Jocelyn Lewis

Hello, and welcome back to Private Markets 360, S&P Global's podcast dedicated to enlightening and educating our listeners about the world of private markets from vast vantage points. Your private markets, 360 costs, both sit within Market Intelligence. I'll start off with introductions. I'm Jocelyn Lewis, Head of Private Debt Commercial Strategy.

Chris Sparenberg

And I'm Jocelyn's cohost, Chris Sparenberg, Head of Private Markets Commercial Strategy. I'm a super fan of our corner of the investment industry. We're thrilled to bring our listeners exciting guests every month for discussions about industry trends and other topics of interest here on the podcast.

Jocelyn Lewis

We sure are Chris. And if you're interested in regular private markets content, hit subscribe and tune in, ready to introduce our guest fries.

Chris Sparenberg

Let's do it.

Jocelyn Lewis

Today, we are joined by Ron Kahn, Co-Head of Lincoln International's Global Valuations and Opinions Group and member of Lincoln International's Global Management Committee. Ron provides debt advisory and valuation services to clients across industries.

With over 30 years of experience advising corporate and private equity clients on the structuring and arranging of financing front acquisitions, leverage buyouts, refinancings and dividend recapitalization, Ron maintains strong relationships with a wide network of financing sources, enabling him to provide issuers with tailored financing solutions to suit their specific needs.

Ron also provides valuations and fairness opinions to a variety of clients, including business development corporations, hedge funds, private equity funds and private debt funds. Today, we will focus on valuations and insights from the latest Lincoln Private Market Index and private markets perspectives report with data as of the fourth quarter of 2023. Ron, thank you so much for joining us today. Welcome to Private Markets 360.

Ron Kahn

Thanks for having me.

Chris Sparenberg

To kick things off, we'd love for you to tell us more about Lincoln International's valuation practice and also how your private market index and private markets perspectives quarterly report came about.

Ron Kahn

The valuations group as part of the investment banking firm, Lincoln International. We're based in Chicago. We have 212 is around the world in 18 countries, let's say, about 65% of the firm's activity is M&A, where we're representing mostly private equity funds and helping them sell their portfolio companies.

The rest of Lincoln revolves around a capital advisory group or private funds advisory group. And then the equity that I spent almost all my time on, which is the valuations group. We started the valuations practice. We probably back in 2002, 2003, almost by accident, but as you can expect, it really got its start in 2008 and 2009 when the world basically came to an end because of the great financial crisis. And sometimes, they always say better being lucky than smart.

But at the time, we were doing valuations. We were doing some private credit valuations, but very small because, as you know, in 2008, 2009 before then, there was really no such thing as private credit. And as a result of the financial crisis, banks, insurance companies, really the providers of middle market that decided that those loans to middle market companies were just too risky and they got out of the business.

What they did do is start private credit. Now before I started the valuations group how you had primarily been placing debt for private equity clients. So 2008, 2009, they lost their job, they started private credit. Interesting, when you think about it, there was no such thing as unit tranche loans before 2008, 2009. All I came about is from the global financial crisis.

We quickly saw a new sheriff in town. It helped us both on the capital advisory group because we were able to tell private equity clients, there's a new way to get your deals financed new sources and a new structure. But we also found out that these private credit shops needed valuations. They needed them for 2 reasons. First of all, their auditors were saying, this is the most important number on your balance sheet, and we're not too sure how to value it.

So you might want to get a third party to help figuring out what all these investments are worth. Maybe even more importantly, private credit uses leverage, not a lot of leverage, but they basically use one-to-one leverage. And the office of the control of the currency were coming down on some of the banks that we're providing leverage saying, these loans are your borrowing base, you don't necessarily know how much they're valued shouldn't you put a collateral for your loan.

So they all decided that they needed valuations because we had known them we basically ran up and down [ Bark Avenue ] to these new funds and said, you probably -- you don't necessarily want to outsource something that's so important, but we've been selling you for years and years.

