Leverage in the Age of Persistence: How PE Firms Are Restructuring Deals as High Rates Refuse to Retreat

When the Federal Reserve began its rate-hiking cycle in early 2022, the prevailing assumption within private equity was that the industry would endure a difficult but finite adjustment period. Deal volume would compress, leverage multiples would decline, and eventually the credit environment would normalize in a manner consistent with historical precedent. That assumption has proven costly for firms that structured their portfolios — and their expectations — around a swift return to the low-rate conditions that defined the prior decade.

Two-plus years into a sustained high-rate environment, with the cost of debt stubbornly elevated and refinancing pressures mounting across vintage 2020 and 2021 portfolios, private equity firms are no longer waiting for conditions to improve. They are adapting their deal structures in substantive ways, deploying instruments and mechanisms that were considered niche just a few years ago, and quietly absorbing the consequences of bets that have not gone according to plan.

The Leverage Multiple Recalibration

The most visible structural adjustment has been the compression of debt-to-EBITDA multiples across leveraged buyout transactions. During the peak years of 2020 and 2021, it was not uncommon to see mid-market deals structured at six or even seven times EBITDA leverage in favorable sectors. Today, the practical ceiling for most transactions in the middle market sits meaningfully lower — closer to four to five times for borrowers without exceptional credit profiles — as lenders have tightened underwriting standards and required more conservative debt service coverage ratios.

This recalibration has a direct and uncomfortable implication for returns. The financial engineering that allowed PE firms to amplify equity returns through aggressive leverage is constrained. Generating target IRRs in the mid-to-high twenties — the benchmark that has historically defined strong performance — now requires either paying lower entry multiples, achieving more substantial operational improvement during the hold period, or identifying exit pathways that were not part of the original investment thesis.

In practice, all three levers are being pulled simultaneously, with varying degrees of success.

Mezzanine Financing Returns to Prominence

One of the more notable structural responses to the current environment has been the resurgence of mezzanine financing as a bridging instrument. Mezzanine — subordinated debt that sits between senior secured loans and equity in the capital structure — had been largely displaced during the low-rate era by the abundant availability of cheap senior debt and the growth of direct lending platforms willing to underwrite aggressive structures.

In the current environment, mezzanine has re-emerged as a practical tool for deals where senior debt capacity falls short of what is needed to make transaction economics work at prevailing purchase price multiples. Mezzanine lenders, many of whom maintained discipline through the boom years and now have significant dry powder, are finding deal flow and are willing to price their instruments competitively relative to the broader credit market.

The tradeoff is meaningful. Mezzanine debt typically carries coupon rates in the 12 to 15 percent range, sometimes with payment-in-kind components that preserve near-term cash flow but accrete principal over time. For sponsors, the arithmetic only works if the underlying business can generate sufficient earnings growth to absorb the blended cost of capital — a requirement that places premium importance on operational due diligence and realistic projection modeling.

Earnouts and Seller Notes: Bridging the Valuation Gap

Another structural mechanism gaining traction is the expanded use of earnout provisions and seller financing. In an environment where buyers and sellers frequently disagree on valuation — buyers citing higher discount rates and compressed exit multiples, sellers anchoring to peak valuations from prior years — earnouts offer a mechanism to bridge the gap by tying a portion of the purchase price to post-close performance milestones.

The use of earnouts is not without risk. Disputes over earnout calculations are among the most common sources of post-acquisition litigation in M&A transactions, and structuring earnout metrics that are both meaningful and administratively clean requires careful negotiation. Nevertheless, deal professionals report that earnout provisions are appearing in a higher proportion of transactions than at any point in the past decade, particularly in the lower middle market where valuation disagreements are most pronounced.

Seller notes — arrangements in which the seller accepts a portion of the purchase price in the form of a promissory note rather than cash at closing — serve a similar bridging function while also providing sellers with ongoing economic participation in the business's performance. For buyers, seller notes reduce the upfront equity requirement and can improve day-one leverage metrics, though they introduce counterparty considerations that require careful structuring.

Continuation Funds as an Exit Alternative

Perhaps the most structurally significant development in the current environment has been the proliferation of continuation funds as an alternative to traditional exit pathways. When the IPO market is unreceptive and strategic buyer valuations are compressed by their own cost-of-capital challenges, sponsors holding high-quality assets that are not yet ready for an optimal exit have increasingly turned to continuation vehicles — single-asset or small-portfolio funds that allow a GP to transfer assets from a maturing fund into a new vehicle, providing liquidity to existing LPs who wish to exit while allowing those who believe in the asset's continued upside to roll their investment forward.

Continuation funds have grown dramatically in volume, with several industry estimates suggesting that GP-led secondaries — of which continuation vehicles are the primary form — now represent a substantial portion of overall secondary market activity. The structure is not without controversy; LPs and governance advocates have raised legitimate questions about conflicts of interest when a GP both sets the valuation and controls both sides of the transaction. Leading firms have responded by implementing independent valuation processes and ensuring that secondary advisory firms provide fairness opinions, but the governance conversation continues to evolve.

The Strategies That Are Quietly Struggling

Not every adaptation is succeeding. Firms that loaded portfolios with highly leveraged assets in 2020 and 2021 — particularly in sectors sensitive to interest rate pass-through, such as commercial real estate-adjacent businesses, consumer discretionary, and technology companies with extended paths to profitability — are navigating genuine distress. Refinancing walls that were comfortably distant two years ago are now pressing, and the options available to sponsors in that position are limited and expensive.

Amend-and-extend negotiations with lenders have bought time for some borrowers, but they have not resolved the fundamental mismatch between debt service obligations and cash flow generation in businesses where EBITDA growth has not materialized as projected. For these situations, the most likely outcomes involve negotiated equity injections, debt-for-equity exchanges, or, in the most challenging cases, consensual restructurings that impair sponsor returns significantly.

The broader lesson the current environment is delivering — with considerable force — is that leverage is not a substitute for operational value creation. Firms that built their investment theses around financial engineering and multiple expansion are being tested in ways that their more operationally focused counterparts are not. In a market where rates may remain elevated well into 2025 and beyond, that distinction is becoming increasingly consequential for fund performance and LP confidence alike.