Equity Capital Markets Update – November 2024

Discussions from Thomson Reuters’ M&A and Private Equity Forum: Equity Investments in Private Companies

The Private Equity (PE) Capital markets have played an increasingly prominent role in the broader financial ecosystem, drawing heightened participation from middle market business owners and investors. Of note, 44.1% of middle market CEOs surveyed completed at least one Private Capital markets transaction over the last 12 months, according to Capstone’s 2024 Middle Market Business Owners Survey. However, inorganic growth solutions for business owners and growth equity and PE investors have continued to prove dynamic—a trend Capstone’s Head of Equity Capital Markets, Chris Hastings, echoed while presenting at Thomson Reuters’ M&A and Private Equity Forum in September. Through panel discussions led by middle market investors and advisors at the forum, we have identified several factors below that are expected November to shape the PE Capital markets heading into 2025, followed by an in-depth analysis of PE market conditions.

In many sectors, private company valuations are lower than they have been historically, and we find that many business owners will consider the liquidity option of selling a minority stake to growth equity and PE investors to preserve the alternative of a full sale of the company in future years when valuations recover.

Chris HastingsHead of Equity Capital Markets, Capstone Partners

Four Key Shifts in Private Equity Strategy

PE and growth equity firms have substantially increased their presence in the middle market over the last two decades. However, investors’ fundraising, investment, and exit strategies have continuously evolved to account for current market conditions and the changing needs of fund investors and business owners. Outlined below are four key trends from Thomson Reuters’ panel discussion on the shifting strategies of PE in the middle market.

1. Softening Valuation Environment Drives Demand for Growth Equity Solutions

While merger and acquisition (M&A) valuations are heavily dependent on a company’s financial profile and operating sector, the overall middle market M&A valuation environment has remained soft compared to historical levels. The average middle market purchase multiple was 8.6x EV/EBITDA in Q3 2024, according to Capstone’s Q3 2024 Capital Markets Update. While this average was consistent on a year-over-year (YOY) basis, it remained muted compared to full-year 2021 (10.1x EV/EBITDA)—the most recent peak of middle market M&A activity. Depressed M&A valuations have spurred a flurry of growth equity deals as many business owners have looked to secure partial liquidity and defer a full sales process until a more favorable valuation can be reached.

Capstone’s Head of Equity Capital Markets, Chris Hastings, commented on the available growth equity solutions during the panel discussion. “One of the solutions that we like to propose is selling a minority stake of a company. If a business owner is ready to exit and it just happens to be a tough market for that sector regarding valuation, rather than sell the full company today, sell a minority stake to a friendly growth equity investor. That way the business owner can still create liquidity in a situation where they are not the happiest with the valuation—often referred to as two bites of the apple. The owner gets to take a portion of the proceeds with this transaction and can then capture the balance of the proceeds when the growth equity firm is ready to exit. The other common solution in selling a minority stake of a business is to put performance metrics in place. If a business owner believes that their company is going to grow significantly in the next couple of years, they can negotiate a future valuation with the investor if the company hits those metrics. This a win-win. As the company performs, the investor can make a better return, and the owner can benefit from an increased valuation,” said Chris Hastings.

2. Private Equity Takes a More Active Role in Diligence and Portfolio Management

PE and growth equity firms have taken a more active role in the due diligence process and in portfolio management as they have become increasingly selective in their investment pursuits. An above average financial profile and a strong post-closing management team have continued to be key determinants of M&A pricing in the middle market among financial buyers, further driving sponsors’ heightened involvement.

“One thing in a particular that we’re seeing is a lot longer lead time on the due diligence that they’re [PE] doing. They’re digging in a lot more to make sure that there really is a fit between the operational strategy, portfolio company strategy, and exit strategy. We’re also seeing them pass on a lot more deals earlier in the process and longer integration times between deals as opposed to doing those back-to-back acquisitions,” commented Katelyn Fredericks, Partner at Nelson Mullins Riley & Scarborough, during the panel discussion. “From a fund perspective, we’ve seen that some of our [PE] clients, who are very focused on having a differentiating factor, have an in-house Portfolio Operations team. These teams are not dedicated to any one portfolio company, but they go across portfolio companies and are used on the intakes. When they’re looking at targets and making an acquisition, they’re vetting them on the front end and taking best practices in privacy, information technology, financial, and operations. They’re standardizing these across their portfolio which helps them on the back end when they’re ready to exit,” added Alec Watson, Partner at Troutman Pepper Hamilton Sanders.

3. Difficult Sponsor Fundraising Environment Necessitates Debt Advisory Services

PE fundraising has continued to be challenged by diminishing limited partner (LP) returns and pent-up exit activity, creating heightened demand for debt capital. Of note, the number of U.S. portfolio companies held by PE funds surged to 11,567 as of Q3 2024, marking a 49.8% increase compared to 2014, according to PitchBook’s Q3 2024 U.S. PE Breakdown report.¹ Although sponsors’ portfolio inventory will eventually come to market, this elevated backlog has hampered fundraising activity to date. Through Q3 2024, total capital raised by PE firms declined 19.5% YOY to $121.4 billion. The number of funds raised also declined, falling 20.9% YOY through Q3 2024. Sponsors’ portfolio exits, and the accompanying returns, are crucial components for PE fund formation. As a result, sponsors have increasingly utilized debt capital advisory services to source credit and finance acquisitions. “There is a lot of pent-up exit activity in private equity, and if you can’t get the capital back, it’s hard to raise that next fund. So, the fundraising environment has been really, really challenging in private equity. If you can’t raise that next fund and you don’t just finance it [an acquisition] yourself, then you’ve got to use somebody,” said Brad Batten, Managing Partner at Broadtree Partners, during the Thomson Reuters’ panel.