We're actually placing the exact same securities that unit is to value. So we did not necessarily need to get outside sources to validate the valuations. It worked. And so today, I think most people would consider us the largest provider of valuations to private credit. We're closing in on that stat for private equity. But right now, we're doing as a firm, 5,000 portfolio company valuations every quarter.

Jocelyn Lewis

Ron, as you're doing those valuations, too, all that data that you're consuming, when did you get the idea to start the private market index and the private markets quarterly report?

Ron Kahn

In 2016, we were probably doing -- I'm guessing 1,000, 1,500 portfolio company valuations, but they were increasing exponentially every quarter. The one thing that's really nice about the practice is not only we need to get new clients, but we're growing organically with our clients.

So as our clients who are these large global asset managers are getting more funds to the money that is pouring into private credit is just phenomenal. They obviously have to deploy their capital. They are making new investments and with the beneficiary because we get to value those additional portfolio companies.

So in 2016, I'm not too sure exactly why we had a meeting, but there was a meeting with the Chairman of the firm, the Head of IT, some marketing people, and it came up with the marketing from the IT person at this meeting that, again, now in 2016, believe it or not, we really didn't have the cloud.

Everything was still done on service. And the head of IT was like -- came into this meeting and said, "You guys are killing me. I'm having to spend a fortune every quarter buying new servers to house the information you're getting on your portfolio valuation."

Now keep it in mind for every portfolio evaluation, we initially get all the loan documents, the investment committee's memorandum. We get the budgets, we get board packages. And then we get updated financials every quarter that we're doing this, including whatever, board packages, monthly -- the quarterly financials and the MD&A and things like that.

All this was going into the service, which was overwhelming. The system required us to buy more IT service. So the head of IT said, "Why don't we just get rid of this information?" The Chairman of the Board fortunately said, you have gold on your hands.

Don't you dare get rid of it. We could use this information to provide insights for our clients. And in fact, why don't we take this information and start an index of enterprise values for private equity-owned companies because I should say that of the 5,000 companies that we value, probably 99% are private equity owned.

I was like, "I have no idea how you build an index. That is way beyond my pay grade." And the Chairman of the firm said, "We're a mile away from the University of Chicago, from Bulls school of business." It's the #2 school in the country, why don't you reach out to one of the professors. In fact, Steve Kaplan, who is probably known as the most famous, most prestigious academic on private equity is based there, reach out to them.

I will never forget on a Saturday morning, painstakingly sitting at my kitchen table writing an e-mail to Steve Kaplan, thinking he is never going to respond, but I'm going to give it a shot. So I spelled out what Lincoln was, what we're doing on the valuation side, how we wanted to start an index. I pushed send and believe it or not, 10 minutes later, he responded saying, when do you want to come down to campus and meet, I did 2 weeks later, and it's a good relationship that we've had with Steve and some of his colleagues that has proved to be extremely beneficial.

And it was really Steve, who designed the Lincoln private market index. We actually now have used 2 of his other colleagues, professors, Mike Minnis and Pietro Veronesi to create a Lincoln senior debt index and a Lincoln default index, and they continue to look over our shoulder to make sure that the integrity of the data that we produce is sound.

Steve has had several of his PhD students use the data to help write their thesis. I will say for any clients that are looking out there, this stuff is totally anonymous. Even Steven, the professors don't have access to the names of the companies that we value, so we carefully guard that. But it's been very beneficial to not only the professors, I think, in helping them with their classroom work, but they view some of their students to help write thesis using it.

Jocelyn Lewis

Fascinating. So different use cases. The boom of private credit, how has your valuation practice evolved?

Ron Kahn

Certainly gotten bigger, going from nothing in 2009 to 5,000 today. But interestingly, I would say that the methodologies that we're using today are no different than what we've started to use in 2009. We primarily use 2 methodologies. One is geared towards how private credit deal makers think about their credits and the other one is a little bit more formulaic and geared towards the auditors.

