The bullish sentiment of the last decade in private equity (PE) dealmaking, characterised by unparalleled growth in both deal value and volume, now threatens to dissipate in the face of changing macroeconomic and geopolitical factors. We explore the immediate risks that lie ahead for PE investors and the transformation levers that can be used to mitigate them.
IS THE TIDE TURNING FOR PE?
This year, public markets have felt the impact of interest-rate uncertainty, geopolitical instability and recession fears. So far, however, PE has remained relatively unscathed. The illiquidity of the asset class may enable firms to ride out the storm, although PE portfolio assets are not immune to the multitude of risks that now abound.
The worsening outlook demands further investigation. Below we examine several factors that are likely to characterise and/or drive an aggregate reduction in valuation.
Extravagant overpricing will likely correct
Excessive capital inflows drive higher deal competition, higher asset pricing and ultimately lower returns. As the pricing expectations of buyers and sellers converge over the coming months, the real extent of any overpricing in PE dealmaking will become apparent – and so too the extent of the valuation bubble. New deals are likely to involve higher debt pricing, consisting of higher interest rates and hedging costs, while transactions are expected to take longer to close as banks scrutinise companies more closely against their exposure to increased rates and inflation.1 Of course, latent dry powder may bolster deal competition and prop up valuations, but the true magnitude remains unknown. In this context, PE firms can protect valuation arguments by implementing rapid transformation agendas to bolster returns.
Increasing economic risk
Dismal economic conditions further complicate matters. Soaring inflation (a 40-year high of 10.1% in July 2022) has triggered a tightening of central bank monetary policy, with the bank rate rising to 2.25% – the highest since the global financial crisis – following increases in both August and September.2 The global economic slowdown is forecast to continue into next year, impacting on the outlook for public markets and increasing the risk of recession. The near-term demand shock of a recession could mean challenging financial conditions and worsening investor sentiment for portfolio assets lacking robust free cash flows. While the illiquidity of PE will drive a delay in the rebasing of pricing expectations, broader economic woes are likely to result in an eventual correction, prompting portfolio assets to evaluate ways of mitigating these risks in the short term.
Tightening exit markets
The prospect of a downturn is likely to diminish the pool of possible interlopers for any portfolio asset. Where assets are buoyed by market tailwinds, sellers will increasingly answer to the power of buyers in determining value and overall capacity for exit. IPO markets, which previously represented a key exit route, now offer limited liquidity opportunities as they dry up in anticipation of market-wide rebasing. Global IPO value was down 73% in the first half of the year compared to 2021.3
As the market turns, we provide a reminder of how PE firms can mitigate adverse conditions and drive genuine value through three post-deal transformation levers.
1. Act early
The rollout timing of PE value creation programmes has significant implications for implementing change – with earlier rollouts being more effective. Despite this, only 16% of UK PE firms execute their value creation programmes immediately post-deal, with a larger proportion of firms beginning after six months.4 In this way, many PE firms fail to leverage the critical window during which sub-optimal business practices can be transformed, mitigated or removed. PE houses should initiate earlier rollouts, with a focus on performing rapid diagnostics as part of their ‘first 100 days’ agenda, to assess the scale of change required for the future state of the asset.
2. Work with existing management
Encouraging leadership teams to proactively address transformation hot spots and working collaboratively with them throughout design and implementation fosters accountability and maximises the likelihood of successful change adoption. Early collaboration invites senior leaders’ involvement in defining future transformation and broader strategy. This encourages transparent communication throughout the organisation. By starting early and championing collaboration, investors can work with their teams to calibrate areas of change, while protecting prosperous elements of the organisation.
3. Deploy digital
An increasingly critical aspect of transformation, and a possible route to further justifying valuations, is the deployment of digital strategies and architecture to enhance the business model of a portfolio asset. Whether portfolio companies embed digital within their core offering, digitise with cost control in mind, or consider bolt-on investments to balance their digital portfolio, an organisation’s digital thesis must be fully aligned with its core value proposition, bearing customers and employees in mind.
WHAT MATTERS MOST
Digesting the multitude of risks that portfolio companies face while properly calibrating transformation programmes to mitigate them is a large undertaking. It is critical to ensure that leadership teams are not overwhelmed in the short term, when responsiveness matters the most, and that they take ownership of the transformation initiatives that follow.