2023 Private Equity Fundamentals

Exits are falling and interest costs are rising, but what about portfolio company financials?
 

By: Dan Rasmussen

Private equity lagged public equity markets last year by a significant margin. The easiest explanation is that this is simply the result of smoothing: PE firms didn’t much mark down their portfolios when the market sold off in 2022 and then didn’t have to write them back up as much in 2023.

But according to Bain & Co.'s latest report, buyout exits are down 66% since 2021 and 44% from 2022—which suggests that something more worrisome is happening underneath the hood. 

Could the lagging performance also reflect any weakness in the underlying portfolio companies? We returned to an analysis we did last year of the financial performance of the sponsor-backed companies with public financials. This universe of North American companies includes all sponsor-backed private companies with public debt and all public companies with >30% sponsor ownership that had IPOed since 2019. This is far from a representative sample, but it's the best we can do with public data.

We found that the lagging marks might be more a reflection of fundamentals than institutional investors with 40%+ of their portfolios in private markets might have hoped. While sponsor-backed companies have generally grown faster than the universe of publicly listed companies, this was not true in 2023.

Figure 1: Revenue Growth, PE vs. S&P 500

Source: Capital IQ, Verdad analysis

What’s worrisome about this slowdown is that private equity firms are significantly more leveraged than public companies. And while public companies tend to borrow long and fixed, private equity-backed companies tend to borrow short and floating, often borrowing in the private credit market rather than issuing bonds. The median sponsor-backed company saw borrowing rates rise from 4.9% in 2022 to 7.2% in 2023, while the median S&P 500 borrower’s costs only moved from 3.2% to 3.7%.  Bain & Co. found that interest coverage ratios have dropped from 2.9x in 2022 to 2.4x. “Those are the lowest levels since 2008 and suggest that, for the average buyout-backed portfolio company, paying off interest has already gotten significantly harder,” noted the consultancy.

PE-backed firms generally have much lower margins than public companies, so this rise in interest costs has meant that the median PE-backed company is actually generating zero free cash flow.

Figure 2: 2023 EBITDA Margins and Free Cash Flow Margins

Source: Capital IQ, Verdad analysis

To outperform the market, a company generally needs to grow faster than the market, generate a higher free cash flow yield than the market, or see valuation multiples rise faster than the market.

In 2023, PE-backed companies grew slower than the public market and generated significantly lower free cash flow.  The lagging performance of buyouts relative to public markets looks like it might be more than just smoothing. It may reflect the weakening of the relative fundamentals.