Will the Federal Reserve’s Rate Cuts Spur a Rise in Middle-Market Buyouts?

• Middle-market transactions are more sensitive to rate changes, where even a small cut in SOFR can lead to substantial savings in overall borrowing costs.

• The potential impact of the recent rate cuts on middle-market buyout transactions created optimism among financial sponsors that financing would be more affordable.

• Although the market is still digesting the impact of the Fed’s recent rate cuts, the volume of leveraged buyouts in North America surged by nearly 7% in the third quarter of 2024 compared with the same period a year ago.

• Given this upward trend and favorable financing conditions, the middle market appears well-positioned to keep benefiting from recent and pending rate cuts, likely driving further LBO transaction growth and enhanced valuations in the coming quarters.

The Federal Reserve’s recent rate cuts of 50 basis points in September and another 25 bps in November have sent ripples through the financial system. And while the effects of lower rates on public equities, debt markets, and large corporate financing have dominated headlines, the impact on private equity has been similarly profound.

The dance between rates and leveraged buyouts

The federal funds reserve rate surged from 0.09% in January 2021 to 5.33% in December 2023.1 During that period, the number of global leveraged buyout (LBO) transactions dropped by 63.7%. High interest rates over the past couple of years have limited the number of LBOs, with the higher cost of capital reducing potential returns for private equity firms and making these deals less attractive. Additionally, lenders became more cautious in the higher-rate environment, tightening credit conditions and making it harder for firms to secure favorable terms. As a result, the percentage of equity contributions in all LBO transactions increased to 53.3% in 2023 from 47.8% in 2021.

The Percentage of Equity Contributions Has Increased as LBO Volumes Declined

(US$ billion)

Source: Pitchbook database. Represents total US leveraged buyout transaction volume in the Pitchbook database from 1 January 2020 to June 2024. 1H 2024 represents data from 1 January 2024 to 30 June 2024.

Higher borrowing costs also prompted a wave of refinancing and restructuring activity within private equity. As the chart below shows, while the market value of the overall leveraged loan index remained the same from 2021 to 2023, the use of debt for refinancing and recapitalization surged to 38.4% of all debt transactions in the first half of 2024. Firms that had borrowed at historically low interest rates in the past were eager to refinance before rates increased further. By refinancing, companies aimed to avoid a higher interest burden in the future, thereby stabilizing their capital structures and ensuring that debt remained manageable despite the more challenging credit environment.

Refinancing and Restructuring Surged as a Percentage of Debt Transactions

Source: August 2024 US Leveraged Loan Index Factsheet. Market Value Outstanding refers to the total market capitalization of all outstanding leveraged loans. Pitchbook database. Retrieved on 7 October 2024. Represents the use of debt for refinancing and restructuring purposes outside the use of debt for other purposes, including all general debt, acquisition financing, and other debt transactions.

Although the market is still digesting the impact of the Fed’s recent rate cuts, the volume of leveraged buyouts in North America surged by 6.8%2 in the third quarter of 2024 compared with the same period a year ago. For private equity firms, lower interest rates typically mean cheaper borrowing, but the implications run deeper, particularly for those focused on middle-market buyouts.

As the chart below shows, the price gap between the S&P 500 and the S&P Small Cap 600 remained steady from 2020 to 2023 but began to widen starting in late 2023, once the federal funds effective rate surpassed 5.33%.

The S&P 500 and S&P 600 Price Gap Widened as the Fed Funds Rate Rose

Price index of S&P 500 and S&P 600

Source: FactSet. Represents the Price Indexes of S&P 500 and S&P 600 from 29 November 2019 to 1 November 2024.

An uncertain backdrop with rising inflation and rates drove the small-cap/large-cap performance gap

The S&P 500 has outperformed the S&P 600 recently due to several key factors. First, in times of economic uncertainty, investors tend to favor the stability of large-cap companies in the S&P 500, which often have strong balance sheets and global operations, providing a safer investment option. Second, the S&P 500 includes a larger proportion of resilient sectors, such as technology (31.7%),3 which has continued to show strong demand, whereas the S&P 600 has more exposure to cyclical sectors such as industrials (18.2%) and financials (19.6%),4 which are negatively affected by the interest rate pressure. Third, inflation has hit smaller companies harder, as they typically lack the pricing power of large-cap firms, making it harder for them to pass rising costs onto consumers. This has weighed on their profitability relative to the larger, more diversified companies in the S&P 500. Lastly, rising interest rates disproportionately affected small-cap companies in the S&P 600, as these firms often rely more on debt financing, making them more vulnerable to higher borrowing costs.

According to Bloomberg, S&P 600 companies have had 5.5x total debt/EBITDA on average for the past five years, while S&P 500 companies had only 4.0x net debt/EBITDA.5 When the Fed cuts rates, the reduction in interest expenses has a more manageable and immediate effect on small to middle-market firms’ cash flows, allowing them to redirect savings toward operational improvements or further investment.

