Private Equity Deal-Making in 2023: Dead or Alive?

As macro-economic circumstances turned down over the middle of 2022 and markets were further disrupted by the fallout from the so-called mini-Budget, the UK PE deal-making environment slowed markedly. Many market participants, whether LPs, GPs, debt providers or the advisory community, began to fear a protracted down-turn, perhaps lasting through the whole of 2023 and even beyond. But as we head towards Q2 of 2023, how realistic is this expectation? And what will it take to re-start the engine in earnest?

We have gathered perspectives from market participants and commentators on these questions over the past 2 months. Although there is a range of views, the emerging picture, though still uncertain, is much less negative than 3-6 months ago, and meanwhile the market has kept moving, albeit at significantly reduced volumes vs. recent history.

We believe the following are the key issues:

The dominant dynamic is still the large volume of dry powder

The amount of equity capital available or committed to invest remains at historic highs. Even if some investors or capital providers become more cautious, an actual lack of capital to execute deals is considered unlikely.

This dynamic is expected to prevail into the medium term. There may be some proportionate reallocation of investors' capital away from PE over time, but most market participants expect this to take 5 years to play out if it does happen, and even if so, the amount of PE capital available is still expected be very substantial.

The debt markets are not closed

Debt market stability is emerging, but is highly segmented. The best assets with strong track records in counter-cyclical or low beta industries, e.g., insurance broking or wealth management, are achieving similar amounts at similar margins over base as historically. However, newer assets or those in more volatile spaces, e.g., those related to the housing market or consumer specialist lending, may still struggle to get funded at prices and amounts that make leveraged deals viable. Underperforming assets or those in severely challenged industries are experiencing higher margins over base for debt and lower available amounts, and some no availability at all.

Some mainstream debt providers have reined in their appetite quite considerably, in line with this segmentation, but overall the debt markets are far from closed. Indeed some specialists, e.g., private debt funds, are experiencing high demand to fund higher quality, lower risk deals than they can usually access, and at the higher yields that they require to meet their own funders’ needs. This could result in structurally higher importance for these funds, and significant competitive advantage for those equity investors that either have strong relationships with them, or who have access to their own “full stack” capital up and down the balance sheet. We are also seeing some sellers put together stapled debt packages, particularly for larger deals, and ensuring longer-run refinancing of their assets ahead of sale to mitigate or remove uncertainty on the sell-side part of the process.

Both LPs and GPs want to trade in 2023

Unlike the period following the Credit Crunch and GFC, during and following the COVID crisis LPs pressured funds to demonstrate the ability to deploy their capital and to realise investments. With few other alternatives at that time, LPs were very keen to continue to make returns in PE as an asset class, sometimes with the implied threat of not participating at the next fund raise. Although perhaps now slightly less intense, in part as other asset classes are now more viable, this pressure remains.

On the GP side, the need for many PE houses to raise funds again soon means that they also remain keen both to deploy capital and to realise existing investments with a view to demonstrating that they can meet LPs’ needs. Many organisations are raising funds now, which is proving to be a tough environment, meaning that this demonstration of performance is at an even higher premium.

The recovery will likely be rapid when it comes

The desire to do deals as soon as feasible has filtered through to preparation. Many assets are now being readied ahead of time, with a view to starting processes rapidly when market conditions are more settled. Many investment banks are increasingly busy with new sell-side mandates despite current subdued deal volumes and the obvious fact that the macro-economic environment is still volatile and highly challenged.

There are also some views that serious crises are becoming more frequent, so sales processes are progressing closer to “oven ready” state partly to ensure they are not caught by the next (as yet unknown) crisis potentially arriving soon after the current one is passed. For example, some processes waited for COVID to be over, followed by a period of stability, then re-started and got close to completion only for the current crisis to emerge, again bringing the process to a halt. Whether or not the general point about higher incidence of crises is true, those who went through this unfortunate cycle are keen to avoid a repeat.

As a result, many market participants anticipate that, when macro-economic stability returns, deal volumes will follow rapidly as there is expected to be a large number of processes ready to launch.

When will the starting gun be fired?

But when will normality break out, and what circumstances are required to achieve this?

5 pre-requisites are commonly given by market participants as benchmarks to establish widespread confidence and therefore normalised market deal volumes:

1. Broad consensus on medium-term base rates: as long as buyers and sellers disagree on expectations for base rates, with the natural flow through to equity values, it will remain difficult to price especially highly leveraged deals. However, our sense is that the moment for achieving this consensus is close by: it is now a small minority that regards a rapid bounce back down to near-zero base rates as likely. The recent decade and more since the GFC has been an extended anomaly, not the new normal, albeit that many even fairly senior PE investors have never experienced anything else, given the length of this period. Of course, the resulting decline in value for some assets will leave them “stuck” in portfolios as they are now out of or not sufficiently in the money to crystallise current valuations. Depending on factors such as sector exposure, some PE funds may be significantly disadvantaged by this. But overall the market is viable as soon as there is agreement on how to price, and indeed we have observed that many PE investors are somewhat relieved by the lower prospective pricing environment, privately acknowledging that recent vertiginous valuation multiples may have become unrealistic or unsustainable, at least in some areas.
2. Base rates to have definitively peaked: confidence is required that there will be no further upward surprises in rates, supported appropriately by macro-economic conditions, and central banks and markets indicating their strong expectation that the peak is passed. Recent Bank of England commentary indicates that this may be closer than markets were expecting even a few months ago.
3. Inflation to be clearly structurally declining: the pressure on costs and affordability exerted by inflation must have started to fall off structurally. Arguably we have already reached the early stages of this, but with rates still very close to their recent peak and significant uncertainty during what is still the peak winter energy usage period, we anticipate that at least a few more months’ evidence is required here.
4. Macro-economic forecasts to stop getting worse: while the period ahead is almost certain to be recessionary, provided the situation is seen as being contained, then conditions are tradable. Although still negative, the trend in recent forecasts has been improving on a like-for-like basis, i.e., successive forecasts from the same forecaster have generally been becoming less negative, most notably from the Bank of England in February. If this continues, the sense is expected to emerge that “the knife is no longer falling”, and growth plans for assets can be made and valued more confidently.
5. A period of proven, stable trading: a period of sufficient length demonstrating robustness to the current environment is required to show that each asset is itself capable of success in these circumstances. For some highly robust, counter-cyclical assets, this may be very short, or may already have been achieved. For others, for example highly discretionary consumer expenditure or non-standard consumer lending, this period may be longer, as the full effects of higher interest rates on household finances have not yet played out, and the stable trading period could potentially not start to be measured until this has happened, resulting in longer delays in these areas.

Expectations vary as to when these tests might be passed, and to some extent the answer depends on the specific circumstances of each asset and the industry or market segments in which it participates. But some consensus on timing is emerging: the range of views expressed is around the end of Q2 2023 on the optimistic side, and as late as Q1 2024 on the pessimistic side, with a plurality expecting late Q3 or Q4 2023.

Overall, a muted H1, but buckle up for when the market returns

The PE deals market in 2023 will undoubtedly remain muted for some months ahead. However, we expect it to keep moving in the meantime, with the majority of deals either extremely attractive assets that would be highly sought after at any time or those with particular timing pressures.

We are already seeing early signs of a return to more stable and less negative market conditions, and the consensus on these required between buying and selling parties to make confident deal-making feasible. When this process gathers momentum, which many expect to be 6-9 months from now, we anticipate that the market will return rapidly, supported by a large volume of deals ready to go immediately that circumstances permit.