Q&A: Reflecting on challenges and opportunities for private equity

October 2023  |  SPECIAL REPORT: PRIVATE EQUITY

Financier Worldwide Magazine

October 2023 Issue

FW discusses challenges and opportunities for private equity with Valentin M. Pfisterer at Ashurst, Matthew P. Salerno at Cleary Gottlieb Steen & Hamilton LLP and Jan Schubert at Gibson Dunn.

FW: What do you consider to be the key themes driving private equity (PE) over the past 12 months or so? How would you characterise recent deal activity?

Pfisterer: In line with general economic conditions, the private equity (PE) industry experienced a long-lasting upswing, including post-pandemic, until about late 2021 or early 2022. 2022 brought about a severe setback triggered, among other factors, by the war in Ukraine, disrupted supply chains, a rapid increase in inflation, rising interest rates and more generally tense economic and geopolitical conditions. As a result, M&A activity by PE firms declined significantly compared to previous years, with some of the remaining deal activity a result of restructuring and distressed scenarios. Among the sectors which were hit particularly hard was the real estate sector, where deal activity almost grinded to a halt. Other sectors, in turn, such as industrial, logistics, infrastructure, energy and renewables, as well as healthcare, climate technology and technology more broadly, and software including data analytics and artificial intelligence, have stood their ground or even gained traction. In our view, deal activity is driven by prevailing macro-trends such as demographic development, energy transformation and technological advancement where buyers and sellers continue to find common ground. Also, across sectors we have seen heightened attention around environmental, social and governance (ESG) and sustainability-related matters, even though the latest trends from the US appear to indicate a slowdown in this area.

Salerno: The PE M&A markets for the last 12 months have been marked by economic uncertainty, challenging debt markets and divergent views of valuations between buyers and sellers. Some estimates indicate that in the first half of 2023 PE M&A was down by nearly 55 percent relative to the same period in 2022. For a variety of reasons, bank lending has been significantly lower in 2023 as compared to 2022 and that has left direct lenders to fill the void. This decline in competition from bank lenders, combined with the higher rates that direct lenders typically charge, and a high interest environment, has led to a higher cost debt capital for sponsor-led transactions, putting downward pressure on sponsor buy-side valuations. At the same time, sell-side sponsors have been reluctant to similarly adjust their valuation expectations and have chosen to keep higher quality assets off the market, rather than sell at depressed valuations, leaving fewer potential targets in the market. We have begun seeing increased deal activity in the last six to eight weeks, which may be an indication that some of these pressures are abating as buyers and sellers adjust to the current environment.

Schubert: The past 12 months have been a period of more uncertainty than normal in Europe, with inflation rates and energy costs at an unusual height, more reliable supply chains but weakness in business demand, and the ongoing conflict in Ukraine. This also affected PE dealmaking. Firstly, there has been an emphasis on portfolio work. PE firms have taken steps to ensure that their assets will be robust and ready to prosper once market conditions recover and the funding landscape improves. Secondly, the small- and mid-cap market witnessed ‘buy and build’ activity with funds from oftentimes existing debt facilities. This strategy allows for synergistic growth by leveraging existing platforms. Overall, recent deal activity in the European PE landscape has been bifurcated. The small and mid-cap markets have, at least with respect to certain sectors, still been active, showcasing resilience. Conversely, the large-cap market has taken a noticeable pause. However, we begin to see preparatory work for some large-cap deals, indicating potential momentum in the near future.

“PE firms have taken steps to ensure that their assets will be robust and ready to prosper once market conditions recover and the funding landscape improves.”
— Jan Schubert

FW: What types of opportunities are PE firms targeting? Have any recent deals in particular caught your eye?

Salerno: In this market, PE firms are focused on identifying deals that are executable, particularly deals where they may be uniquely positioned to be the acquirer – whether due to deep industry experience, opportunities to partner with a friendly or familiar management team, or because as a PE buyer they can bring increased deal certainty relative to a strategic buyer which may have significant antitrust risk. In terms of industry focus, there has been a lot of activity in technology, software and information technology transactions, as well as in industrial and commercial services. Activity in healthcare M&A transactions has been down over the course of the year, but there have been some significant transactions this year. Notable deals across all sectors in 2023 include GTCR’s pending acquisition of Worldpay, Warburg Pincus and Advent International’s acquisition of Baxter’s Biopharma business and TPG and AmerisourceBergen’s joint acquisition of OneOncology.

