Middle Market PE Trends in North America: Q4 2024 Outlook

As Q4 2024 approaches, the North American middle-market private equity (PE) sector is experiencing a complex environment shaped by both operational improvements and external pressures. Contrary to earlier reports of strong deal activity, the sector’s performance has been nuanced, with moderate growth in specific areas but significant challenges related to financing, exits, and fundraising. Moreover, with the U.S. Federal Reserve pausing rate hikes, the cost of capital remains elevated but stable. Here’s an outlook based on current data.

1. Selective Growth in Deal Activity

The first half of 2024 saw a moderate rebound in middle-market private equity deals, especially in buyouts, with deal values rising by 12%. This growth, however, was not uniform across all sectors. Industries such as technology and healthcare saw higher activity levels, while others lagged behind. Overall, deal volume has remained below pre-pandemic levels, reflecting the ongoing caution in the market.

This partial recovery underscores a shift in strategy, with general partners (GPs) focusing on improving operations and driving growth through strategic value creation rather than relying on favorable macroeconomic conditions, such as low interest rates, which are no longer present.

?2. Operational Improvements as a Key Driver

In 2024, middle-market PE firms have emphasized operational enhancements to create value. Many GPs have adopted hands-on management strategies, focusing on leadership changes, process improvements, and targeted acquisitions. These operational changes are necessary in an environment where capital is more expensive due to high but stable interest rates.

Firms are streamlining portfolio companies to drive up EBITDA and improve margins, which is critical in offsetting the increased cost of financing. This strategy has been particularly beneficial for middle-market companies, which tend to be more flexible and responsive to operational adjustments.

3. Interest Rates: A Pause in Hikes, but Financing Remains Expensive

Contrary to expectations of further increases, interest rates have remained steady in the second half of 2024, with the Federal Reserve pausing its rate hikes. The federal funds rate is being held at 5.25% to 5.50%, as the central bank evaluates inflation trends and economic conditions. Inflation has moderated, but it remains above the Fed’s 2% target, contributing to a cautious outlook for the economy.

While the pause in rate hikes has offered some stability, the cost of borrowing remains significantly higher than it was during the ultra-low-rate environment of the previous decade. As a result, middle-market firms have had to adjust their financing strategies, focusing on improving cash flow and securing more favorable entry multiples when acquiring new companies.

4. Exit Activity and Liquidity Constraints

The slow pace of exits continues to be a major challenge for middle-market PE firms. Although exit values are expected to rise by 17% in 2024, the year will still likely end as one of the weakest in terms of total exit value since 2016. This has created liquidity challenges for many firms, as general partners are holding onto portfolio companies longer than anticipated.

The reopening of the initial public offering (IPO) market has provided some opportunities, but it has not significantly alleviated the overall pressure on exits. Most exits continue to come from corporate acquisitions or sponsor-to-sponsor transactions, which have seen flat activity levels throughout 2024. GPs are working harder to find alternative exit strategies to satisfy limited partners (LPs) eager for liquidity.

5. Fundraising Challenges in a Concentrated Market

Fundraising in the middle-market PE sector has remained difficult throughout 2024. The global private equity industry raised $422 billion by mid-year, but much of this capital was captured by large firms, with the top 10 buyout funds absorbing 64% of the total. This concentration of capital among the biggest players has made it harder for smaller and middle-market firms to attract new commitments from LPs.

Moreover, LPs have grown increasingly frustrated with the slow pace of distributions, leading many to be more selective in their capital allocations. Middle-market firms, particularly those without established track records, are facing more competition for limited capital, making fundraising a key challenge as we move into Q4 2024.

Conclusion

The North American middle-market private equity sector is facing a complex environment in Q4 2024. While there has been selective growth in deal activity and operational improvements have helped drive value, the sector continues to grapple with elevated borrowing costs, slow exits, and concentrated fundraising challenges. The pause in interest rate hikes provides some relief from rising financing costs, but the cost of capital remains high, necessitating a focus on improving operational performance to sustain growth.

Firms that can balance operational enhancements with strategic financial management will be better positioned to navigate the uncertain landscape heading into the final quarter of the year.

Sources:

- PitchBook, Q2 2024 US PE Middle Market Report

- Morgan Stanley, 2024 Outlook: Private Equity

- Bain & Company, Searching for Momentum: Private Equity Midyear Report 2024

- J.P. Morgan, 2024 Economic Outlook