UK: An Introduction to Private Equity: Buyouts
2024: A Year of Recovery?
The year 2023 was a challenging one for private equity, marked by a 60% drop in global investments due to geopolitical instability and macroeconomic issues. In the UK, rising interest rates and persistent inflation had a significant impact. However, 2024 has brought cautious optimism, with expectations of more stable monetary policy and better alignment between buyers and sellers on pricing.
UK private equity deal volumes slightly increased in the first seven months of 2024, although overall deal value declined. Most transactions have been add-ons to existing portfolio companies, indicating a strategic focus on strengthening current assets rather than pursuing new deals or exits.
Fundraising has shown signs of recovery, with global private equity funds closing USD408.6 billion in commitments in H1 2024, up from USD374.6 billion in 2023. However, the longer fundraising periods (18 months on average) suggest that limited partners remain cautious, struggling to commit amid a slow exit market. The number of funds closed has also declined since 2021, indicating a concentration of capital among fewer sponsors. Several consolidation transactions have already occurred in the UK private equity and infrastructure sectors in 2024.
Bridging the Capital Gap
In the UK, it seems that the era of low interest rates and inexpensive access to credit is over for the foreseeable future, threatening the traditional leveraged buyout model. With unattractive debt terms, private equity sponsors are increasingly writing larger equity checks to finance deals. In 2023, for the first time, leveraged deals were financed with more equity than debt – a trend expected to continue.
Of course, an abundance of undeployed capital (reaching record highs by mid-2024 according to S&P Global Market Intelligence) enables private equity sponsors to finance deals with more equity. In 2024, many sponsors have been able to fully equity underwrite buyouts, seeking third-party financing later. However, as the fundraising environment becomes more competitive and timelines lengthen, sponsors will need to explore creative funding strategies, particularly for large-cap transactions.
Co-investment strategies are a good example of this and, increasingly, sponsors are turning to their limited partners (LPs) with co-investment opportunities – not only does this help fund the larger-cap transactions, but also provides an attractive fundraising tool, where LPs can take advantage of the governance rights and lower fees that come with direct co-investment.
Pricing
Sellers’ reluctance to accept lower multiples in a period of higher interest rates continues to obstruct a return to high volume deal-making in the UK. To bridge the gap on pricing expectations, we see earn-out mechanisms rising in popularity – buyers, unwilling to pay a premium for anticipated future revenue growth, preferring to pay once growth is actually realised. “Seller reinvest” is another emerging buy-side strategy, testing sell-side confidence in valuations while reducing the capital buyers need to draw from limited partners.
Pricing challenges have also led to many private equity sponsors extending their hold periods and therefore delaying the initiation of exit processes (except for top-performing assets, which have continued to attract competitive bids and strong multiples). On the buy-side, an increased appetite for sourcing bilateral deals reflects a preference for avoiding the competitive tension of auction processes, allowing more time to thoroughly due diligence the target and get comfortable with valuations.
Against the backdrop of a tough deal-making environment, private equity sponsors increasingly choose to focus on portfolio company value creation and readiness for exit, for example through enhanced operational performance, renegotiating key contracts for more favourable terms, and improving legal and regulatory compliance with improved and updated policies. Strategic add-on acquisitions also remain a common tactic to boost exit multiples by expanding into new markets or achieving horizontal integration.
For underperforming assets, sponsors have taken the opportunity to implement turnaround or other restructuring plans, sometimes requiring additional equity injections (at lower valuations, with the hope of realising greater gains in the future). Where existing management incentive equity is underwater, sponsors will often reset the incentive plan through new share classes or contingent cash bonuses to ensure management’s interests are more closely aligned to maximise value at exit.
Meeting a Need for Liquidity
The UK has not seen a resurgence in exits via secondary buyouts or IPOs. The London Stock Exchange added only eight listings in H1 2024, lagging behind other European financial centres. There is some optimism that the change in government and reforms to the Financial Conduct Authority listing rules will boost UK IPO activity, but as private equity sponsors are judged on their ability to generate returns for their LPs, they cannot wait indefinitely for market conditions to improve, and many have turned to creative ways of generating liquidity in 2024.
Continuation funds are increasing in popularity, allowing sponsors to retain promising assets beyond the original fund’s life and offering liquidity to outgoing LPs while unlocking new capital. General partner-led secondaries have become more common, with pricing structures addressing potential conflicts of interest: deferred payments and EBITDA-linked earn-outs are typical, and sponsors are expected to reinvest a significant portion of their capital. Continuation fund-level debt financing also remains available, though lenders often seek security beyond the holding entity, looking upwards to the continuation fund’s uncalled capital.
An Opportunity in Public Markets
Despite the general drop in deal-volume, UK private equity activity in the public markets remains noticeably resilient, with a healthy volume of takeovers of listed companies (“take-privates” or “P2Ps”). Aggregate deal value of UK public-to-private transactions increased in H1 2024 by 21% compared to the same period in 2023, driven by favourable exchange rates and UK equity discounts. High-profile P2P deals continued into H2 2024, supported by direct lender financing.
Carried Interest
In its first Autumn Budget, the new Labour government in the UK confirmed (what many in the industry have feared) that the tax treatment of carried interest will change. As an interim measure, the tax rate of carried interest will increase from 28% to 32% for the 2025/26 tax year, but further reform is expected to take place from April 2026, bringing carry fully within the UK income tax code. Successive governments of all political leanings maintained the capital gains tax treatment of carried interest for decades, allowing the private equity industry, and its portfolio companies, to flourish and turn the UK into the world-leading asset management hub that it is. The extent and significance of changes that could see carried interest eventually being taxed at combined income tax and NI rates of up to 47% remains to be seen.
Read the full article here: Private Equity 2024 - UK | Global Practice Guides | Chambers and Partners