With GPs facing limited exit options and LPs demanding liquidity, Meg Wilson, partner at EY-Parthenon, explores how PE houses can keep their options open and preserve, protect and underpin value

The economic turmoil of the post-pandemic era and the transition to a higher cost, higher interest rate economy is clearly impacting private equity valuations and disrupting the normal holding cycle. Exits have been made even more problematic and uneconomic by subdued and often fickle capital markets. 

The challenges facing portfolio companies are particularly acute in sectors hardest hit by cost increases, interest rate rises and structural change. Some companies' trading potential has been affected by the pandemic or war in Ukraine – or their impact on supply chains, costs and top-line performance. Others boomed during the pandemic but have lost ground since due to new pressures, changing behaviours or inability to sustain their momentum.

This stress hasn’t translated into a significant restructuring wave. This is partly due to a high level of deals with lite-to-no covenants, which can delay the identification of problems, but also allow companies to correct course before the lender needs to get involved. 

There has also been a trend towards owners seeking more solvent, out-of-court restructuring solutions. But while this has provided a recovery route, there will be some cases where they’ll need to reset leverage levels and capital structures more comprehensively. And it’s also worth remembering that we haven’t seen the full impact of interest rate increases filter through. 

PE deals from the 2020-22 era will face trickier refinancings from mid-2024 onwards, at much higher interest rates and against a more challenging operational and lending environment.

There has been a trend towards owners seeking more solvent, out-of-court restructuring solutions

And with traditional lenders seeking to de-risk, access to capital and facility amendments will also become more limited. This could make value retention and growth tougher, with more portfolio companies forced to explore more expensive private credit and alternative finance. 

There is also a further valuation risk from the significant backlog of unsold portfolio companies. Any improvement in the economic outlook or exit options could create a flood of new sale mandates. 

So, what can PE houses and portfolio companies do to keep their options open and preserve and underpin value?

Navigating choppy waters

We’re transitioning to a more complex, expensive environment, with several fundamental transitions to address outside the financing envelope, including customer behaviour, supply chains, technology, energy and money. 

Businesses need to build flexibility by considering a broad range of business planning scenarios and identifying gating checks to drive timely pivots to different pre-planned tracks. Making it easier to adapt to change is key.  

They also need a proportionate focus on upsides and downsides to drive measured risk taking. Quantifying the potential magnitude of both profit and cash opportunities and vulnerabilities will underpin both value creation and external stakeholder confidence. Also, some portfolio companies may need to refocus from value creation to value preservation. 

Alternative options

Having a clear view of the intersection between near-term profit generation and cash conversion has never been so important. Reinforcing cash culture can be a differentiator, including reviewing investment decisions, optimising working capital, considering non-cash alternatives and identifying the contributions alternative stakeholders can bring.

If a situation becomes difficult, the adage of not paying too much for too little has never been truer. Deals must deliver changes or concessions that give sufficient breathing room and liquidity for the business to do more than survive. They need to provide an opportunity to thrive and return to value creation to avoid a return to square one.

Time to act

Tighter liquidity and the rising cost of capital mean that investors and funders are turning their attention to companies with strong fundamentals, including a robust balance sheet, healthy cashflow, understanding of ESG concepts and the ability to embrace new technologies.  

Deals must deliver changes or concessions that give sufficient breathing room and liquidity for the business to do more than survive

Determining the most favourable time to act and developing sufficient runway to hit the optimal transaction or refinancing timeline will be a significant value driver. This may require considering partial or staged solutions or building optionality with a credible plan B. Flexible timing in this environment will allow for agility and capturing best value.

Above all, those companies who think diversely about the possible outcomes and build flexibility will be best prepared to preserve value and thrive in difficult times.

Contributed by Meg Wilson, partner, EY-Parthenon, turnaround and restructuring strategy