4. Private Equity Increasingly Utilizes Continuation Funds as an Exit Strategy

A slow recovery of PE exit activity has facilitated the expansion of continuation funds, which enable general partners (GPs) to return liquidity to LPs and extend exit timelines of maturing portfolio companies. This solution has become increasingly prevalent as a depressed M&A valuation environment has led many sponsors to extend holding times and delay traditional exits. Notably, the number of PE exits into continuation funds rose 35.3% YOY to 69 exits through Q3 2024, according to PitchBook’s Q3 2024 U.S. PE Breakdown report. In addition, total capital raised globally for continuation funds increased 66.4% YOY to $97 billion through the first half of 2024, buoying the long-term outlook for exits into continuation funds. A quiet Initial Public Offering (IPO) market has also supported heightened continuation fund exits, as noted by Capstone’s Head of Equity Capital Markets, Chris Hastings, during the panel. “As long as the IPO market remains shut, we’ll likely see this trend continue. If private equity firms can’t exit through an IPO, then many will sell companies to a continuation fund. This trend, and the volume of continuation funds, will continue,” said Chris Hastings.

Growth Equity Activity Rises as Sponsors Limit Debt Exposure

PE firms have increasingly deployed growth equity investments to generate returns rather than full buyouts/majority stake deals. Growth equity investments typically target late-stage, rapidly expanding businesses, bolstering growth through operational leverage rather than financial leverage. This strategy has become a key value creation tool for many sponsors, especially as the exit environment has continued to favor profitable businesses with strong EBITDA margins and limited debt exposure. Of note, the number of growth equity investments through Q3 2024 rose 15.1% YOY to 1,145 deals, according to PitchBook’s Q3 2024 U.S. PE Breakdown report. Total growth capital deployed by PE firms reached $75.8 billion during the same period, marking an increase of 4.9% YOY. Fundraising challenges have afflicted both buyout and growth equity funds through Q3, with total growth equity fundraising volume and value falling 22.5% and 30.3% YOY, respectively. However, growth equity funds have continued to comprise a meaningful share of total PE funds raised. Growth equity funds accounted for 14.1% of total sponsor funds through Q3 2024, mirroring the prior year period (15.5%). Sponsors’ ability to successfully exit growth equity holdings and distribute LP returns will likely spur elevated fundraising activity in the long-term.

Private Credit Continues to Overtake the Broadly Syndicated Loan Market

The Federal Reserve’s 50 basis point interest rate cut in September has provided much-needed visibility on the rate path for the Leveraged Loan market—lowering base rates for leveraged debt financing. In addition, bank and non-bank lenders have lowered spreads amid heightened market competition and diminishing loan volumes. Of note, total U.S. loan value declined 44.9% QoQ to $223 billion in Q3 2024, according to PitchBook’s Q3 2024 U.S. Credit Markets Quarterly Wrap report.² While total loan activity slowed in Q3, the Leveraged Loan market has increasingly shifted from refinancings to acquisitions and recapitalizations, providing an ample supply of opportunities for loan investors. The Broadly Syndicated Loan (BSL) market, comprised of publicly traded loans, has rebounded in terms of total returns and leveraged buyout (LBO) financings. Notably, the U.S. Morningstar LSTA Index’s total return reached +6.5% as of Q3 2024. The number of BSL-financed LBOs also saw drastic growth, doubling QoQ to 18 deals in Q3. However, private credit-financed LBOs continued to comprise the vast majority (77.8%) of total LBOs in Q3, increasing QoQ to 63 transactions. The rise of private credit has largely been driven by a contraction in bank lending as many banks have focused on larger borrowers and tightened lending standards for cashflow loans. Private credit institutions will likely continue to capitalize on the withdrawal of traditional bank lenders through innovative borrowing solutions such as asset-backed loans and structured credit.

Capital flow to the middle market has appeared to signal the onset of a broader market recovery. However, the scope of the Private Capital markets will continue to be dictated by a myriad of factors, namely interest rates, business owners’ expansion plans, and LP investment appetite. PE firms—and their ability to adapt to changing market dynamics—will likely serve as the crux of middle market dealmaking through year end and into 2025.

To discuss key takeaways from Thomson Reuters’ M&A and Private Equity Forum, provide an update on your business, or learn about Capstone's wide range of advisory services and Private Capital markets knowledge, please contact us.

Max Morrissey, Vice President, was the lead Market Intelligence contributor to this article.

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For more on middle market M&A trends, deal volumes, and valuations, access out Capital Markets Update here.

Article was updated for data accuracy on November 7, 2024

Endnotes

1. PitchBook, “Q3 2024 U.S. PE Breakdown,” https://pitchbook.com/news/reports/q3-2024-us-pe-breakdown, accessed October 22, 2024.

2. PitchBook, “Q3 2024 U.S. Credit Markets Quarterly Wrap,” https://pitchbook.com/news/reports/q3-2024-us-credit-markets-quarterly-wrap, accessed October 22, 2024.