European private equity in 2023: a broadly positive outlook despite economic headwinds

October 2023  |  SPECIAL REPORT: PRIVATE EQUITY

Financier Worldwide Magazine

October 2023 Issue

After many record-breaking years, 2023 demonstrated that the times of predictable growth in the private equity (PE) industry have, at least temporarily, come to an end. The continuing war in Ukraine, rising interest rates and global supply chain difficulties have put pressure on businesses and financial investors alike. This resulted in a decrease in the number of deals and a reduced average deal value in the PE industry in Europe in the first half of 2023. The average deal execution timeline, from approaching potential investors to the closing of a transaction, was also more prolonged compared to previous years. In parallel, exit and fundraising activities slowed down in the first half of 2023 compared to prior years.

Does this mean there is a negative outlook for PE in Europe for the rest of 2023? Despite the current challenges, most PE funds still share a broadly positive outlook for the remainder of the year. Set out below are some of the key factors to be considered from a PE perspective.

Every crisis is an opportunity

The vast majority of PE funds have taken an opportunistic approach to dealmaking in 2023. The healthcare and life sciences, business services and technology and software industries continued to represent a core investment focus for many funds. While there is still an abundance of dry powder and attractive targets are sought after, sellers and buyers have found it increasingly difficult to agree on an adequate valuation of the assets. This valuation gap between sellers and buyers has contributed to the slowdown in activity and an extension of deal execution timelines. It may be difficult to predict, but if more sellers are gradually resetting their own valuation expectations, this may create opportunities. In the context of auctions and other competitive processes, investors that have previously shied away because of extremely high valuations and tough competition may be tempted to reconsider their approach now. Several investors also expect that for the remainder of 2023 there could be more bilateral opportunities as, in uncertain times, sellers may be inclined to focus more on transaction certainty than the race for the highest bid.

Other opportunities may be realised as corporate groups divest non-core assets to adjust to the challenging economic environment, hence increasing the number of available targets for PE buyers. The first half of 2023 demonstrated examples of industrials as well as banks considering carve-out transactions to clear balance sheets and to set free additional liquidity. While not all PE funds may be willing and able to handle the complexities of implementing the disentanglement of the target business from the seller’s group, substituting various seller’s group functions and managing transition services, there is a steadily growing number of European PE funds endowed with the necessary manpower and operational experience to handle carve-out situations.

There are also indications that the market for distressed assets will continue to grow, which could attract PE investors focusing on special situations. The ongoing transformation in some of Europe’s core industries, such as the automotive sector, the impact of significantly higher energy costs on the margins in industrial manufacturing, as well as the unstable general economic outlook, have added additional momentum. The number of potential targets being brought to the market out of corporate reorganisations or restructurings by insolvency administrators in the first half of 2023 was already higher than in previous years.

Finally, there are also signs that limited partners are putting more pressure on general partners to hasten exits, particularly where the backlog of unrealised assets has slowed down distributions. Many assets in portfolios are edging or have even exceeded the usual holding periods as PE funds were hesitant to promote exits in view of uncertain returns. The slowdown on exits has also negatively impacted fundraising activities as LPs are hesitant to deploy new capital if the prospects of returns on invested capital have become less predictable.

Increased focus on diligence and negotiations

With tightening returns on investment margins, it became clear during the first half of 2023 that PE buyers are assessing targets and investment decisions carefully, consistent with the approach taken in 2022. This resulted in a continued emphasis on due diligence, be it from a legal, financial, commercial or technical perspective. Creative solutions are also required, particularly where a valuation gap between buy-side and sell-side needs to be bridged. In times of macroeconomic uncertainties because of high energy costs and supply chain difficulties, there has been a greater focus on dynamic purchase price structures, with more direct risk sharing between sellers and buyers, for example through earn-out and deferred compensation elements.

Debt financing

Rising interest rates, as well as a decreased appetite for risk on the part of certain financing providers, rendered access to debt financing more difficult in the first half of 2023. In some cases, particularly heavily leveraged deals needed to be called-off or were significantly delayed given the lack of suitable debt financing. This is unlikely to change significantly in the coming months. As a result, a number of PE funds anticipate that securing suitable acquisition financing will continue to be a significant challenge and that the increased cost of acquisition financing may push certain buyers to the dealmaking sidelines. In the first half of 2023, some private equity funds adjusted their deal structures by acquiring minority stakes as a solution to the lack of debt financing, retaining the potential to acquire a majority stake via refinancing later – this market-wide trend is expected to continue in the coming months. It is still unclear if and when current international political tensions can be expected to stabilise, helping to reduce the volatility of the global capital markets and rising inflation – both of which are indirect cost drivers for debt financing.

ESG and digitalisation

Most private equity funds expect that environmental, social and governance (ESG) will play an increasingly important role as more investors focus on environmental protection, sustainability and social responsibility as important elements of their investment strategies. Attention will need to be paid to ESG-related aspects along the entire PE value chain, from fund formation to deal execution. ESG also plays an important role in further promoting the industry’s digital transformation. With increasing ESG reporting and monitoring obligations on the one hand, and ever-growing numbers of funds and assets under management on the other, the need for better digital solutions supporting fundraising, dealmaking and portfolio administration for the PE industry is palpable. Larger funds are likely to make their own investments into dedicated digital infrastructure, while smaller funds may in-source services from third-party providers.

Conclusion

Historically, PE has demonstrated its resilience to economic downturns and other challenges. This phenomenon has also held true for the first half of 2023. The combination of deal experience and the ability to take a flexible approach means that the European PE industry is well placed to overcome and capitalise on the challenges ahead.

 

Frank Henkel is a partner at Norton Rose Fulbright. He can be contacted on +49 (89) 212 14 84 56 or by email: frank.henkel@nortonrosefulbright.com.

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BY

Frank Henkel

Norton Rose Fulbright

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