Deloitte’s Head Of Investment Banking Reads The Private Equity Tea Leaves

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Phil Colaco knows his way around the middle market. He’s worked as an investment banker in the space for the past two decades, including the past six years as CEO of Deloitte’s U.S. investment bank—last year, his team advised on about 700 transactions. So as questions swirl about what volatile stocks, rising interest rates and a shifting economic outlook could mean for private equity firms and other strategic acquirers, his brain seemed like a good one to pick.

The market looks different today than it did at the start of the year. Gone is the era of dirt-cheap debt and surging stock prices. Rising rates, rocky equity markets, war in Ukraine and inflation have combined to create a dealmaking slowdown. But Colaco suggests a dose of perspective: What things are slowing down from, after all, is the most breakneck year in the history of private equity. On a longer timeline, current conditions don’t look so unfriendly.

“Is it worse than it was four months ago? Yes. Is it bad in any sort of historical context? No,” Colaco says. “The big change is there has been a little more bifurcation. If you’re a B+ to an A+ company, you’re still getting very high multiples, great valuations, lots of bidders. If you’re a B- or below business, I do think valuations have come down.”

For private equity firms, the most significant shift may be higher interest rates—and the likely prospect of further increases in the months to come. When rates were near zero, firms were able to rely on piles of essentially free debt to finance their buyouts. Now that debt is getting more expensive.

“Just doing simple math, either the buyer is going to have to take a lower return, or they’re going to pay less,” Colaco says. “That’s where the rubber really hits the road.”

Before the global financial crisis, major Wall Street banks were the primary lenders that fueled the buyout industry. But their activities were curtailed by new regulations in the wake of the crash, and in the past decade, a new class of private debt lenders has filled the void—business development corporations, hedge funds and other investors willing to embrace a little more risk in exchange for potentially higher returns.

That risk was minimal in recent years, when times were good. Now, it might be getting a bit more significant. When the economy took a turn for the worse in 2008, it was big banks that felt the crunch first. If it happens again in 2022, Colaco says these sorts of private lenders will be on the front line instead.

Another slice of the private market that could be in line for a shakeup is ESG. Using environmental, social and governance principles as a guiding light for investing has grown more popular in recent years. But for private equity, it’s become more popular largely because that’s what LPs are asking for—not necessarily because the firms themselves think it’s the best path to profits.

There are different schools of thought. Much of recent Wall Street history has been driven by the idea of maximizing shareholder value—essentially, that the point of a company is to make as much money as possible for shareholders. More recently, we’ve seen a rise in maximizing stakeholder value—essentially, that the point of a company is to do the most good for everyone whose life it touches, including shareholders but also employees, customers and other citizens. might maximize shareholder value, but it sure doesn’t maximize stakeholder value.

There’s a body of academic research indicating that embracing ESG principles can help increase a company’s profitability. Unfortunately, that’s not always the case. Often, there’s a financial sacrifice. Is it a sacrifice LPs are still willing to make? Early returns suggest the answer might be no.

“It seems like ultimately, it’s going to come down to the LPs themselves, and the LPs are going to have to say: How do we prioritize ESG versus pure financial return? And are we willing to take less of a return in order to be positive on the ESG side?” Colaco says. “That’s an easier decision when everything is good. It’s going to be a much harder decision now that things maybe aren’t as rosy in the equity markets.”