It’s that time of year when investment experts put pen to paper and attempt to predict next year’s investment environment based on that of the previous 12 months. Now, we’re as wary of predictions as the next person, but there are some things that we’d expect (and hope) to see in the world of private equity (‘PE’) and alternative investments based on the current economic indicators.
Fundraising and investing in alternatives
There’s no two ways about it, 2023 has been a tough year. Fundraising has been suppressed across the industry. PE funds gathered $315bn in the first half of 2023, $80bn less than the same period last year1. Projections for the whole year show the total coming in at around $450bn, the lowest since 20152. In that time, we have had Brexit, Trump, Covid-19, another round of global quantitative easing, rising inflation, supply chain problems and conflicts around the world.
There are multiple reasons for the decline this year, ranging from the lingering impact of the denominator effect (whereby a portfolio’s allocation to alternatives has become ‘overweight’ due to falling values of public market investments) to the higher returns from fixed-income investments providing an increasingly attractive option to investors, to the price of debt.
You’ll likely have seen historic data showing that times like this are optimal for investing, like this one
Source: Pitchbook
The crux of which is summarised neatly in Warren Buffet’s easy to quote but more difficult to follow advice to ‘be greedy when others are fearful’. Unfortunately, investors often fail to take advantage and fear to tread. The recent environment has not inspired a strong appetite for risk, even if historic data suggests that investors may come to regret that reticence. We humans are emotional creatures after all.
From our own position we have strived to create deeper relationships with our clients and help them to understand the fund strategies we think are capable of performing against the macro backdrop. We’ve also presented businesses and investment opportunities which have demonstrated resilience and which we think are capable of growth even in the current conditions. There are signs that risk appetite is improving for the right opportunities.
So, what do we think about next year? Is the worst behind us as we head into an election year in both UK and US? Well, interest rates appear to have peaked and are expected to decline slowly over the next two to three years, with analysts speculating that rates will start to come down between May and August 20243. Both UK and US inflation rates are dropping and, encouragingly, the most recent inflation data for both economies revealed falls greater than market expectations. This visibility, coupled with lower levels of fear with regard to a deep global recession, has perhaps already begun positively affecting the rate of PE transactions in recent weeks. According to EY, there has been a 63% increase in the number of PE transactions of US $100m or above in Q3, vs the nadir in Q1 2023.
Source: https://www.ey.com/en_uk/private-equity/pulse
Private equity exits and distributions
The exit environment has been poor in 2023. For the third consecutive quarter of 2023, the European IPO market saw subdued IPO activity. However, there was an uplift in Q3 volume and proceeds compared to Q1 and Q2. The European follow-on market has performed well, with volume and proceeds for 2023 YTD exceeding the same point in 2022, signalling investor support for quality companies, being a good precursor to the recovery of the IPO market4.
We’ve seen elements of this across our portfolio with exit timeframes pushed out to the right or support required to help companies through these tougher times. It is important to note though that many of our fund investments, with their diverse underlying portfolios, have continued distributions to investors.
This demonstrates one of our key principles, that a diverse portfolio of alternative investments can reduce volatility and provide realisations which can be recycled into new investments over an extended period. This allows investors to take advantage of the diversification gained by investing over a time period, across different parts of the cycle.
As the macro-economic environment stabilises in 2024, exit activity should improve, benefitting our single asset exposures and funds alike.
Deal flow and alternative investment strategies
A direct result of the suppressed fundraising environment this year has been the improved access to investments and managers that, previously, our clients would not have been able to invest in.
This has been reflected in the strong deal flow we’ve seen in our co-investment product line (late-stage venture growth opportunities which are typically only available to institutional investors) and in the access to blue-chip PE managers through our Funds product. This was exemplified with the opportunity to invest in the $26bn CVC Fund IX – the largest PE fund ever raised (CC clients were able to invest in units of £25k vs usual typical ticket of €20m). Happily, for investors, we expect this trend of access to continue and the relationships we have established, and continue to nurture, to yield future opportunities for our clients that would otherwise remain out of reach.
Reacting to structural change
There are two structural themes in private markets which are influencing our private markets fund selection strategy at present and will be reflected in the opportunities we offer clients in 2024.
The first is the evolution of private market investment vehicles, as managers seek to tap into the global private wealth pool and respond to the ‘democratisation of private equity’. In recognition of the misalignment between private investors’ usual experience of investing in liquid public market funds versus 10 year PE fund structures, many GPs are launching evergreen PE funds, that is PE funds with a degree of liquidity available.
The second relates to the high price of debt and our thesis that this is going to squeeze the historically expected PE buyout return levels of c.2.0x net money multiples.
We believe that the managers and strategies that are going to outperform are going to need to work harder across the deal origination and value creation stages of an investment to target these kind of returns in future. Stronger returns are likely going to be attached less to ‘buy-and-build’ strategies and more to those targeting ‘fix-and-expand’.
Managers that already have true proprietary sourcing networks which enable them to source the best deals at the best prices and are hands-on with portfolio companies, are going to be (at least) one step ahead of the pack. We think this plays to one of our core strengths, that of our vast client network, which contains hundreds of successful and proven business leaders who understand the way private capital helps develop businesses. The ability to tap into this pool of diverse talent has always been one of our key differentiators. It allows us to evaluate opportunities across a wide range of sectors and then support investee companies to grow, supported by people who have ‘done it all before’.
The high cost of borrowing money will also see continued innovation in the private debt space. Post GFC, the industry evolved as banks retrenched and some highly regarded debt funds emerged to plug the gap banks had left behind. Risk-adjusted returns are likely to improve for those lenders who are flexible in their offering and can successfully strike deals acquiring equity for debt like risk. This is something we have previously and continue to target in the single asset transactions we offer too.
Conclusion
I started this article with a warning about predictions, but as 2023 draws to a close, there are reasons to be cheerful about the coming year and the evolving investment environment. Key economic indicators suggest a deep global recession is looking increasingly unlikely, even if the ground is still expected to be rocky for many. The exit environment is showing some tentative signs of life too.
And, while nobody should expect a sudden transformation, the impact of various macro shocks over the past few years have now lost their ‘shock’ factor. Those that persist have been ‘priced in’.
Successful companies and investors adapt. For those confident enough, there will always be opportunities for growth and - I’ll finish with a prediction – in that respect, 2024 will be no different.
Sources:
3. Trevor Pugh, Tradition, Sterling Weekly Commentary 5th December 2023 / https://www.telegraph.co.uk/business/2023/11/13/ftse-100-markets-news-interest-rate-housing-share-price-bae/
4. https://www.pwc.co.uk/services/audit/insights/ipo-watch-europe.html