Schubert: PE firms are looking for investment opportunities that offer both stability and growth, especially in today’s less predictable economic landscape. We see a strategic focus on more recession-resistant sectors. Specifically, the information technology, telecommunications and healthcare sectors emerged as a preferred avenue, given their inherent stability and potential future prospects. Also the industrial and chemicals sector performed well. These sectors showcase robustness amid economic downturns. Energy transition also fosters deal activity in related industries. Two recent deals that caught my eye and followed this pattern were Carrier Global’s acquisition of Viessmann Climate Solutions and Astorg’s acquisition of implants manufacturer hg medical. These deals are good examples of deal activity in two prosperous and relatively stable sectors.

Pfisterer: In the recent past, we have seen a relatively low amount of large-cap PE transactions in Germany. Notable exceptions are, among others, Advent’s formation of an engineering joint venture with Lanxess, Cinven’s acquisition of Bayer’s environmental science professional business as well as various take private transactions. In our view, the key reason for sluggish deal activity in the large-cap segment is challenging market conditions, in particular adverse financing conditions in the high interest rate environment, which make debt-financed large-scale PE transactions costly and hard to complete on profitable terms. In turn, even after the 2022 setback, we have seen some activity in the small- and mid-cap areas, with PE increasingly investing in line with prevailing macro-trends. Also, as company valuations in the public markets adjusted downwards, we have seen a rise of attempted or successful PE-led take private transactions in Germany, including Oaktree/Deutsche Euroshop, Silverlake/Software AG and EQT/Suse.

FW: To what extent are technologies such as artificial intelligence and data analytics being utilised to assist with operational aspects such as target identification and digital transformation, for example, both within PE firms and across their portfolio companies?

Pfisterer: Data analytics and artificial intelligence (AI) technologies undoubtedly are a strong, transformative force and have the ability to transform many workflows and decision-making processes, both within PE firms and across their portfolio companies. PE firms, but also investment banks in connection with their advisory roles, increasingly consider analytics and AI technologies as valuable tools throughout the entire investment lifecycle through target identification, financial and valuation analysis, modelling and benchmarking, due diligence and performance monitoring. Analytics and AI have the potential to allow for more reliable and coherent decision making, increased performance and reduced costs. This may be particularly interesting in a period in which PE firms prioritise operational optimisation and value creation in their portfolio companies.

Schubert: We are seeing more data analytics tools that aspire to be AI. Having said that, data analytics has become an integral part of the business of PE firms and their portfolios. For example, analysing data sets helps to identify potential investment opportunities. Data analytics is also part of improving buy-side due diligence to gain deeper insights into markets, industries and specific companies. In addition, digital transformation within portfolio companies is often driven by the integration of AI and data analytics. These technologies will, for example, help optimise supply chains, make data-driven decisions that improve operational efficiency and competitiveness, and personalise customer experiences. An illustrative example is the use of data analytics in sectors such as online retail, where understanding consumer behaviour is paramount.

Salerno: The adoption of AI and analytics is still at a very early stage. There are security concerns around cloud-based AI programmes, and despite the promise of AI’s capabilities, I have not seen many companies utilising AI-based data analytics in a systematic manner, outside of some limited examples for technology-focused portfolio companies. However, AI is increasingly an area of focus and discussion, and we expect use of AI to only grow over time.

“We are seeing sponsors prepared to make, and sellers willing to accept, more aggressive asks around net working capital and debt-like items.”
— Matthew P. Salerno

FW: In your experience, has there been a shift in the way PE firms structure and negotiate their deals, with a view to reducing risk and maximising future returns?

Schubert: PE firms, mindful of macroeconomic factors, exercise caution across sectors, especially regarding asset valuation. This caution is reflected in thorough target selection and comprehensive due diligence, and accompanied aspects like cyber risk and ESG factors. Deals are unfolding at a slower pace, and buyers use this for detailed assessments. In the past, pre-emptive bids were fairly common, but are now rarely seen. Certain sectors are gaining heightened attention. Interestingly, we are also seeing some deals with less leveraged financing, focused on building companies on a stable foundation. Legal terms have not seen significant changes, though they have become slightly more buyer friendly. With few exemptions, material adverse change (MAC) clauses do not exist. Earn-outs are sometimes but not often included. It remains customary that a seller’s warranties and tax indemnities are covered by warranties and indemnities (W&I) insurance. In essence, the PE landscape is adapting to a nuanced risk landscape while preserving core frameworks.

