European Private Equity: A broadly positive outlook despite economic headwinds

After a record-breaking year in 2021, 2022 demonstrated that the years of predictable growth in the private equity industry have, at least temporarily, come to an end. The war in Ukraine, the energy crisis, rising interest rates and global supply chain difficulties have put pressure on businesses and financial investors alike. This resulted in a slight decrease in the number of deals and a slightly reduced average deal value in the private equity industry in Europe in 2022. The average deal execution timeline, from approaching potential investors to the closing of a transaction, was also more prolonged compared to previous years.

Does this mean there is a negative outlook for private equity in Europe for the coming year? Despite the current challenges, most of our private equity clients still share a broadly positive outlook for 2023. Set out below are some of the key factors to be taken into account from a private equity perspective.

Every crisis is an opportunity

The vast majority of our private equity clients anticipate taking an opportunistic approach to deal-making in 2023. The healthcare and life sciences, business services and technology and software industries are expected to remain a core investment focus for many funds. Whilst there is still an abundance of dry powder and attractive targets are sought after, valuations are in many cases likely to stay below the high levels seen in recent years. This valuation gap between sellers and buyers has contributed to the slowdown in activity and extension of deal execution timelines. But as sellers reset their own valuation expectations, this may create opportunities. In the context of auctions and other competitive processes, investors who have previously shied away because of extremely high valuations and tough competition may be tempted to re-consider their approach. A number of investors also expect that there will 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 realized as corporate groups divest non-core assets in the more challenging economic environment, increasing the number of available targets. There are also indications that the market for distressed assets may grow in 2023, which could attract investors focusing on special situations.

Increased focus on diligence and negotiations

With tightening returns on investment margins, it is expected that, during the coming year, private equity buyers will continue to assess targets and investment decisions carefully, consistent with the approach taken in 2022. This will result in a continued emphasis on due diligence, be it from a legal, financial, commercial or technical angle. Creative solutions may also be required – particularly where there is still a valuation gap between buy-side and sell-side needs to be bridged. In times of macro-economic uncertainties as a result of high energy costs and supply chain difficulties, it is also likely that there will be 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

In 2022, 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 some cases, particularly heavily leveraged deals were abandoned due to the lack of suitable debt financing. This is unlikely to change significantly during 2023. As a result, a number of our private equity clients have told us that they 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 deal-making sidelines. In 2022 we saw some clients adjust 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 at a later date – this is a market-wide trend that we expect to continue during the coming year. It is still unclear if and when current international political tensions can be expected to stabilize, helping to reduce the volatility of the global capital markets and rising inflation – both being indirect cost drivers for debt financing.

ESG and digitization

Most private equity funds expect that ESG will play an increasingly important role in 2023 as more and 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 private equity value chain, from fund formation to deal execution. ESG may also play 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, deal-making and portfolio administration for the private equity industry is palpable. Larger private equity 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, private equity has demonstrated its resilience to economic downturns and other challenges. In the same way as our clients, we maintain a positive outlook; the combination of deal experience and the ability of investors to take a flexible approach means they are well placed to overcome and capitalize on the challenges ahead.

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If you are interested in discussing any of the topics in M&A Outlook 2023 in more detail, or have any questions, get in touch to find out how we can work together.