Smaller-sized transactions and carve-outs are the types of deals most likely to make it across the finish line as a slowdown in private equity-backed M&A activity extends into 2023.

Inflation, high interest rates and the risk of recession are expected to weigh on private equity dealmaking through at least the first half of the year, said Andrea Guerzoni, global vice chair of strategy and transactions for professional services firm EY. Those same macroeconomic headwinds factored in a 32% year-over-year decline in private equity exits in 2022 and a nearly 39% year-over-year drop in the value of private equity entries.

"Private equity continue to have, actually, a quite interesting pipeline, but the pace in which these deals are analyzed and executed has slowed down significantly on the back of this situation," Guerzoni said.

On the other hand, those same economic headwinds are creating potential buying opportunities for private equity firms.

Guerzoni said geopolitical uncertainty and an ongoing effort to rethink global supply chains amid the COVID-19 pandemic have large businesses around the globe planning to jettison noncore assets. Sector expertise will be a key differentiator among the firms vying to buy up spinoffs and divestments, Guerzoni said.

"All these assets will become very interesting targets for private equity, especially if the price for an asset is not that easy to benchmark against a very volatile [public] equity market," Guerzoni said.

Buyer and seller disconnect

Buyers of all types are behaving more conservatively in the current environment, modeling a global economic downturn or possible recession into performance expectations for potential acquisitions, said Scott Wolff, managing director at middle-market private equity firm American Securities LLC. Those factors suggest lower valuations for acquisition targets, but sellers may not be on the same page, and that disconnect is largely responsible for the ongoing standoff in M&A markets.

"[Sellers] have good businesses that were trading at peak multiples not that long ago and still have those relatively high valuation expectations, and they don't see a temporary blip in the market or the macros as having a meaningful impact on their businesses," Wolff said.

But for large corporations looking to unload noncore assets, selling at a time of low valuations may not be as much of a concern, Wolff suggested, especially if a deal eliminates some debt or generates cash the company can reinvest in core strategies.

"They're still likely to move forward with some of those exits even if it's not at the max dollars because it's the right thing for them to do strategically," Wolff said, adding that American Securities is continuing to field carve-out queries, even amid the broader M&A slowdown.

Smaller is better

Guerzoni expected credit markets to loosen over the coming two to three quarters as inflation and interest rates cool and the market develops a better sense of fair valuation multiples. Until then, big private equity buyouts and other large M&A deals remain difficult to finance.

"Investment banks, banks, they have a lot of overhanging debt they cannot syndicate at this moment. Also, the availability of a large amount of debt is questionable at this moment," Guerzoni said.

Wolff said American Securities continues to pursue take-private conversations with small to medium-sized companies. "Simply based on the financing dollars available, it's easier to get smaller things done."

Because pulling together financing for a large leveraged buyout remains difficult, private equity firms are also having conversations with companies looking to sell a stake in their businesses, possibly alongside an agreement to sell the rest at a later date. Wolff said these smaller deals are easier to finance and generate some liquidity for the business owners.

"It's not core to what we do, but we are having more conversations with sponsors willing to sell a stake in their business," Wolff said.

Sector expertise is key

Firms with deep sector expertise are at an advantage in this environment, said David Dunstan, a managing director at Citizens Capital Markets Inc. and head of the M&A advisory group's industrial practice. It takes knowledge and confidence to look beyond the uncertainty of the next 12 to 18 months and envision a path to the end of a typical three- to five-year private equity investment cycle.

"The opportunities, I think, are significant, and those that are really deep in the sector are going to be able to visualize that better than, say, a generalist," Dunstan said.

Wolff said a private equity firm's sector expertise can be leveraged to find a price that "incents a seller to sell." A price that represents value for the private equity firm and the seller is a narrow target that requires experience to hit.

"It might not be exactly what they expected to get a year ago, but it might be above what they could get in a broader auction because we have some angle, we have some insights that others don't have," Wolff said.

Getting acclimated

Dunstan said a recent Citizens survey of 400 middle-market business and private equity executives suggested they are learning to live with high interest rates and a more uncertain economic outlook, two of the key factors that hindered M&A activity in 2022. A majority of survey respondents predicted that corporate valuations and company performance benchmarks would hold steady or improve in the year ahead.

"Business owners and private equity executives are getting more comfortable operating in a higher interest rate environment, getting more comfortable with regard to the possible timing and extent of a recession, and are able to make better-informed decisions with regard to acquiring new platform businesses, making add-ons as well as contemplating the sale of existing portfolio companies," Dunstan said.

Private equity firms sitting on record or near-record amounts of dry powder have the capital available to get deals done. Firms do not invest just for the sake of deploying capital, Guerzoni said, but at a certain point, limited partners expect fund managers to get off the sidelines.

"What the investors expect is that these management teams actually take stock of the new reality, readjust course and do the job, whatever the conditions are. I think this is going to happen. In all the crises I have been through over the last 20 years, it has always happened," Guerzoni said.