Salerno: More options are on the table than sponsors were considering in the 2020-22 period. At that time, when auctions were highly competitive, a premium was placed on being the simplest party to deal with who could deliver maximum certainty and the highest valuation, so many leveraged buyouts were done on a ‘plain vanilla’ basis. In today’s environment – in part to bridge value gaps – we are seeing sponsors prepared to make, and sellers willing to accept, more aggressive asks around net working capital and debt-like items and more structured investments where the sponsor might take a preferred instrument to meet return hurdles, as well as increased use of earn-outs and deferred consideration. As representation and warranty insurance (RWI) premiums have come down, we are also seeing more sponsors take advantage of RWI as a way to insulate against diligence risks.

Pfisterer: Up until late 2021, zero-interest policies applied by central banks and optimistic market sentiment drove up company valuations to unsustainable highs. Meanwhile, risk management techniques, including due diligence, were somewhat disregarded or neglected. Since 2022, financing costs have substantially increased due to the rise in interest rates and the overall sentiment in the PE sector has become significantly more cautious. Risk management techniques, including due diligence, are being applied more rigorously again, with financial modelling and company valuations carried out more conservatively and deals no longer completed at any price.

FW: Have any recent legal or regulatory developments affected PE firms’ approach to executing deals or optimising their portfolio companies?

Salerno: Antitrust regulators, particularly in the US and the UK, have become increasingly active and aggressive and have commenced a higher than usual number of second phase investigations to slow transactions down and learn more about companies and industries. US regulators have demonstrated an increased willingness to pursue litigation as an antitrust enforcement strategy. This has had a deterrent effect on some transactions, and in some cases it has made it easier for PE firms to complete transactions since they can often offer sellers a lower risk path to exit due to lower antitrust risk. In addition, in the last few years, the global foreign direct investment regime has expanded significantly, resulting in a substantial increase in the number of filings required on any given transaction, as well as the amount of time between signing and closing.

Pfisterer: Certain legislative and regulatory initiatives at European Union (EU) level, as well as on a domestic level across Europe, are aimed at addressing macro-trends and challenges such as demographic developments, energy transformation and technological advancement. These initiatives include, among others, the Green Deal at the EU level, as well as a variety of initiatives to promote energy transformation on a domestic level across Europe. These initiatives are aimed at, or contribute to, steering private investment into the climate tech sector and – unsurprisingly – we see PE increasingly looking at targets in the climate technology sector. Moreover, in reaction to the war in Ukraine, the EU and multiple countries have imposed economic sanctions on Russia and Belarus and, in turn, Russia has reacted by imposing a number of countermeasures. This has prompted many PE firms, in the same way as corporates, to dispose of their Russian holdings and business activities to avoid the commercial, compliance and reputational risk associated with such business. Also, sanctions and countermeasures imposed have had an adverse impact on supply chains, posing a challenge to PE portfolio companies.

Schubert: Globally, there has been a push for enhanced ESG disclosure and practices. Many PE firms are now prioritising ESG due diligence and integrating sustainability initiatives within portfolio companies. Regulatory changes in multiple jurisdictions have placed greater emphasis on reviewing foreign investments. In Germany, for instance, the government has tightened regulations around acquisitions by non-EU entities, especially in sectors considered critical for national security. Rules were amended to expand the scope of sectors under scrutiny. And the latest announcements from the ministry point toward a further tightening of the rules. As a consequence, investors eyeing assets in sensitive sectors must navigate a more rigorous review process and anticipate potential delays or even modifications to their proposed investments. In response, PE firms are often working even closer with external legal counsel and integrate regulatory considerations into their due diligence and strategic planning early on.

“Sanctions and countermeasures imposed have had an adverse impact on supply chains, posing a challenge to PE portfolio companies.”
— Valentin M. Pfisterer

FW: How would you describe PE exits in the current market? What challenges do PE firms face when preparing for and executing exits?

Schubert: PE firms are executing fewer exits compared to previous periods. There is a lot of caution when exiting large-cap portfolio companies. The challenge lies in pinpointing the perfect exit timing. Internally, it is crucial for PE firms to assess if the portfolio company is moving toward its peak performance or if there is potential for further value creation. Externally, the availability of suitable buyers is paramount. Even if enough potential acquirers are around to run a hot auction process, buyers’ ability to secure financing in the current economic climate can become a decisive factor. Thus, while opportunities for lucrative exits exist, the confluence of both internal and external factors makes the exit decision complex. PE firms are exercising caution and strategic foresight to navigate this exit landscape.

