Rattled rates

Some relief may be on the way. Equity markets are rallying and rates are starting to decline after this week’s CPI print that showed a resumption of easing inflation trends that helped rates tighten at the end of 2023 and into this year.

Indeed, following the CPI print, 10-year Treasuries dropped to around 4.36%, down from highs of 4.70% just last month.

However, it’s taking some time for the market to adjust to the reality that rates are not going back to their ultra-low post-global financial crisis levels, said Tim Ingrassia, co-chairman of global mergers and acquisitions at Goldman Sachs.

For a decade after the GFC, 10-year yields averaged 2.4%, but Ingrassia said the rate is likely to stabilize somewhere between the 25-year average of 3.3% and the pre-2008 average of 4.8%.

Average HY effective yields may stay at their current mid-7% levels as well given that spreads are near all-time lows and are more likely to widen from here, partially counteracting lower Treasury rates.

“This is not telling people to wait to sell assets,” Ingrassia said. “This is telling people there is no benefit to waiting.”

Even though these are higher rates than most issuers were hoping for, a dose of stability could inject more M&A volumes.

“People are waiting for normal, and the new debate is what is normal?” Ingrassia said. “I think the definition of normal is going back to normal rather than pining for a belief that we're going back to something like a 3% 10-year.”

Sponsor 2 sponsor

Even amid increased pressure from LPs to start selling, sponsors remain selective and don’t want a bad deal for what they feel are strong assets.

Private equity exit valuations were down 44% in 2023 both year-over-year and versus the last five-year average, according to a report from Bain & Company.

Even if sponsors can sell their best assets, it’s hard to reinvest in another quality asset, attendees said.

Opening up more sponsor-to-sponsor sales could help loosen the log jam, and private equity firms are open to it.

Conference attendees said that sponsors are turning to more creative structures to get these transactions done, which is typical in a recovering M&A market.

One structure involves rolling existing equity over from the first sponsor while selling a majority stake to the buyer.

For example, BC Partners is retaining a minority stake in IT solutions provider Presidio after selling a majority stake to Clayton Dubilier & Rice for $2.1bn. Banks funded that transaction and refinanced the company's debt with a new $1.853bn TLB and $750m SSNs that priced earlier this month.

In other instances, the selling sponsor may even kick in a new equity investment as well, attendees said.

Another strategy is to utilize earn-outs — where the buyer pays a portion of the company’s valuation at close and the rest after the company hits higher EBITDA or other financial targets set out in the agreement.

Although not PE-owned, information technology tech provider Insight Enterprises included an earn out in its acquisition of cloud business SADA, according to a Moody’s report. Insight just this week priced $500m SUNs that will be used to refinance its existing ABL revolver and general corporate purposes.

These structures ensure that both parties have skin in the game. It also creates an incentive for sponsors to leave some meat on the bone for another buyer and not simply milk the asset for all its worth, market participants said.

Public vs private

It wouldn’t be a credit conference without some discussion of private versus broadly syndicated financing options.

Panelists said that as long as rates remain high, private credit will be an attractive option for sponsors — largely because direct lending avoids the complications of rating agencies.

Given the expensive cost of debt, highly levered LBO structures have little margin for error to avoid dropping into triple-C territory, which can cause headwinds for CLO managers — the biggest buyers of leveraged loans.

Sponsors would like to see rating agencies put more of an emphasis on cash flow and debt service ratios rather than just traditional debt-to-EBITDA metrics, to counter some of the high leverage levels. But that doesn’t seem to be changing anytime soon.

What is changing is that rates are starting to come down, and that’s allowing banks to exert more aggressive pricing pressure compared with private credit. Some issuers have already refinanced debt in the broadly syndicated market this year that is 350bps cheaper than what they were paying in a private credit deal.

Artificial intelligence

There’s a frenzy of hype around AI right now and sponsors are looking for ways to capitalize on it.

That includes reviewing how the technology can benefit existing portfolio companies, how private equity can invest in new emerging sectors, and how to avoid sectors that are negatively impacted by AI.

Some sub-sectors are proving too risky for sponsors to underwrite because of AI risk, which is leading to deals getting killed in investment committee meetings, a panelist said.

We’ve written about how client management outsourcing companies are facing pressures from AI. Others such as Getty Images had their refi plans squashed by AI concerns.

One area of focus for potential growth from AI is in data centers.

The main players in the AI space are estimated to invest some $200bn in new capex spending by 2025, according to a Goldman Sachs report. Sponsors and banks are looking to capture some of those dollars by investing in and funding companies that will help build the infrastructure, cooling mechanisms, and solar panels for these large data centers.

Demand from AI computing is part of some investors’ thesis when looking at a new leveraged loan deal for power generator Hamilton Projects or the auction for middle market prefab shelter maker Trachte, for example.