Primary Investments | Manulife Investment Management

Key takeaways

It's a challenging time to be a private equity sponsor.
Interest rates are up, distributions are down, and new funds are remaining in market longer than their predecessors were just a couple of years ago.
The environment creates an opening for LPs to build new sponsor relationships in the lower middle market, where we believe many of the most promising opportunities reside today.

If private equity sponsors had the upper hand before interest rates started increasing in 2022, then relative strength has since shifted toward limited partners (LPs). LPs with capital to commit can seize the moment by building new relationships with proven—and formerly inaccessible—sponsors and then allocating into the uncertainty pervading today’s macroeconomic environment. We’re searching for interesting opportunities in the lower middle market, where leverage levels for many candidates are often substantially lower than they are for large-cap targets. Sponsors in this part of the market are accustomed to generating returns through means other than leverage and can really make a difference with thoughtful, skillfully executed add-on acquisitions to platform companies.

Take, for example, sponsors seeking founder-led buyout candidates. Founder-owned businesses are often capital constrained and often have been less willing or able to take risks in large-capacity expansions or add-on acquisitions. Private equity opens new possibilities. Given the smaller deal sizes, it’s easier to raise the debt capital for these transactions today since many lenders have backed away from larger buyouts.

Capital scarcity is affording some LPs new openings with coveted sponsors

Source: PitchBook, September 30, 2023. LHS means the left-hand side y-axis; RHS means right.

A key for any buyer resides in finding a seller who cares about deal attributes beyond price alone. Founders typically seek trustworthy buyers who see the business not as a target, but a legacy to be honored, nurtured, and strengthened. The buyer can compete on non-price terms, and the seller can cash out completely or derisk and stay involved. Some sponsors prefer to invest in firms in which the founder retains an ownership stake and maintains an active role in the business as it prepares for transformational growth. That can also give founders a second bite of the apple: Retaining, say, 10% to 40% of the business allows the founding owner to benefit from the next exit—the proceeds of which can even exceed the founder’s proceeds from the initial buyout. Such an arrangement aligns the incentives of all the owners, both longstanding and new.

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