Pfisterer: Since the economic downturn in late 2021 and early 2022, PE exits have become scarce across the board. Generally speaking, decreasing company valuations have made exits less profitable for PE sellers and high interest rates have made acquisitions more expensive for PE purchasers. In particular, public markets have not been an attractive exit avenue for PE firms recently. Since the economic downturn, initial public offerings (IPOs) have been almost non-existent, with the notable exceptions, in Germany, of Porsche and Ionos. While Porsche’s successful IPO is largely considered an exception due to the product and strong branding and other factors, the IPO of PE-backed Ionos in early 2023 failed to act as an icebreaker. As a result of the lack of attractive exit options, PE firms are looking for other options and holding periods have tended to lengthen.

Salerno: Although there has been more deal activity in recent weeks, deals do seem to take longer to get done and the issues are more complicated with value gaps that can be bridged but require more creative solutions to do so. We have also seen a number of assets that are expected to come to market after sponsor sellers decided to hold back as a result of underperformance caused by general economic conditions. Against this backdrop, it is important for sellers to present as clean a picture as possible, particularly if the underlying business is facing economic headwinds. This means resolving, as much as possible, any open litigation, government investigation or major contract negotiation, as well as having a strong story for the company’s growth potential.

FW: Looking ahead, what are your expectations for the PE market over the coming months? What trends do you expect to shape deal activity, portfolio improvements and fundraising efforts?

Pfisterer: Broadly speaking, the macro-situation is unchanged compared to early 2022 when the economic downturn hit. Inflation has proved to be persistent and interest rates have reached highs unknown for decades. The war in Ukraine is ongoing with unabated intensity and global economic and geopolitical conditions remain tense. Even though Germany is technically not in a recession at the moment as GDP in the second quarter of 2023 was not negative, we do not expect a major uptick in PE deal activity in the near future. Yet we are confident that tensions will ease and PE deal activity will return in the mid-term, albeit not necessarily to 2021 levels during this time period. We expect that PE investment will continue to be focused on prevailing macro-trends. In our view, demographic development, energy transformation and technological advancement and other macro-trends and developments will be the driving themes shaping PE investment activity in the short and medium term.

Salerno: PE is a machine that is designed and built to do deals and the 2023 levels of low deal activity are likely unsustainable for the industry. As a result, I think we are likely to see increased deal activity as sponsors may be willing to stretch a little more on valuations to ensure they are deploying their dry powder at a reasonable rate. We are also likely to see sponsors increasingly prepared to pursue exits, including higher quality assets due to increased pressure to return capital to limited partners as they look ahead to their next fundraising cycle.

Schubert: Some market observers believe the worst is over. Although it might be too early for a robust upswing in the European PE market, as confidence grows in a stabilising economic environment, deal activity is expected to increase. Sectors that did see deal activity in the past six to 12 months will likely benefit first as, according to market observers, the pipeline for deals in these sectors remains full. A notable trend shaping this upturn will be an accelerated pace of transactions, accompanied by an increase in pre-emptive offers. This suggests that buyers will be more aggressive, trying to lock in deals even before they officially hit the market. Concurrently, the emphasis on portfolio improvements will persist. However, it is also fairly certain that we will see a push toward exiting investments once the value of successful holdings is enhanced.

 

Valentin M. Pfisterer is a counsel in Ashurst’s corporate transactions practice in Frankfurt am Main, Germany, and advises national and international corporates, financial institutions and investors in connection with M&A transactions, equity financing transactions, joint ventures, equity capital market transactions and in general corporate law matters. He has particular experience in advising issuers and underwriters in connection with equity capital markets transactions, and investment banks in their role as financial advisers in connection with private M&A transactions and public takeovers. He can be contacted on +49 69 9711 2860 or by email: valentin.pfisterer@ashurst.com.

Matthew P. Salerno’s practice focuses on corporate and financial transactions, particularly public and private mergers and acquisitions, private equity investments and contests for corporate control. He joined the firm in 2001 and became a partner in 2010. He can be contacted on +1 (212) 225 2742 or by email: msalerno@cgsh.com.

Dr Jan Schubert is a Frankfurt, Germany, based partner at Gibson Dunn. He advises private equity firms and strategic investors on domestic and cross-border private M&A transactions, joint ventures, management investment programmes and venture capital financings. He can be contacted on +49 69 247 411 511 or by email: jschubert@gibsondunn.com.

© Financier Worldwide

THE PANELLISTS

 

Valentin M. Pfisterer

Ashurst

 

Matthew P. Salerno

Cleary Gottlieb Steen & Hamilton LLP

 

Jan Schubert

Gibson Dunn

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