So private credit dealmakers very rarely think good ratings. I know that's what your colleagues do a lot. But on the private credit side, they normally don't think is this a B, B minus, a B plus. They think in terms of leverage multiples. And so one of the methodologies that we have is basically to create a capital structure as if the deal was done today. The professionals at these private credit firms love that methodology. Frankly, the auditors don't love it because it's as objective than they would like.

And so we did establish the second method where we do shadow rate all these portfolio companies. Again, deal teams don't seem to really like that because they don't think in terms of ratings, but the auditors like that, and we do both methods. Usually, we weigh them 50-50 and come up with a mark. And obviously, we've tweaked the methodologies over time. Some of it is sweating based upon how active the broadly syndicated market is. But it works quite well having those 2 methodologies.

So if you have a company that's leveraged 6x, and it's got a $2 million increase in EBITDA, all of a sudden, your leverage capability goes up $12 million, but your rating won't necessarily change. And so that method is very sensitive to changes in fundamental as opposed to the synthetic shadow rating method, which is if you have a $2 million change in EBITDA, you're really not going to change your rating, but those ratings are more sensitive to changes in yields in the broadly syndicated market. We think that we produce a more robust mark that way.

Jocelyn Lewis

You certainly do by combining methods. And it's also interesting to hear that auditors have a preference. And then, I guess, the deal makers have a preference as well. But at the end of the day, you're coming out with that valuation or that valuation range that ultimately serves both purposes.

Chris Sparenberg

Ron, let's shift gears here a little bit and talk about the illiquidity premium. How do you account for the illiquidity premium when valuing private credit? Have you seen a decrease in this premium over the past year when BSL markets are relatively closed?

Ron Kahn

It's interesting to see how the broadly syndicated market does affect private credit. We see that they are directionally correlated but not necessarily completely correlated in how they operate because a broadly syndicated market can be affected by inflows or outflows of liquidity where private credit basically is insulated from that.

So what you saw primarily in '23, probably starting the midpoint of '22 when the Feds started raising their rates, broadly syndicated market was not as robust as it had been or has how we have been seeing it lately.

And so the illiquidity premium basically rose because there was no alternative for sponsors to -- they had to use private credit because they really couldn't use the broadly syndicated loan. What you've seen probably even since December 15 is the BSL market has come back quite strongly and is now a competitive product for private credit.

Private equity really has 2 options. They each have their own uses. But because private credit now has a competitive product in the BSL, we've actually seen spreads come down in private credit, probably 25 to 50 basis points at the upper end of that range for larger deals, which truly compete with broadly syndicated loan, but we're seeing that decrease in competitive spread, it is because sponsors have those alternatives.

Chris Sparenberg

That's incredibly interesting. And as we shift our focus to default rates, what is the latest data from Lincoln show for private company default rates? We know that S&P Global Ratings data shows corporate defaults rose to 153 in 2023. It's about an 80% increase from 2022 with 85 defaults and the speculative-grade U.S. default rate rose to 4.47%. Curious to hear what you've seen in the data and all the work you're doing at Lincoln International.

Ron Kahn

Our default rate is covenant defaults, which tend to be either leverage of fixed charge covenants, but we do know when there's covenants for when we're doing the valuation. And where we did see a spike earlier in the year on covenant defaults, for the last couple of quarters, we've actually seen decreases in the default rate. When we first saw these decreases, we were like, why is this happening?

This does not make any sense. But the thing that we noticed was the very large increase in amendments. Of the 5,000 companies, roughly 18% in 2023 had amendments. The defaults were largely anticipated and tracking all this data, we've seen that company's performance has been quite resilient. In fact, much better than I think anybody would have expected a year or 2 ago. Just as a side for 2023 of all the companies we value, the average EBITDA increased 4.8%, which in today's economy, I think, is quite reasonable.

