Political turmoil, Covid-19, conflict in Europe, energy crisis, supply chain disruption, cost of living, inflation, interest rates: the backcloth to turbulent times in dealmaking. Buyer caution stands in contrast to high valuation expectations softening normal activity across geographies. Hardly a positive outlook then? Acknowledging the challenges economies face, there is another view. PE and other private asset managers have the firepower, drive and agility to unlock value despite the turmoil.
Heightened scrutiny and selectivity
For many investors, a challenging debt market and increased cost of credit (and its impact on valuation) are key gating items. While credit funds remain flexible and well placed to respond rapidly to the next wave of opportunities, prevailing uncertainty has translated into greater selectivity and sluggish transaction timelines, with lenders digging deeper in diligence. However, sellers are de-risking through lender education, and a preference for targets with portable credit is emerging. Whilst availability of bond financing has been curtailed for now, direct lending remains available for strong investments and is well positioned to support deals when stability returns.
A period of recalibration
As market participants adapt to the new macro environment, a flight to quality is expected and established sponsors are finding favour with lenders and sellers alike. Meanwhile, investors and prospective sellers are grappling with diverging expectations on market outlook and valuation. Sellers are looking to the strong pricing trends of recent years, while deal executives are faced with more scrutinous investment committees and increased financing costs. But logical deals are getting done now and we expect pent-up firepower to be deployed rapidly once the macros are priced in.
Creativity and innovation
The gap in expectations is protracting deal negotiations, as stakeholders explore structures more suited to the current, unpredictable market. Vendor loans and earn-outs have returned. For existing investments, some sponsors are reconsidering capital structures, management incentives and revisiting projected returns. For new deals and existing situations alike, creative collaboration and innovative thinking will be key in finding solutions and unlocking value – PE is well versed in both.
Activity levels vary
Market segments are being impacted differently. Large cap deals with complex financing are perhaps harder to achieve in some instances. However, where a more modest level of new debt is required or where a larger equity cheque is viable, investors can be nimble. Tapping into existing facilities or a healthy investee balance sheet also provide alternatives on smaller deals and add-ons. For PE sellers, interest in deals will be boosted by well-capitalised strategic buyers.
A promising pipeline
The market is expected to remain buoyant for high-quality assets, although perhaps on terms that differ from those we are accustomed to. Macro drivers will push otherwise strong businesses to market next year. Investors are continuing to show interest in all key jurisdictions, with many UK-based managers showing a particularly strong interest in UK, US, Western and Northern European assets. Some portfolio companies will need to be restructured and new investors will be well placed to replace incumbents where capital structures are no longer fit for purpose. Private markets will continue to be an alluring alternative to public markets while public valuations are depressed, demonstrated by a high number of GPs expressing renewed interest in executing public-to-private transactions in 2023.
While M&A markets are recalibrating globally, no one knows how 2023 will unfold. The impact of Covid-19 ultimately fueled investor activity on an unprecedented scale, making it perhaps hard to pinpoint what “normal” really is. What is clear is that the fundamentals underlying the current softening in activity are very different to those of the 2008 GFC. Financial institutions are strong. Early indications of increased stability in interest rates should allow market participants to model for the future, access credit more readily and have a greater degree of confidence in execution. Diligence will increase and terms will tighten but that is part of the normal cycle. PE has a proven track record of leading through turmoil and some of the best returns have been found on capital invested in economies recovering from shock. We can’t see any reason why this time will be any different.
Will Yates is a partner and Oisin Sudway an associate at the City law firm Travers Smith