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Quarter 2019 (“Q1”) US Private Equity (“PE”) Middle Market (“MM”) Report highlights myriad factors that curbed deal making levels and stalled liquidity events in the quarter. These include distress in the high-yield and leveraged loan markets in Q4, an inauspicious pricing environment and the longest government shutdown in history. Both MM deal and exit activity seem poised to rebound, however, as market tranquility was restored in the first quarter and as GPs circumvent market pressures with deal strategies such as add-ons and sale-leasebacks. MM fundraising levels remained aloft as LPs continued allocating capital to private equity at a rapid pace and as fund sizes continue to scale, which will likely bolster deal and exit sizes down the line. This edition also spotlights PE activity in China as the country looks set to play an eminent role in the PE industry.
Q1 2019 middle-market deal making activity slowed compared to 2018’s record pace, and cumulative value declined as PE firms closed on smaller deals. Financing costs were prohibitive due to distress in the high-yield and leveraged loan markets during Q4 2018, prompting numerous GPs to push back deals. Despite the lower deal value, multiples remained elevated as competition continues to be fierce and technology—which typically trades at higher multiples—accounts for a swelling portion of deal flow. GPs, though, are combating these pressures by utilizing dividend recapitalizations (recaps) and sale lease-backs, among other strategies, to boost returns. Exits, on the other hand, saw declines in count and value as GPs were reluctant to sell in an adverse pricing environment. Public markets in the US declined meaningfully in the quarter, causing mark-to-market losses that many GPs would loathe to realize.
The decline in markets, coupled with the longest government shutdown in history, meant Q1 was devoid of MM PE-backed IPOs for the first quarter since the global financial crisis (GFC). An unremitting market recovery in fixed-income and public equity markets during the first quarter leads us to believe exit activity will pick up throughout the year. Despite declines in deal and exit value, fundraising figures remained steady in the quarter. LPs continue to allocate to PE at a record clip, boosting MM fundraising. Funds—within and above the MM—continue growing in scale, with vehicles between $1 billion and $5 billion accounting for over three-quarters of capital raised in the MM. This proliferation of massive funds will have downstream effects, likely leading to larger deal and exit sizes. As fund sizes grow persistently, GPs with a history of raising mega-funds ($5 billion+) continue to return to the MM with smaller, more-focused funds.
According to the RSM US Middle Market Business Index (MMBI), middle market business sentiment declined in the third quarter of 2019 to 129.4 from 132.3 in the prior period, as overall global economic growth slowed, the manufacturing sector continued to contract and tariffs began to affect business results. While current-quarter sentiment remains solid, forward-looking indicators in the survey’s subindices denote some risk for middle market businesses in the months ahead.
It is important to note that the third-quarter MMBI survey was conducted prior to the most recent escalation of the trade war between the United States and China, the resulting impact on the global supply chain and the ensuing tightening of financial conditions reflected in declining stock prices, an inversion of the yield curve and a widening of credit spreads in the bond market. These developments may cause further deterioration of middle market business sentiment in coming quarters.
The heightened level of concern around the economy’s direction is most noticeable in the relatively low number of middle market executives who indicated they expect to boost capital outlays on fixed business investment—a telltale sign of the heightened “uncertainty tax” resulting from instability in the macroeconomic environment.