What's hurting these companies is SOFR. In 2021, they were borrowing, let's call it, 5%, 6%. And today, it's 11%, 12%, and it's only -- not necessarily because of increase in spread, but because of increase in SOFR. And so private equity sponsors and private credit providers so that these defaults were eminent because companies were going to have trouble with fixed churn, again, not because of their earnings, but because of the increased SOFR and they proactively got together and say, that these companies are too important to us. They're doing well. It's something that's out of our control. Let's see if we can address the problem proactively.

Jocelyn Lewis

That's really fascinating that you saw about a 20% increase or the total amendments were about 20% of the deals that you value because looking at private credit, you'd say, okay, it makes sense that you could get that amount of amendments done.

But I wonder on the broadly syndicated loan side, where we were talking about the differences between the 2, if you could get that amount of amendments done on the broadly syndicated loan side in that same period of time because you have to go out and get all of those lenders and all of those syndicates to come together and really vote on the amendments on that side.

Ron Kahn

And that is probably one of the big advantages of private credit. You're paying probably 200, 300 basis points more to have a private credit loan from BSL. And what you get for that is the ability to negotiate with somebody if you need these amendments, if you need additional capital, whatever it is, you're sitting across the table from 1, 2, 3, maybe even 4 lenders, and they're all the same mindset because most private credit is hold to maturity.

They just work it out, trying to get that done in a broadly syndicated loan market, as you pointed out, is a way more arduous process. So if a company has a very stable capital structure and there's no real needs, then of course, they're going to take advantage of that lower pricing and go with the BSL, particularly today, while that BSL market is open. But for many private equity firms, they're always doing add-ons.

They're just doing spin-offs. They want to do dividend recaps. There's all different things they need to do to try and improve the performance of their portfolio company. And so dealing with a smaller group of lenders away from the public eye and keep in mind that there are no -- you don't need any ratings on a private credit deal where you doing a BSL, you're going to pay that premium and go with a private credit.

And I think that's why private credit has boomed to this. People cited is $1.6 trillion market, where, again, in 2009, it didn't even exist. And just to show you how sponsors and lenders are working together. Of these 20% amendments, 30% have sponsor infusions and them and 65% have increased pricing for the lender. So the lender is making an accommodation by either waiving or amending a covenant.

So the portfolio company does not have -- and it's normally fixed charge issues, again, not because of earnings issues, but because of increased SOFR. And the sponsor is saying, "Yes, I'll pay a little bit more in pricing, but I will also do my fair share and make some infusion of capital to help the capital structure or provide a little more capital for growth." And it's worked out incredibly well.

Jocelyn Lewis

It certainly did. I think there were a lot of people that just thought private credit. They synonymized it with loan to own. It's just not the case. We don't want to own these company.

Ron Kahn

The number of companies that we see that are actually taken over by a lender on any given quarter, of the 5,000, you could probably count on one hand. It just doesn't happen.

Jocelyn Lewis

I bet. Turning to another topic of interest to many valuation multiples. So one of the insights from the private markets perspective report was that multiples contracted for the fourth consecutive quarter. So do you see this continued multiple contraction as the new normal?

Ron Kahn

First of all, people have been questioning private equity valuations for most of 2023, saying that these companies were overvalued and the mark should come down substantially. It's interesting and probably one of the real values of looking at the private market index because, as I talked about, correlations between BSL and private credit, there's some directional similarity between the Lincoln Private Market Index and say the S&P 500.

But what's really the difference between the 2 is, first of all, how they are driven. The S&P is very largely driven by changes in multiple. The LPMI is almost all driven by changes in earnings. Multiples don't affect it nearly as much. And where these public company valuations have shown incredible valuation, the LPMI is showing a much more steady state.

If you track it from when we started the index in 2014 all the way today, they are very similar and where they end up. But the graphs are quite interesting because the S&P goes up and down and up and down and the LPMI is actually quite flat. We're primarily seeing multiples come down because of, again, what's going on with interest rates and the ability of buyers to acquire these companies at multiples that need to be less than where they have historically been.

Companies that were bought in '21 and before the multiples were exceptionally high by historic standards. And if you were to buy those same companies today at those similar market, first of all, the amount of leverage that you can get is probably a little bit less. Most lenders are requiring close to 50% equity as opposed in '21, it was closer to 40%. So you have less debt available and as we mentioned before, at a much higher price.

