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Private equity deal lawyers eye valuation headwinds from interest rates, war and de-globalization

From sharply lower private company valuations to tougher review of cross border acquisitions, the world of private equity deal-making faces fresh challenges in 2022, corporate lawyers that work with financial sponsors say.

All told, the deal business remains mostly robust for alternative players with global private equity and venture capital transactions increasing 6% to $98.8 billion in April, according to data released Friday by S&P Global Market Intelligence. In a sign of trouble, however, the number of deals in April fell 22% to 1,611.

While the private equity world remains partially insulated from the daily moves in the stock market, it hasn’t escaped the macroeconomic carnage caused by steep losses in public equity prices in the face of inflation and potential recession.

High-flying, money-losing unicorns are seeing their private market valuations drop sharply as deal-makers ponder the impact of higher interest rates on companies that burn cash.

Softbank Corp.
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-backed buy-now-pay-later financial technology company Klarna Bank AB has seen its valuation fall to about $15 billion now from $46 billion a year ago as it attempts to raise fresh capital, The Wall Street Journal reported.

See: When companies outgrow unicorn size, what should we call them?

Markus Bolsinger, partner at Dechert that works with private-backed companies on deal-making, said higher interest rates take a heavy toll on unicorn valuations since they shape cash flow projections for money-losing companies.

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If a private company needs capital, its cost of borrowing has already been higher, but now interest rates on loans are climbing fast as interest rates rise. This dynamic has made private equity firms and venture capital funds that back private companies more cautious about money-losing operations.

When considering equity infusions into companies, private equity firms also shape their investments by the valuations of comparable companies.

“When using a discounted cash flow model to value a company, those cash flows get more heavily discounted when interest rates increase,” Bolsinger said. “There’s been a shift to focusing on profitability and a push for venture capital-backed early stage and growth companies to conserve cash and reach a path to profitability earlier. ”

Besides interest rates, other headwinds to deal-making come from rising geopolitical tensions, whether it’s protecting intellectual property from China, or trying to adhere to sanctions against Russia and billionaire friends of Vladimir Putin.

Mark Thierfelder, chair of Dechert’s global private equity practice, said more headwinds face cross-border deals in both the private equity and corporate deal-making worlds, amid an overall trend of de-globalization.

Regulators have gotten more aggressive on antitrust enforcement of deals, he said.

Also, rules around foreign direct investment have become more strict in many jurisdictions as governments move to weigh national security implications of overseas ownership.

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In the U.S., the Committee on Foreign Investment in the U.S. (Cifius) has been flexing its muscles to review cross border deals such as China’s Foxconn EV Technology Inc.’s $230 acquisition of a Lordstown Motors Corp. factory in Ohio that once belonged to General Motors Co.
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Other countries such as India have been moving to update similar regimes to review whether M&A tie-ups hurt national security.

“Borders have hardened,” Thierfelder said.

Economic sanctions against Russia have also forced private equity firms to freeze investments from any companies and individuals with close ties to Vladimir Putin.

Higher interest rates and jitters about inflation and a recession have also made financing M&A transactions more challenging, said Lindsay Flora, who specializes in private debt offerings.

A lot of deals aren’t getting done,” she said. “Banks are looking closely at each deal. Larger banks are more hesitant while direct lenders are more active partly because they face fewer regulations.”

The syndicated bank market for loans remains more challenging and she’s been working on one deal that’s been in the market for three months, Flora said. She declined to provide any details.

Accounting of expenses related to the COVID-19 pandemic remain in flux as well. Debate continues over which expenses related to the pandemic should or should not be added back into Ebitda and cash flow numbers used to craft valuations.

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