2023 has been another challenging year for the private equity (PE) industry. Macro-economic uncertainties that caused headwinds throughout 2022 have persisted throughout 2023, as well as the emergence of geo-political instabilities following the conflict in Israel and Gaza and rising tensions between China and Taiwan.
Against this backdrop, it is not surprising that PE deal activity, both on a global scale and in Europe, has further declined in 2023 compared to 2022 (globally a 40% decline in year-over-year deal count compared to 2022 – source: BlackRock 2024 Private Markets Outlook). Within the PE industry, deal making activity in the large-cap segment was hit even harder than in the mid-cap segment. This was largely owing to higher costs and reduced availability of debt financing, which is traditionally more crucial for larger deals than for mid-sized and smaller deals, where PE sponsors were often able to bridge the lack of debt financing by increasing their equity stakes.
This phenomenon, often described as the "equitization" of PE transactions, led to an all-time high of the average equity contribution per buy-out transaction in the industry in 2023. In contrast to the large-cap segment, PE sponsors active in the mid-cap segment were often able to maintain certain deal activity levels by focusing on implementing their buy and build strategies through add-on acquisitions. Despite the ongoing transition from a sellers' market to a buyers' market in 2023, average EBITDA multiples remained relatively stable at high levels (on average 12x EBITDA – source: Mergermarket). The notorious valuation gap between sellers and buyers continued to negatively impact the PE market in 2023 – as even creative deal or pricing structures (such as earn-out and deferred consideration models) as well as alternative financing solutions (including vendor loans) were not always able to achieve successful signings and closings.
Is there optimism for the private equity industry in Europe in 2024?
Though some of the known headwinds may not vanish overnight and deal-making activity may be further impacted by factors such as the forthcoming presidential elections in the US, as well as anticipated elections in the United Kingdom and Canada, among others, most of our clients active in the PE sector in Europe share a cautiously optimistic view for 2024. This is mainly based on the following factors:
Reduced cost of acquisition financing
Since the start of 2023, inflation rates in the US as well as in the Eurozone have trended downwards. There is a growing sentiment in the PE industry that, by mid-2024, the US Federal Reserve may lower interest rates and that the European Central Bank will follow closely behind. Lower interest rates will reduce the cost of acquisition financing and allow PE sponsors to return to leveraging their deals more effectively. Also, lower interest rates are expected to loosen the more restrictive bank lending practices experienced in recent times. All of this is likely to bolster access to acquisition financing and, hence, deal making activity by PE sponsors.
Increasing pressure from Limited Partners
In 2023, General Partners (GPs) experienced increasing pressure from Limited Partners (LPs) to deploy committed capital by making investments. With the usual fund life cycles proceeding in 2024, fewer PE sponsors will be able to comfortably continue in a "wait and see" mode. In addition, there is a significant backlog of exits from existing PE portfolio companies and a growing trend of GPs avoiding full exits in favour of partial exits combined with a re-allocation of the relevant assets to continuation fund vehicles. More and more LPs are now pushing the GPs to return money upstream to the investors by fully realising investments. The increasing pressure from LPs, both on the acquisition, as well the exit, fronts is very likely to add additional momentum to deal making activity by PE sponsors in 2024.
New opportunities for PE sponsors from corporate divestitures
In 2024, PE sponsors may increasingly benefit from the continued transformation of many industry sectors in Europe, such as automotive, chemical, energy, and industrial manufacturing, as well as private banking and asset management. Such transformation processes by corporate entities very often entail the divestiture of assets deemed not core to the corporate's business strategy. A recent study evidenced that two-thirds of the participants from large European corporates expect a significant uptick in carve-out activity in the next 12 months. This will open opportunities for those PE funds familiar with buying carved-out businesses from corporate sellers. A combination of the right investment thesis and the necessary operational experience will allow PE funds to benefit from untapped value-creation potential.