It was 5% to 6%, it's now 11%, 12%. So even if you put in 50% equity, sometimes, you may have to put in even more equity because you want a fixed charge coverage of no less than 1.2 when you put on those deals. So there's this standstill between buyers and sellers, which is -- has created a real low in M&A activity and is putting downward pressure on valuation multiples.

Buyers are saying, with this increased leverage and this increased cost of leverage, I can't pay the multiple pay before and it normally comes down to around between 1.5x and 2x churn in multiples in order for them to get the same IRR because of these financing issues. On the flip side of it, you have sellers who are getting increased pressures from LPs for distribution, saying, "Wait a minute, I bought this company at 15." I could sell it now to help my LPs get a distribution, but I'm going to have to sell it at 13.

Even though the company has done well, if you do the math on an LBO model and you bought something at 15 and you sold it at 13, you have minimal IRR. And so the sellers are saying, "I can't do this." I know my LPs want a return of capital. But if I do, my IRR is going to be so low. I'm not just sure I'm going to be able to raise another fund.

To stand off buyers saying, what I just can't. I am not going into a deal where I have a suboptimal IRR. And the sellers are saying, "I can't necessarily sell and not get an adequate return because I'm just not going to have the track record to buy to raise another fund."

And slowly, in my experience over the years, it's the buyers who prevail because the people who have the capital, there are almost always the one that call the shots. And so I think that is why you are seeing these multiples come down. They probably will continue to come down, absent a sharp decrease in [indiscernible] (00:24:49), but that's, I think, what you're seeing in multiples today.

Chris Sparenberg

And it seems like that's especially pronounced in the venture world. We saw valuations rise for some time until about 2022, and then we've seen a steady decline, but it's really hard to know across the space, what effect that's having on a lot of these start-ups. This is kind of a spiritual successor question to a point we discussed with Cambridge Associates on a previous episode where they can see high-level valuation trends. They can see them coming down. But no real notion in that data of what corresponds to a down round or how the venture market is behaving overall. Curious to know what you're seeing.

Ron Kahn

I think we're seeing valuations of venture deals come down even more than what we're seeing with operating companies. So nothing else, the liquidity and our venture capital's appetite to support these early-stage companies, particularly companies that have no earnings. We call these ARR deals. They're basically valued at a multiple of annual recurring revenue.

The appetite of these venture capital funds to put in money into these companies that are pre-earnings has declined significantly since the Feds started raising their rates and valuations are often based upon last round of financing, that may be the most relevant metric to look at. And I think that you've seen a lot of these companies that were done at extremely high ARR multiples are not necessarily getting the growth that they had expected.

So if you're buying a company that is a 10x, 12x ARR and you were expecting a 20% growth per year, it might work out, but all of a sudden, that growth is now 5%, 6% to pay 20x ARR. It just doesn't make any sense. And so the multiples come all the way down. To your point, I think the Venture Capital valuations have been hit harder than what we're seeing with pure operating companies.

Chris Sparenberg

Thank you, Ron. We enjoyed today's discussion about valuations, their evolution and how market dynamics over the past year or 2 have transpired. We'll be waiting to see the buyers and sellers and how they converge on price, how the reopening of the BSL market, plus the higher for longer rate environment will impact valuations over the next year. We thoroughly enjoyed our conversation with you, Ron, and we're grateful to you for coming on.

Ron Kahn

Thanks for having me.

Chris Sparenberg

Thank you again to our wonderful guest for a great chat today. We really appreciate everyone listening in. If you're looking for more private markets content, hit subscribe to catch future episodes and listen to our earlier episodes wherever you listen to podcasts. Cheers everyone.

Jocelyn Lewis

Thank you so much. You can also subscribe to our monthly private markets 360 newsletter. The link is in each episode of bio or connect with us on LinkedIn. Have a great day.