The rising cost of leverage as well as volatile valuations amidst a global economic downturn and tightening monetary policies have been identified as the greatest challenges facing the private equity (PE) industry, according to global law firm Dechert's latest Global Private Equity Outlook 2023.

Globally, private equity deal values have almost halved from US$1.2 trillion to US$685 billion between Q1 and Q3 in 2022 as the industry continues to adjust to an increasingly tough climate for transactions. While deal activity remains above pre-pandemic levels, the number of transactions dropped by 18% year-on-year (YoY), to a total of 4,694 deals in the first three quarters of 2022. In EMEA, the number of buyouts fell by 22% from Q1 – Q3 2022 compared with the same period in 2021, a steeper rate of decrease than global activity.

Commenting on the report, Christopher Field, co-head of Dechert's global private equity practice and a partner in Dechert's London office, said, "Going into winter you're likely to see even further contraction in activity, as people are going to be very focused on keeping portfolio companies alive and well rather than new deal activity."

Fundraising also falls

PE fundraising has also fallen significantly during 2022, dropping 16% by value and 30.6% by the number of funds closed through Q3 2022 compared to 2021. According to respondents, the most significant challenge to fundraising in EMEA and by an even greater margin APAC, is large LPs increasingly concentrating their investment relationships with a smaller number of funds. This contrasts with their counterparts from North America, where they were more likely to point to the challenges of competing against other funds (particularly large and/or more diversified GPs) for LP capital (according to 27% of respondents) and that of convincing investors their capital will be put to work quickly (according to 22% of respondents). Following the rout in public markets, longer fundraising cycles are expected as a result.

Creative deal sourcing

Firms have been adjusting by deploying a variety of strategies to sustain their deal pipelines. Almost seven in ten of respondents (68%) surveyed globally shared that they were sourcing deals via incubators, executive training camps and deploying teams on the ground in vibrant start-up markets, with 60% leveraging their networks to source proprietary deals.

"There is always something going on in the middle market, whether it is new platform deals or add-on acquisitions. Even though the amount of capital being invested has fallen, private equity has really demonstrated its resilience," said Dr. Markus P. Bolsinger, co-head of Dechert's global private equity practice and partner in the firm's New York and Munich offices.

The rise of private credit

In a cycle of rising inflation and interest rates, private credit continues to be the preferred mode of financing, with over half (52%) of EMEA respondents now using private credit more than traditional bank financing for their buyout deals, although APAC continues to take the global lead on relying on private credit (60%) in buyout deals, with only 20% turning to the banks for support. In unravelling the popularity of private credit, 30% of global respondents agree that the current top advantage of using private credit compared to traditional bank financing is greater flexibility on financing terms. This is followed by the advantages of being provided with higher leverage levels (21%) and greater predictability with private credit (19%).

As the report also notes, until inflation has been brought under control, PE fund managers can expect high-yield bond and syndicated loan markets to remain challenging.

Can PE firms meet the needs of their investors?

When it comes to returning capital to investors, PE firms face the same valuation challenges as their counterparts in the public markets. The biggest challenge EMEA respondents expect to face on returning capital to investors over the next year is the difficulty in securing a buyer willing to meet their desired valuation amid the current risk-off environment.

The same proportion (40%) of EMEA respondents also point to challenges in determining the right type of exit, sentiment matched by those in APAC compared to just 27% of North American respondents.

"Multiples had gone up significantly over the last two or three years and we're seeing a contraction, especially in certain pockets and sectors," said Bolsinger. "A lot of that is just that rates are significantly higher than they were a year ago, and so discounting cash flows at that rate brings valuations down."

A divergence in market sentiment for private equity liquidity events over the next 12 months was also tracked in the report: 82% of North American respondents and 80% of respondents from EMEA had a favourable view, with only 45% of APAC respondents sharing a similar outlook.

What's hot and what's not

Moving forward, the majority of global respondents are very likely to consider partnerships with strategic buyers (75%), with club deals (57%) and GP-led secondary/continuation fund transactions (50%) rounding off the top three deal types. On the other end of the spectrum, respondents were not very likely to consider options such as leveraged recapitalisations (28%) and, unexpectedly, take privates (26%).

Siew Kam Boon, co-head of Dechert's global private equity partner in Dechert's Singapore office, commented: "APAC represents one of the most diverse buyout regions in the world. While dealmaking has been down this year partially driven by uncertainties in the Chinese market, Southeast Asia is continuing to demonstrate strength, spearheaded by expanding manufacturing activity, regional digitalisation initiatives, as well as lifting travel restrictions which facilitate in-person deal sourcing in the region."

In terms of what asset classes respondent firms are considering investing in over the next 24 months, private credit/direct lending (82%) is the most popular selection. This is closely followed by venture capital (76%) and distressed debt (63%). Compared to the above, other asset classes such as cryptocurrencies, commercial/residential real estate, real assets (e.g., metals & mining, farmland, water) came in at the bottom of every respondent's wish list.

Geopolitical and other risks

Geopolitical risks continue to loom large following the breakout of war in Ukraine at the beginning of 2022 particularly for PE firms active in EMEA. The two-sided squeeze of rising costs on one side and rising interest rates on the other is also a challenge for the global PE industry at large. There is no question that these are testing times, but the PE industry is nothing if not resilient. It has shown that, as a proactive steward of investee companies with a decades-long track record, it can successfully weather market conditions, come rain or shine. Now it is once again being asked to demonstrate that resilience.

Sabina Comis, a fund and tax partner and member of the Paris Management Committee, comments: "After a record-breaking year in 2021, the private equity market has proven its resilience, returning to pre-pandemic levels of activity. Still, we are to face various new challenges, with geopolitical context impacting interest rates and cost of leverage, as well as competition between funds. As a leading global law firm with strengths in key international markets, our goal is to provide the best solutions to funds and their management to help them address the challenges of this changing environment."