Equity rollovers unlock more mid-market deals

March 27, 2024 (Preqin News) - Confronted by higher interest rates and diverging views on valuations, private equity dealmakers have increasingly turned to equity rollovers to unlock transactions, with more than half of mid-market deals reportedly doing so last year.

In a recent report, corporate law firm Goodwin Procter found that 57% of US mid-market deals featured equity rollovers in 2023, up from 46% in 2020. It attributes the increase to ‘a climate of economic uncertainty and challenging debt-financing markets.’

An equity rollover means that a seller agrees to retain a portion of their ownership stake post-acquisition instead of receiving sale proceeds in another form, such as cash or other consideration.

At this time of lower valuations, rollovers allow existing asset owners to free capital up immediately while retaining some access to future upside if valuations increase. This makes them a useful tool in helping to unlock transaction bottlenecks.

‘You can't really overstate the impact that increased borrowing costs have had on deals,’ Zachary Lupu, Partner in the Private Equity practice in New York at Goodwin Procter, and co-author of the report, tells Preqin News. ‘It has become imperative for sponsors to find alternative sources of acquisition financing, and so an increased reliance on rollover really helps fill that void.’

The number of annual buyout deals increased by 78% between 2014 and 2021, going from 7,605 to 13,504, before dropping by 15.6% in the two years to 2023, according to Preqin data. Aggregate deal value fell by 29.7% between 2021 and 2023, sliding from $1.62tn to $1.14tn, while the average deal size largely stagnated (from $584mn in 2021 to $569mn in 2023).

For GPs needing to return capital to investors yet unwilling to dispose of assets that may be worth more than current market valuations imply, higher rates and subdued valuations are a headache.

‘There's a streak of institutional investors needing to exit, but also not really wanting to part with that future upside,’ Lupu says. ‘And so, what we're seeing in terms of the market is structures like 50/50 deals where a GP will syndicate or sell down a portion of their investment to deliver partial monetization to their LPs, but they also want to keep exposure to future potential upside’.

Expectations of higher valuations have been underpinned by the outlook for borrowing costs. The notion that policy setters may cut rates later this year, combined with record dry powder, is driving speculation that deal volume will increase as the year progresses. Some GPs say they have already noticed deals ticking up since the second quarter of last year.

‘In terms of our deal flow, we definitely saw an uptick towards the end of last summer,’ Trent Hickman, Managing Director at lower middle-market-focused VSS Capital Partners, tells Preqin News. ‘I think the financing markets have improved quite a bit since last spring or early summer, those markets are much more open now, but the underlying levels of interest rates are still higher.’

While a retreat from higher borrowing costs may trim rollover use in completing transactions, the timeframe and pace of any future rate cuts will be key to determining their ongoing role.

‘If interest rates come down quickly, that may reduce the need for such reliance on rollovers. But if they come down more slowly, the question is whether there will be an acceleration downwards in the use of rollovers, or whether it will be more steady,’ says Lupu.

While interest rates have heavily influenced rollover frequency in recent years, borrowing costs are not the only consideration. Equity rollovers also have the capacity to provide tax benefits to the seller. For example, they permit holders of qualified small business stock to continue their hold period and preserve advantageous tax treatment on their equity for future disposition.

Perhaps more significant in a busy deal environment will be their role as a catalyst for investor-management alignment. When an initial seller remains in the portfolio company’s management team, this also benefits the buyer.

‘One of the biggest variables in any deal is certainly the quality of management and the quality of relationship that we're able to build with them’, adds Hickman.

_{The opinions and facts included in the above do not constitute investment advice. Professional advice should be sought before making any investment or other decisions. Preqin accept no liability for any decisions taken in relation to the above.}