Though the title of this article might evoke images of a children's story, the narrative unfolding in Private Equity is far from a fairy tale. The golden age of PE, marked by robust growth in a low interest rate environment, has been superseded by an extended period of economic gloom.
Early this year, a period of recovery had been anticipated from Q3 onwards. However, the stubborn nature of this downturn is forcing PE players to recalibrate their thinking and reassess the challenges and opportunities ahead. So, where are we now?
The Post-COVID buying spree: A closer look
PE firms were driven by a blend of optimism and opportunism in the aftermath of COVID-19. The unique challenges presented by the pandemic created a perceived opportunity, catalysing a fundraising and acquisition frenzy.
The urgency to act led many firms to make acquisitions without the usual in-depth due diligence. This haste, combined with the prevailing market headwinds, is now exerting pressure on these newly acquired assets. This lack of historical rigour has, in some cases, since revealed hidden weaknesses and unforeseen challenges in these investments.
Additionally, many PE firms capitalised on the uncertain climate to refinance their existing portfolio companies. These refinanced debts are maturing soon, adding another layer of complexity – and some concern – to the PE landscape. A wall of maturities is approaching, and the question of how to overcome this obstacle looms large.
Unpacking the reality of a perfect storm for PE
Several converging factors are contributing to unprecedented simultaneous headwinds for PE and their Portcos:
The continued low-growth environment, coupled with rising interest rates, poses significant financing challenges. The era of cheap money is over, and the cost of capital is increasing, intensifying the pressure on acquisitions and existing investments.
Inflationary pressures have significantly impacted Portco performance, squeezing margins and profitability. Passing on the rising costs of goods and services to consumers to avoid earnings erosion has been a familiar tactic, met with mixed results. Now, as we see signs of deflationary movement in some markets, the thinking will shift to how these efforts can be elegantly unwound while protecting value at the same time.
Many Portco management teams – and even some within PE – lack experience in navigating a high inflation, high-interest rate environment. This inexperience increases the chances of missteps and missed opportunities, exacerbated by the extended nature of this anomalous economic period, given the previous decade’s stability in this respect.
Cash flow pressures
All of these factors continue to strain cash flows. The impending debt maturities could trigger significant disruption in the European PE sector over the next 12-24 months and the ability to service debt and maintain liquidity will be a dominant concern in PE and Portco boardrooms alike.
Q3/Q4 outlook: Reshaping the future of PE
As we look ahead to the close of another year and into 2024, we see three key themes emerging that will shape the future of PE:
1. Shifting M&A dynamics
- Strategics take the lead: For the first time in years, strategic investors have an advantage over PE in deal-making. This shift is altering the competitive landscape and changing the dynamics of negotiations.
- Large-Cap deal slowdown: We expect fewer large-cap deals in the next 12 months. Those that do materialise will likely involve consortiums, reflecting a more cautious approach.
- Shift to Mid-Cap: We'll see a trend of large-cap players moving to mid-cap or AIM, where equity-to-debt ratios are more balanced. This shift represents a recalibration of risk and opportunity.
- Rise in distressed M&A: This environment will benefit distressed investors and credit funds. The increase in distressed assets is creating opportunities for specialised investors.
- Infrastructure funds on the rise: Given their easier financing, longer hold periods, and lower return expectations, infrastructure funds are increasingly stepping into traditional PE territory. This encroachment reflects a broader diversification within the investment community.
2. Financing evolution
- The Rise of Credit Funds: We're witnessing increased activity in credit funds. In some cases, they might even assume control of struggling assets, changing the ownership landscape.
- Stressed vs. Distressed Financing: The "Amend and Extend" approach will persist, but its longevity remains uncertain. The line between stressed and distressed financing is blurring, and new strategies may emerge.
- Equity Bridge Financing Demand: Tactical Opportunities will gain traction as firms seek more flexible financing solutions. This shift reflects a broader trend towards innovative financing structures.
3. Sector consolidation
- Survival of the fittest: Funds that are proactively managing their portfolios and those invested in resilient sectors are poised to thrive. The ability to adapt and innovate will continue to separate the winners from the losers.
- The bigger get bigger: Large, diversified funds with the flexibility to pivot will prosper. It's highly likely that these behemoths will acquire smaller, less agile funds that are underperforming, driving further consolidation in the industry.
The coming months will be pivotal. As the wall of maturities approaches, PE leaders must be agile, strategic, and forward-thinking. Those that can adapt, whether through consolidation, diversification, or other innovative financing solutions, will not only weather this perfect storm but emerge more resilient and at a competitive advantage. The fairy tale may be over, but this next chapter in PE’s story is just beginning to unfold, undoubtedly filled with challenges, but also ripe with opportunities for those fully prepared to seize them.