The banking crisis is set to perpetuate private equity firms’ financing challenges as more traditional lenders withdraw from the market.

The collapse of Silicon Valley Bank and Signature Bank, along with the rushed acquisition of Credit Suisse, has shaken industry faith in banks. As a result of the crisis and the Federal Reserve’s interest rate hikes that began last year, GPs that rely on banks’ lending arms are getting more creative in their capital deployment and moving to the lower end of the market for deals.

“There are very few primary effects on private equity, but there are secondary and tertiary effects,” said Sean Mooney, founder and CEO of BluWave, a private equity platform. “It’s going to become a money supply issue.”

The main result is increasingly conservative debt lending practices, a trend PE firms have been grappling with since the second half of 2022—when the Fed’s rapid tightening cycle brought the bank-led leveraged loan market to a virtual halt. From the second half of 2021 to the latter part of 2022, bank-led leveraged loan volume related to LBOs fell 80.2% year-over-year, according to PitchBook’s 2022 Annual Global Private Debt Report.

While the global financial crisis of 2007-2009 was spurred by the demise of some of the world’s largest banks, now the disruption is coming via smaller banks.

“The market is experiencing this equal and opposite event [compared to] 2008,” Mooney said, adding that the collapse will have similarities in its overall market impact.

With banks becoming more cautious in their lending practices, the bigger PE players are looking for novel capital deployment strategies.

Instead of financing LBOs, which typically require multiple loans from multiple different banks, larger firms are reaching toward deals that require less leverage, buying assets that can be financed through majority equity transactions and avoiding the loan supply issue altogether, said Karl D’Cunha, a managing director in the investment banking division at Ankura Capital Advisors. This means that PE firms will likely turn to assets, or companies, with less debt on their balance sheets.

D’Cunha says the LBOs that do go through this year will be higher quality, meaning these deal types will be concentrated in industries with lower risk profiles, like agriculture and infrastructure, as both lenders and PE firms become more selective in the deals they conduct.

At the smaller end, lower-middle-market and middle-market deals will be easier to finance than deals at the top of the stack as they require fewer loans and fewer lenders. In fact, middle-market funds—defined as between $100 million and $5 billion in size—accounted for 76.5% of all PE deals in Q4 2022, the highest quarterly level in the past five years, according to PitchBook’s 2022 Annual US PE Middle Market report.

“For large companies to do a private equity-backed deal, they’ll require like 10 banks to all come together and provide the financing. Particularly right now, it’s going to be really hard to put that club together and get someone to syndicate,” Mooney said. “Now, for a lower-middle-market deal, they only need one bank to say yes.”

Take-privates offer creative financing structures

Despite financing pressures, deal flow should continue steadily throughout the year as PE firms work to unload record amounts of dry powder and face pressures from LPs to deploy capital consistently. In 2021, PE firms accumulated a record $1.5 trillion in dry powder they have yet to deploy, according to PitchBook data. Without unlimited access to leverage, large PE firms are attempting to unload dry powder through alternate strategies such as take-privates, particularly in the middle market.

In 2022, take-private deal flow slowed toward the end of the year and market caps dropped from mega-deals to the middle-market space. In the first half of 2022, median deal size of all announced take-privates was $1.7 billion, but by the end of the year, it shrank to $316 million.

Over half of this year’s take-privates have taken place in that middle-market sweet spot, where PE firms can buy assets at an attractive price and with little leverage.

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