Succession as window of opportunity
Across Europe SME and family entrepreneurs are increasingly becoming an ageing population. According to a recent study by the German Institute for Mittelstand Research, approximately 190,000 succession cases are forecast to occur in Germany alone by 2026. Similar needs for entrepreneurial succession exist in France, the Netherlands and the Nordics. PE sponsors have become an important factor in facilitating entrepreneurial succession in Europe through their buy-out activities. This also reflects a fundamental change of the perception of the PE industry by SME and family entrepreneurs. While a decade ago PE sponsors were often perceived as predators merely extracting value, today more and more entrepreneurs acknowledge that PE sponsors can play a vital role in preserving entrepreneurial heritage, safeguarding jobs and promoting the transformation of companies and their business models. Those PE sponsors who already have an existing track record in buying assets and companies from family entrepreneurs may find a growing number of interesting opportunities including some of the hidden champions in the SME universe.
Impact of AI on PE
The emergence of generative AI has transformed AI into a buzzword in the PE industry during 2023, as it is everywhere else. An increasing number of companies in Europe have integrated AI applications into their existing business processes to enhance both their back office, as well as the front office, with new products and customer facing services. At least in the Eurozone, the uncertainties around the permissible use cases for AI are expected to vanish in light of the most recent agreement reached between the European Parliament and the European Council on the EU AI Act. Though criticized by some as limiting innovation, the forthcoming regulation on AI is expected to instill confidence and additional investment security for PE sponsors considering deploying money to invest in AI-enabled businesses. This could trigger an additional push for PE investments around AI applications and related business models.
Special situations
The number of debt defaults has risen significantly over the last twelve months, and companies are facing more and more difficulties extending debt maturities. Forecasts predict that there will be an increase in the number of insolvencies in the Eurozone in 2024 (source – Pitchbook). As more companies are slipping into distress, a window of opportunity will open for those PE funds with distressed M&A expertise. Familiarity with restructurings, an existing track record in dealing with insolvency administrators as well as operational turnaround experience will allow PE funds with appropriate experience and skill sets to find attractive opportunities for acquisition. Those PE investors looking into the growth segment may also find opportunities to strike deals where financing rounds are either delayed or turn out to be "down rounds", prompting investors to withdraw from the cap tables.
Investment into supply chain resilience
Historically, PE investors often shied away from acquiring assets in the supply chain industry since it used to be difficult to realize an attractive return on investment in a typical, relatively short PE holding period. With digitization and the use of big data progressing, there are more and more business models in the supply chain sector that may attract the interest of PE investors. The impact of geopolitical disruption and natural disasters on supply chains has underlined the growing need for technological solutions allowing for the development of data ecosystems capable of surmounting supply chain difficulties in real-time. PE funds have an existing track-record of investing into such technologies, and it can be expected that there will be a growing number of investment opportunities where such technologies are applied to the supply chain sector. In parallel, an increasing number of companies feel the need to bolster their supply chain resilience, for example through activities such as near-shoring, friend-shoring and other regionalization strategies. This may also add momentum to increased deal making activities by PE sponsors.
What next?
Despite macro-economic uncertainties that are likely to persist throughout 2024, we share our PE clients' cautiously optimistic view – not least because of the record-high levels of "dry powder" in the market. It will be interesting to see how the competition among PE investors and corporate buyers will evolve throughout 2024.
In the recent past, when EBITDA multiples were rising every year and the financing environment was more robust, financial investors could comfortably look two or three years ahead and expect to achieve significant value through multiple expansion on exit. With continuing elevated multiple levels (12x EBITDA globally), and an uncertain economic outlook in the very near term, one cannot rely on valuation multiples continuing to rise.
This means PE sponsors and corporate investors will both need to focus more on operational improvements (which in the past used to benefit corporate investors with strong balance sheets, synergies and operational capabilities). It remains to be seen how PE sponsors will be able to tackle such competition from corporate investors in the battle for the most attractive acquisition targets.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
