Public market volatility driven by heightened recession fears trickled to private market enterprise values in Q2

The Lincoln Private Market Index (Lincoln PMI), the only index that tracks changes in the enterprise value of U.S. privately held companies, saw a decline of 0.5% in Q2, its first quarter-over-quarter decline since Q1 2020. The modest decline was driven by a contraction in multiples as private company performance remained relatively resilient quarter-over-quarter. Since the onset of the year, Lincoln has observed a pull-back in multiples; however, until Q2, earnings growth of private companies has more than offset this contraction and led to continued growth in the Lincoln PMI. This quarter an inflection point was reached, as earnings growth did not offset the contraction in private company multiples, which declined from 11.1x to 10.8x in Q2.

“As we have historically observed, portfolio companies in the private markets are not insulated from trends in the public markets and recessionary fears,” marked Steve Kaplan, Neubauer Distinguished Service Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business, who assists and advises on the Lincoln PMI. “However, the Lincoln PMI continued to exhibit resilience compared to the S&P 500 driven primarily by strong fundamental performance by the majority of portfolio companies.”

Resilient Demand Buoys Company Performance

While recessionary fears permeated the economy in the first half of 2022, demand for private companies’ products and services remained strong. Based on data from Lincoln International’s proprietary database, private companies experienced average quarter-over-quarter growth in LTM revenue of 4.7%.

On the other hand, based on the same subset of companies, LTM EBITDA grew just 2.3% resulting in an average margin contraction of 0.5% quarter-over-quarter with technology companies experiencing the greatest margin pressure.

However, while quarter-over-quarter LTM performance has been resilient, an analysis of just year-to-date performance in 2022 reveals a different trend. While year-to-date revenue has grown 13.3% compared to the same period in 2021, EBITDA has been approximately flat, only growing 0.6% with margins contracting 2.3% on average, indicating that more recent company performance is trending negatively compared to the prior year. Notably, revenue growth has exceeded EBITDA growth in each of the last four quarters.

Additionally, over the last year, EBITDA adjustments as a percentage of total adjusted EBITDA increased from 22.5% to 27.8%.

“Though it is remarkable how well demand has held up through the first half of 2022, this year may be a tale of two halves if demand slows in the second half of the year for discretionary businesses,” said Ron Kahn, Managing Director and co-head of Lincoln’s Valuations & Opinions Group. “In H2, private company growth hinges on consumers’ willingness and ability to spend and private companies’ efforts to mitigate inflationary pressures impacting margins.”

Private Credit Market Remains Resilient as Compared to its Public Counterparts

The average fair value of loans in the Lincoln Senior Debt Index (LSDI) decreased for the second quarter in a row from 98.4% of par in the first quarter to 97.4% of par in the second quarter. Despite these declines, private credit markets remained resilient, relative to the broadly syndicated market. Since Q1, the average bid of loans comprising the Morningstar LSTA US Leveraged Loan Index declined from 97.6% to 92.2% of par, although they have subsequently rebounded to 94.3% today.

In a rising rate environment like today’s, the vast majority of private loans are floating rate. While this dynamic ultimately means private credit investors can reap the benefits of higher interest income, rising rates could also lead to stress at the portfolio company level. One way to measure the impact of rates on portfolio companies’ ability to service their debt is the companies’ interest coverage ratio.

Despite the rising rates in the first half of 2022, Lincoln observed that interest coverage ratios over the last four quarters remained relatively stable, clocking in between 2.0x to 2.4x. These results, however, do not consider the substantial increase in base rates in Q2 from sub 1% to over 2% and increases in spreads since the beginning of the year of at least 0.25%. As a result, on a pro forma basis, assuming stable earnings, interest coverage would decline to 1.5x to 2.0x.

Lincoln International also noted that the average default rate remained below the two-year average of 4.7%. However, the average default rate increased to 3.0% in Q2, up from 2.5% in Q1, signaling increasing stress in the private markets.

“Given the current macroeconomic backdrop, loan defaults and tightening interest coverage levels are top of mind for many investors,” noted Ron. “Although private credit default rates remain low and interest coverage ratios remain in line with levels observed over the past year, that could quickly reverse course as private companies face a storm of rising rates and recessionary fears. It would not be surprising to see an uptick in defaults and worsening of interest coverage in the second half of the year.”

About the Lincoln Private Market Index & Lincoln Senior Debt Index

The Lincoln PMI is the only index that tracks changes in the enterprise value of U.S. privately held companies—primarily those owned by private equity (PE) firms. With the Lincoln PMI, PE firms and other investors can benchmark private companies’ performance against their peers and the public markets.

This index is differentiated from other indices as it (1) tracks enterprise values of private companies over time, (2) is based on valuations rather than executive surveys and (3) covers a wide sampling of companies across a range of private equity firms’ portfolios.

The Lincoln PMI seeks to measure the variation in private companies’ enterprise values by analyzing the aggregate change in company earnings as well as the prevailing market multiples for approximately 700 private companies, each generating less than $100 million in annual earnings. The index is calculated using anonymized data on an aggregated basis by Lincoln’s Valuations & Opinions Group, which has distinctive insights into the financial performance of thousands of portfolio investments of financial sponsors, business development companies and private debt funds.

The methodology was determined by Lincoln International in collaboration with Professors Steven Kaplan and Michael Minnis of the University of Chicago Booth School of Business. While other indices track changes to a company’s revenue or earnings, the Lincoln PMI is different in that it tracks the total value of these companies. Significantly, the large number of private companies used to create the Lincoln PMI helps ensure that the confidentiality of all company-specific information used in the Index is maintained.

Further, in 2020, Lincoln launched the LSDI which provides insight into the direct lending market as a fair value index tracking the total return, price, spread and yield to maturity of direct lending securities. The index is developed using much of the same data as the Lincoln PMI and the methodology was determined by Lincoln in collaboration with Professor Pietro Veronesi of the University of Chicago Booth School of Business.

Important Disclosure

The Lincoln Private Market Index is an informational indicator only and does not constitute investment advice or an offer to sell or a solicitation to buy any security. It is not possible to directly invest in the Lincoln Private Market Index. Some of the statements above contain opinions based upon certain assumptions regarding the data used to create the Lincoln Private Market Index, and these opinions and assumptions may prove incorrect. Actual results could vary materially from those implied or expressed in such statements for any reason. The Lincoln Private Market Index has been created on the basis of information provided by third-party sources that are believed to be reliable, but Lincoln International has not conducted an independent verification of such information. Lincoln International makes no warranty or representation as to the accuracy or completeness of such third-party information.

About Lincoln International

We are trusted investment banking advisors to business owners and senior executives of leading private equity firms and their portfolio companies and to public and privately held companies around the world. Our services include mergers and acquisitions advisory, private funds and capital markets advisory, and valuations and fairness opinions. As one tightly integrated team of more than 800 professionals in more than 20 offices in 15 countries, we offer an unobstructed perspective on the global private capital markets, backed by superb execution and a deep commitment to client success. With extensive industry knowledge and relationships, timely market intelligence and strategic insights, we forge deep, productive client relationships that endure for decades. Connect with us to learn more at www.lincolninternational.com.

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