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Rising interest rates are disrupting leveraged buyouts. But specialists remain confident.

by Charles Ansabère

LBOs are the order of the day. After two years marked by a surge in the number of deals, the 2023 vintage looks rather pale. The cause, of course, is interest rates, which increase the cost of debt and disrupt the structuring of buyouts - and hence their profitability. Where it used to cost between 4 and 5%, it now costs between 8 and 10%. Against this backdrop, it is essentially the large-scale transactions that have disappeared from the landscape, and for which everyone is still wondering whether they will be able to re-emerge by the end of the year. For SMEs and ETIs, on the other hand, the picture is less bleak.

However, there was a general period of uncertainty in the spring, during which relatively few deals came to an end. According to the Refinitiv Institute, the first half of the year saw a 30% contraction in volume (with 320 LBOs counted), while the total value of these deals was down 70% on the previous year. QED: small-to-medium-sized companies managed to complete their projects, despite a general mood of anxiety.

Crispation autour des valorisations

The fundamental difference with 2021 and 2022 is that it has become virtually impossible to structure an LBO in the space of three months, as was the case then. The attitude of lending banks, eminently more cautious, does not explain everything. While it's true that they were more cautious about the quantum of debt allocated up until the summer, they nonetheless continued to respond when it came to mobilizing their regional networks - whose proximity to companies is well established. “The situation remains complex for deals with an enterprise value in excess of 100 million euros. On the other hand, it remains possible to syndicate up to 30 or 40 million euros of debt by approaching regional banks, as underwriting is no longer an option”, observes Anthony Dubut, CEO of InnovaFonds, a management company dedicated to supporting industrial SMEs.

We need to look at the other parties involved to understand what may have occasionally caused the machine to seize up. All observers agree that company valuations seem to crystallize the points of disagreement between buyers and sellers. As a result, a number of processes have not been completed due to sellers' persistently high expectations in terms of price, even if investment banks are trying to bring them back to their senses. Added to this is the fact that some offers for sale have simply been postponed, even for quality assets, due to the low prospect of closing the deal at the expected price. Last but not least, it's now more than ever the time to test the market with “dual track” deals, pitting funds against industrial buyers. The era of the “easy LBO” is over.

“SMEs will continue to escape asset and liability warranties and other MAC clauses, which are more appropriate for larger companies”.

"Good-quality assets continue to find takers, but the appreciation of good quality has evolved and the bar is higher.” qualifies Marc Ohayon, co-head of 3i France. Discussions between buyers and sellers are taking longer, and we're seeing a return to the reflexes of the 2008-2015 period, before the market boom, with financing structures and shareholder pact clauses that reconcile the expectations of both parties.” Convertible bonds and mezzanine debt are back in vogue, while sellers are sometimes led to agree to a vendor loan. On the other hand, SMEs will continue to avoid asset and liability guarantees and other MAC clauses, which are more appropriate for larger companies.

“The repercussions of the various crises are not felt at the same time in all sectors and companies. This is one of the reasons why the market is currently divided between deals that get done and those that don't - even though the companies haven't necessarily done badly enough”, says Florent Lauzet, partner and member of Siparex's executive committee. As far as investment banks are concerned, the files seem to be there. It remains to be seen how to present them to the market - and when! The practice of “coffee meetings”, which consists of organizing more or less informal get-togethers to test the appetite of buyers before structuring a formal sales process, would appear to be particularly topical.

Increase in business transfers

But let's not delude ourselves into thinking that the situation is that critical. By all accounts, the outlook remains bright. Despite the recent complications in the LBO market, the fact is that investment funds have large sums of money to invest (the famous “dry powder”, in the jargon of the profession) and it is not in their interest to delay putting them to work. What's more, the need to pass on businesses is becoming a reality, having been announced some time ago. Paul Bougnoux, CEO of investment bank Largillière Finance, which specializes in small and mid-cap companies, points out that “one-third of managers will be forced to sell their companies to retire within the next five years. Many of them have also reviewed their priorities after having to manage the succession of crises we've been experiencing since 2020.”

“A third of managers will be forced to sell their companies to retire within 5 years.” Paul Bougnoux, Largillière Finance.

An analysis confirmed by Anne-Cécile Guitton, president of management company NCI: "The covid has changed managers' approaches,” she observes. Despite economic uncertainty, they frequently express a desire to prepare for the future. In fact, the three deals we set up in 2023 were first-time investments with business owners wishing to organize their managerial succession.” A sign of the times: intra-family succession is no longer the “natural” way out for French SMEs, as retiring managers have no desire to pass on to their descendants the responsibility of navigating through the economic crisis.

More than capital

Let's not forget, too, that LBO funds are designed to provide much more than just capital to companies. For example, they have demonstrated their ability to support the management of their investee companies in implementing or accelerating external growth strategies (what they call “build-ups”). And what could be more timely than to consider seizing such opportunities, at a time when company valuations are less likely to be at their highest? What's more, this strategy should provide excellent leverage to create value and, when the time comes, record an attractive exit multiple.

“Private equity is a relay for the 100,000 SMEs and small and medium-sized companies that remain outside the non-listed market at a pivotal moment in their existence.” Fabrice Piollet, McDermott Will & Emery.

Moreover, having recognized that value creation can only be achieved through the deployment of ESG strategies, funds have generally structured themselves internally to answer questions and provide feedback on priority areas for deployment. And there's nothing trivial about that. As the short-term return on investment is virtually nil, while expenditure can rise very quickly, many companies may decide to postpone such spending for a while. This is a subject that will be on the table very soon for any new LBOs that come to a close between now and the end of the year. Fabrice Piollet, partner at law firm McDermott Will & Emery, points out that “private equity's vocation is to help managers manage their development issues. For the 100,000 or so SMEs and ETIs that remain outside the non-listed market, this is something to bear in mind at a time when they are often going through a pivotal moment in their existence.”