previously may have been done in the BSL market due to their size. In addition, among other factors, the collapse of SVB has led to a shift away from bank-led financing towards non-bank financing solutions such as direct lending. In an uncertain environment, borrowers prefer the certainty of execution that direct lending brings, despite its higher cost of borrowing.

Based on data from Lincoln International’s proprietary database, the average spread on new direct lending issuances was 6.6%, marking the second quarter in a row that the average new issuance spread was greater than 6%. This was an increase of approximately 0.50% from the prior year. The average OID was 2.5%, which has increased approximately 0.50% to 1.00% from the prior year. Lastly, leverage continued to decrease on new deals as interest rates continued to rise, with leverage clocking in at its lowest level in the last 2 years at 4.8x.

The average fair value of loans in the Lincoln Senior Debt Index (LSDI) remained stable at 96.3%. While fair value trends were stable, two less rosy trends persisted in Q1. First, defaults continued to tick up, increasing from 4.2% in Q4 2022 to 4.5% in Q1 2023. Despite this increase, defaults remain well below the 9.4% high observed during the peak of the COVID-19 pandemic. Of note, defaults in the Consumer industry were higher than other industries clocking in at 6.4%. This trend follows historical recessionary periods wherein consumer companies are often the first domino to fall during a decline in discretionary spending.

Secondly, cash flow continues to be constrained by the interest burden facing private companies due to the floating rate nature of most direct loans. In Q1 2023, the all-in yield (excluding OID) on new issuances based on data tracked in Lincoln International’s proprietary database was approximately 11.5%, which was based on a SOFR of around 5%. Despite this, the average fixed charge coverage ratio (which measures the ability to service interest and fixed charges of a portfolio company) tracked by Lincoln was approximately flat from Q4 2022 to Q1 2023 primarily due to reduced capital expenditures as companies reined in their spending. While only 20% of companies had a fixed charge coverage ratio of less than 1.00x in Q1, when accounting for current SOFR for a full one-year period (given fixed charge coverage is based on trailing data), that number increases to nearly 45%. “It will be interesting (pun intended) to see how much the rate increases eat into future private equity returns,” said Professor Kaplan.

“The direct lending market is at a bit of a crossroads at the moment,” said Ron Kahn, Managing Director and co-head of Lincoln’s Valuations & Opinions Group. “Interest in the asset class remains strong and credit terms have remained favorable for lenders; however, as rising rates persist, all-in yields can only remain in the mid-teens for so long. At some point something needs to break—either cracks start to form and defaults jump up or spreads start to move in the opposite direction to ease interest burden on PE portfolio companies.”

Private Company Growth Continues into Q1, but Will it Last?

Q1 2023 represented another quarter of resilient performance by PE-backed portfolio companies, despite continued inflationary pressures which spurred beliefs that private company performance could take a turn for the worse. Approximately 81% of companies tracked in Lincoln International’s proprietary private market database exhibited LTM revenue growth for the period ending March 31, 2023 as compared to the period ending March 31, 2022. However, only 61% of companies exhibited LTM EBITDA growth over that same time. These figures compare to four year averages of 66% and 55%, respectively. It should be no surprise that given the gap between revenue and earnings growth, EBITDA margins have contracted 2% year-over-year.

Unsurprisingly, companies in the Consumer industry have displayed the weakest performance recently, with LTM revenue growing approximately 12% from the year prior and LTM EBITDA declining 2% over that same timeframe. Consumer companies faced a litany of issues, including slowing discretionary spending (which generally results in a shift towards lower margin products), a build-up of excess inventory due to overbuying early in 2022, as well as rising input costs and rising wages stemming from inflation.