SOFR is more responsive to Fed policy changes

Furthermore, middle-market firms often have floating-rate debts that are tied to benchmark interest rates like the Secured Overnight Financing Rate (SOFR). Since the 50-basis-point federal rate cut in mid-September 2024 and the 25-bp cut in November, SOFR has decreased from 5.38% to 4.56% as of 20 November 2024.6 Interestingly, the US 10-year Treasury rate increased from 3.62% to 4.40% during the same period. The increase is likely due to concerns about persistent inflation or expectations of strong economic data that might keep inflation elevated. Additionally, increased issuance of government debt could be pushing yields up as demand for Treasuries adjusts to greater supply. In October 2024, the US Treasury Department announced a quarterly refunding of $125 billion to cover November 2024 through January 2025,7 maintaining record-high debt sales and potentially indicating further increases next year. Additionally, the Treasury’s borrowing estimates for the October-December 2024 quarter were set at $546 billion, with plans to borrow $823 billion in the January-March 2025 quarter,8 further indicating increased debt issuance.

In leveraged loans for middle-market buyout transactions, the loan rates are typically based on SOFR rather than the 10-year Treasury yield. SOFR, closely tied to short-term borrowing costs in the repo market, is more directly responsive to the Fed’s policy changes. On average, middle-market transactions have higher institutional spreads than large corporate transactions.9 According to Pitchbook, the institutional spread of leveraged loans has averaged around 4.07% since the three-month base rate began to increase starting in first-quarter 2022. Notably, the percentage of leveraged loans with institutional spreads exceeding 350 bps reached 76.6% of all loans in 2022, marking the highest level in the four years from 2020 to 2023 (it dropped back to 64.9% in 2023).10 In the 30 days from 26 August to 26 September 2024, the average spread of first-lien loans on transactions between $351 million and $500 million was approximately 100 bps higher than that of transactions larger than $501 million.11 While the large spread itself implies a greater risk premium, middle-market transactions are more sensitive to rate changes; even a small base rate cut can lead to substantial savings in overall borrowing costs.

Even Small Base Rate Cuts Can Yield Substantial Savings in Borrowing Costs

Institutional spread over 3-month base rate

Source: Pitchbook database. Represents three-month Libor (prior to 2022) or SOFR (2022 or later) plus weighted average institutional spread. Base rate reflects the average during the quarter.

The recent Fed rate cuts are likely to have a positive influence on middle-market valuations, as these companies tend to be more sensitive to rate cuts, allowing them to access cheaper capital and thereby sustain or increase their valuations. This resilience at higher valuations creates favorable conditions for private equity firms to exit investments at attractive prices, effectively unlocking liquidity. As a result, firms can recycle this capital into new opportunities, enhancing the overall investment cycle within the middle market and driving continued growth in this segment. While the effects of the recent interest rate cuts have yet to be fully revealed, the rate movements during the 2008 global financial crisis provide useful references.

What the Global Financial Crisis May Reveal About LBOs Today

Source: Bloomberg database. Represents Actual EV/EBITDA of S&P 500 and S&P 600 companies from 30 June 2024 to 31 December 2010.

Interest rate Increases yielded similar valuations across large and small caps (2004-2007)

• From June 2004 to July 2007, the Federal Reserve steadily raised interest rates from 1.0% to 5.3%. During this period, both large-cap (S&P 500) and small-cap (S&P 600) companies had similar EV/EBITDA valuations, with S&P 500 companies at 10.9x and S&P 600 at 10.2x.

• This similarity suggests that, in a high-rate environment, larger companies do not benefit significantly more from high valuations than smaller companies. High borrowing costs affect both large and small companies, limiting the extent to which debt financing can be used to drive up valuations.

Rate cuts spurred divergence in valuations between large and small caps (2007-2010):

• When the Fed began cutting rates in August 2007, ultimately bringing them down to near-zero by December 2008, the data reveals a shift. The EV/EBITDA multiple of large-cap S&P 500 companies decreased to 9.8x, while the small-cap S&P 600 companies maintained a higher multiple of 10.2x.

• This divergence implies that smaller companies benefited more from the low-interest environment than larger companies did. For smaller (middle-market) companies, cheaper borrowing costs provided greater opportunities for leveraged buyouts and other debt-financed acquisitions, thereby sustaining higher valuations.

The potential impact of the recent rate cuts on middle-market buyout transactions created optimism among financial sponsors that financing would be more affordable. The evidence appeared even before the announcement by the Fed, with deal values increasing by 10.5% in the third quarter of 2024 versus the prior quarter. This volume also represents a 33.8% rise over the same quarter in 2023, underscoring strong year-over-year growth in this segment (see chart below).

Middle-Market Buyout Transactions Ticked Up in Q3 2024

Source: Pitchbook database. Represents completed and announced middle market buyout transactions occurred from 1 January 2023 to 30 September 2024. Effective Federal Funds Rate uses three-Month Base Rate sourced from Federal Reserve Bank of New York.

Given this upward trend and the favorable financing conditions, the middle market appears well-positioned to keep benefiting from recent and pending rate cuts, likely driving further transaction growth and enhanced valuations in the coming quarters.