“It’s tough to make predictions, especially about the future,” the saying goes. A year ago, few would have anticipated how rising interest rates would abruptly halt buyout activity in the second half of 2022, given the turbocharged activity of the first half. The question that has haunted private equity as we moved into 2023 was whether buyouts would go through a mild correction or if the industry would once again face the type of collapse it endured in 2007-2008.
Here’s where we find ourselves as we look back at Q1 2023.
A tale of two sizes
2022 was complicated for PE fundraising.
The total capital raised, $361.1B, is almost identical to 2021’s scorching $362.9B. But the total fund count plummeted from 790 to 497. This indicates that LPs are moving their commitments to bigger, more experienced firms with a track record of survival through earlier downturns. For instance, Bain found that megafunds (more than $5 billion) accounted for 57% of global capital raised in 2022. Meanwhile, first-time funds raised only 4% and not even half (48%) reached their target size. Pitchbook found almost the same for U.S. funds: those larger than $5 billion raised 52% of 2022’s capital, and for funds less than $100 million: they raised barely 2%.
As we end Q1, 73 funds have closed, raising $66.8B. Only two megafunds closed this past quarter, but 14 megafunds from 2022 are seeking to close at some point this year.
What is going on with exits?
Part of the reason that fundraising has slipped is that exit activity, both IPOs and M&As, has fallen off sharply. According to Pitchbook Quantitative Perspectives / US Market Insights, Q3 2022, roughly 80% of PE’s capital comes from reinvested distributions, and the second half of 2022 was the slowest for exits since the pandemic. Looking back, most PE GPs chose to hold on to their portfolio companies instead of exiting them at lower valuations, hoping for a rebound later this year.
Pitchbook data shows 1,341 exits generated a total of $321.8B. While this is far off the record-breaking numbers of 2022, the activity is in-line with pre-pandemic levels. However, given that YoY exit value declined by 33.9%, Q1 2023 marks the lowest exit value since Q2 2022.
Preqin points out this could be caused by a significant mismatch in expectations: “Buyers [of assets, whether companies or fund positions] want discounts of between 60% and 70%, while sellers aren’t interested in conversations about numbers that start with less than an eight. As one [industry observer] noted, ‘90 is the new par’.”
In 2022, IPOs fell precipitously in both deal count and value—only 42 U.S. LBO-and VC-backed companies went public in 2022, 30% of 2019’s total of 120. The trend continued into 2023, with just four IPOs of U.S. PE-backed companies in Q1.
“The collapse of the IPO market reflects the overall malaise of public markets,” adds Account Director John Aldrich. “Because of the delay with which PE funds are revalued to reflect market conditions, LPs appear to be over-allocated to buyouts thanks to the denominator effect, further depressing their interest in investing in these funds.” According to Preqin, 60% of the surveyed LPs also expect buyout performance to fall over the year as firms eventually revalue their holdings.
Deal activity is a mixed bag
By the end of 2022, the deal count (9,051) almost matched 2021’s stunning total of 9,286 despite a fall-off in Q4’s activity. Although values fell from 2021’s level, it still exceeded $1 trillion, setting a record for the second-highest in history. If 2023 activity were to continue at Q4’s level, it would still exceed the level of any year pre-COVID. However, after showing some signs of stabilization, deal count fell by another 9.3% last quarter.
For the most part, deal activity is on pause for the moment due to the mismatch between buyers and sellers. Juniper Square Account Director Lance Minor, points out that, “After the buyout crash of 2007-2008, it took time for both parties to adjust their pricing expectations. We are optimistic, however, that the two sides will eventually compromise, sellers driven by the need to make a deal and buyers by their funds’ implacable timeline.”
Preparing for macroeconomic risks
Industry lore has it that deals done during downturns outperform. While this can be argued, research has shown buyout-owned companies in a downturn tend to improve their performance relative to non-buyout owned firms, often by making add-ons—acquiring struggling competitors that lack the deep pockets of buyout parents—and thereby increasing market share. 1
Along with supporting their portfolio companies’ competitive advantage, PE GPs are focused on helping their portfolio companies prepare for 2023’s macro risks, such as a potential recession or persistent inflation. Cambridge Associates suggests that GPs will both seek to implement the classic value-additive strategies of increasing revenue and EBITDA in their portfolio companies, and improve talent management in view of the still-tight labor market. Such efficiency increases will be yet more critical if buyout funds follow the model of Founders Fund and cut their fund sizes and thus the management fee stream available for salaries.
Certainly, buyout activity took a major blow as interest rates rose in the second half of 2022 and banks reduced their lending for leveraged transactions.
As Preqin reported,
Almost all participants agreed that the floodgates will open. Many LPs are expected to sell positions because of the denominator effect. But an even bigger driver will be investors choosing which GPs they’re going to stick with. They'll then exit other positions to give themselves the capacity for new investments with the chosen few.
How big will the flood be? Representatives of Blackstone, AlpInvest, Glendower, and HarbourVest put 2023 total deal value in the range of $80bn–$130bn, rising to $250bn–$500bn by 2025. In the short term, it may be limited by the supply of capital.
Preqin estimates that there’s currently $138.5bn of dry powder – barely enough to meet anticipated volumes this year. Meanwhile, 97 funds are in the market, seeking an aggregate $76bn.
Deals will flow, but the question right now is: when?
Based on the numbers we’re seeing, it seems that—for the most part—things at the macro level are looking relatively good. Private equity didn’t suffer as much as venture capital—while accounts at Silicon Valley Bank and loan facilities froze, private equity announced five megabuyouts worth $31.3 billion.
In terms of total new funds and capital into the space, Q1 2023 was off to a slow start, although we believe private equity to be relatively healthy overall.
1 Shai Bernstein, Josh Lerner, and Filippe Mezzanotti,”Private Equity and Portfolio Companies: Lessons From The Global Financial Crisis,” Journal of Applied Corporate FInance, 32 (3), Summer 2020: 21-42. Note that both PE-owned and non-PE owned companies reduced their investment pace, but PE-owned companies did so by less.