2023 - to PE or not to PE?
Can the private equity industry regain its momentum in 2023?
With the private equity (PE) industry raising an eye-watering $10.7tn and recording its second-best year ever in 2022, after 2021 – one could assume that the momentum will continue in 2023. Yet, compared to the year prior, PE-related deal volumes have declined roughly 30% (q1 2022 to q1 2023). Furthermore, it is estimated that PE firms are sitting on the largest dry powder reserves ever, with estimates of roughly $3.7tn held by PE firms globally. Could this be a signal that PE activity in 2023 is starting to slow down?
For PE firms, the effects of economic turmoil can also be notable. The rising cost of debt makes leverage buyouts (LBO) harder, as the availability of debt used as leverage in LBO transactions is reduced (lower debt multiples), placing a downward pressure on the cash flows of buyout firms which focus on leverage transactions.
Referring to the Weighted Average Cost of Capital (WACC) formula, a common valuation formula used to determine the desirability of an investment, we can start to see a potential effect of heightened monetary policy (see diagram below). The two key drivers of the WACC formula, the cost of debt and cost of equity, are both significantly affected by rising interest rates. Where interest rates are higher, both the cost of equity and debt rises, and thus the formula returns a higher WACC. In most cases, a higher WACC can indicate a riskier investment. This could influence the appetite of PE funds to acquire or invest in new business.
The WACC formula
It can be assumed that tighter monetary policy will likely have a much more considerable impact on portfolio companies and target companies which funds seek to acquire. Falling cash-flows, higher operating costs, and the increased cost of borrowing to fund growth, collectively, can see decreased revenue growth for target/portfolio companies. This could have a potential negative effect on PE portfolios, with the potential for decreased yield/returns, but also limited opportunities to exit as company valuations are driven lower.
On the other hand, it must be noted that – inversely - it could also signify a period of attractive valuations for buy-out firms looking to purchase companies at a significant discount. With dry powder reserves at their all-time highest, firms have more capital available to be deployed than ever before. This could see deal-flow remain high, as PE firms seek to capitalise on attractive valuations.
As we move toward the second half of 2023, it will be interesting to see the stance that PE firms take. Could this be another year of success for private equity? Or will we see a decline in deal flow in light of deteriorating economic conditions?