One industry’s underperformance that may have come as a surprise is Healthcare. While Healthcare is typically viewed as a more recession-resilient industry due to its inelastic demand patterns for non-elective procedures and preventative care, the industry has experienced margin degradation primarily resulting from heightened labor costs and unfavorable reimbursement rate trends. Due to these dynamics, while Healthcare’s revenue was approximately in line with the 12% overall growth in LTM revenue year-over-year, Healthcare’s LTM EBITDA growth was the second lowest outside of Consumer, clocking in at ~3% as compared to ~5% for the overall universe of private companies tracked by Lincoln International. This underperformance also led to Healthcare being the weakest performer in the LPMI in Q1, as its index level was flat, compared to the overall growth of 1.5%.

For the full year of 2023, private companies are projecting an average revenue and EBITDA growth of 10%. This perhaps suggests that the margin contraction experienced in 2022 is expected to tail off, but at the same time, margins are not expected to expand in the near-term. Lastly, it remains to be seen if this EBITDA growth is achievable. Since the inception of the LPMI, there has not been a year in which EBITDA growth has reached double digits.

“Private companies have been able to largely handle the curveballs thrown at them in 2022 and, looking ahead, it appears as though portfolio companies and sponsors are expecting that growth to continue,” noted Kahn. “However, market participants remain cautious if this growth can be achieved and as a result, there has been a marked slowdown in M&A activity in the early innings of 2023.”

About the Lincoln Private Market Index & Lincoln Senior Debt Index

The LPMI is the only index that tracks changes in the enterprise value of U.S. privately held companies—primarily those owned by PE firms. With the LPMI, PE firms and other investors can benchmark private companies’ performance against their peers and the public markets.

This index is differentiated from other indices as it (1) tracks enterprise values of private companies over time, (2) is based on valuations rather than executive surveys and (3) covers a wide sampling of companies across a range of PE firms’ portfolios.

The LPMI seeks to measure the variation in private companies’ enterprise values by analyzing the aggregate change in company earnings as well as the prevailing market multiples for approximately 800 private companies, each generating less than $100 million in annual earnings. The index is calculated using anonymized data on an aggregated basis by Lincoln’s Valuations & Opinions Group, which has distinctive insights into the financial performance of thousands of portfolio investments of financial sponsors, business development companies and private debt funds.

The methodology was determined by Lincoln International in collaboration with Professors Steven Kaplan and Michael Minnis of the University of Chicago Booth School of Business. While other indices track changes to a company’s revenue or earnings, the Lincoln PMI is different in that it tracks the total value of these companies. Significantly, the large number of private companies used to create the Lincoln PMI helps ensure that the confidentiality of all company-specific information used in the index is maintained.

Further, in 2020, Lincoln launched the LSDI which provides insight into the direct lending market as a fair value index tracking the total return, price, spread and yield to maturity of direct lending securities. The index is developed using much of the same data as the LPMI and the methodology was determined by Lincoln in collaboration with Professor Pietro Veronesi of the University of Chicago Booth School of Business.

Important Disclosure

The Lincoln Private Market Index is an informational indicator only and does not constitute investment advice or an offer to sell or a solicitation to buy any security. It is not possible to directly invest in the Lincoln Private Market Index. Some of the statements above contain opinions based upon certain assumptions regarding the data used to create the Lincoln Private Market Index, and these opinions and assumptions may prove incorrect. Actual results could vary materially from those implied or expressed in such statements for any reason. The Lincoln Private Market Index has been created on the basis of information provided by third-party sources that are believed to be reliable, but Lincoln International has not conducted an independent verification of such information. Lincoln International makes no warranty or representation as to the accuracy or completeness of such third-party information.

About Lincoln International

We are trusted investment banking advisors to business owners and senior executives of leading private equity firms and their portfolio companies and to public and privately held companies around the world. Our services include mergers and acquisitions advisory, private funds and capital markets advisory, and valuations and fairness opinions. As one tightly integrated team of more than 850 professionals in more than 20 offices in 15 countries, we offer an unobstructed perspective on the global private capital markets, backed by superb execution and a deep commitment to client success. With extensive industry knowledge and relationships, timely market intelligence and strategic insights, we forge deep, productive client relationships that endure for decades. Connect with us to learn more at www.lincolninternational.com.

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