In this article, I’ll analyse the 2023 private equity market, focusing on key trends, insights and a 2024 forecast. Notably, deal values dropped by about 45% in mid-2023, while exits saw a 70% decline. This has heightened fundraising challenges, potentially leading to a 30% decrease by year-end 2023.

Since June 2022, uncertainty has surrounded the expectation of an impending recession, leading to questions about when the private equity market will regain its dealmaking momentum. Despite the rapid increase in interest rates, it’s worth noting that the federal funds rate is currently at levels similar to those observed in 2006 and 2007, the two most active years for dealmaking in the industry until 2021. Therefore, interest rates should be a manageable barrier to completing deals.

Despite experiencing higher-than-usual inflation, corporate earnings remain strong in numerous sectors, with some even displaying robust performance. There are no clear indicators of a broken banking system or massive asset bubbles akin to those seen during the 2009 Great Recession, which would necessitate extensive remedies over an extended period. Consequently, the present market does not exhibit any fundamental flaws.

The critical question is when dealmaking will resume and what’s causing the delay. A significant challenge for the industry’s recovery is injecting more capital into limited partners (LPs) pockets. To revitalise the sector, it’s crucial to funnel money into exits and other liquidity solutions, boosting LPs’ confidence for future investments. There is a significant backlog of portfolio companies awaiting exits, requiring liquidity for transactions.

Challenges in securing investment deals

Investments face challenges, notably in financing large transactions, due to higher loan costs and strict lender standards, especially from banks. On a positive note, private credit has gained prominence in the middle market, helping fund more significant transactions and showcasing the financial sector’s adaptability. However, ongoing market uncertainty has led to a persistent gap in price expectations between buyers and sellers, raising questions about its duration. 

Key trends in investments

In 2023, annualised global deal values dropped by 45% compared to the previous year, along with a 40% decline in deal counts. A significant strategy in the buyout market was the use of add-on acquisitions, making up 11% of total transaction value and accounting for 60% of the overall deal count. These add-ons typically involve smaller acquisitions incorporated into larger platforms.

In the US, the average purchase price multiples have remained high, around 12.5 times Ebitda in the latest data from Q1 2023. In contrast, European multiples have been on a downward trend, with the most recent Q1 data indicating a multiple of approximately 10 times Ebitda. This significant difference in the US and European deal markets is unusual. It can be attributed to various factors, including fluctuations in US earnings, movements in GDP, a technical recession in Germany and the broader economic landscape in Europe. There is a substantial disparity in the pricing of U. earnings compared to European earnings.

Global dry powder perspective

The global dry powder in private asset class strategies was stable at around $3.7trn in 2023, with $1.1trn allocated for buyouts. About 75% of this buyout allocation is considered “fresh powder,” meaning it’s less than three years into its investment period, providing ample time for effective fund deployment. In the context of buyouts, the current dry powder level represents approximately three to four years’ worth of typical deal investments based on the average deal values over the past five to seven years.

Looking back over the last two decades, the dry powder to deal activity ratio falls within the normal range. Therefore, concerns about an excessive amount of dry powder in the buyout sector appear unjustified at this time.

Challenges and strategies in exits

In the first half of 2023, the focus shifted towards exits rather than investments in the financial landscape. All exit avenues experienced a significant decline during this period, particularly global buyout-backed exits, which plummeted by 67%, marking a drastic two-thirds drop compared to the previous year. The overall exit count also dipped by 40%, underscoring the gravity of the situation. The primary challenge is the immense backlog of exits involving more than 26,000 portfolio companies held in buyout funds, collectively valued at around $2.7trn. Of concern, a quarter of these companies have remained under the management of general partners for six years or more. 

General partners urgently need to strategize to unlock the potential of these $2.7 trillion in assets, which involves reevaluating initial values and finding ways to maximise earnings while ensuring acceptable returns. The urgency arises because limited partner cash flows turned negative in 2022, following a positive trend in 2021. Negative cash flows have persisted for the last five years as capital calls have been outpacing distributions, raising concerns about their duration and depth.

To address these liquidity challenges, general partners are exploring alternative options beyond traditional full exits or sales. These include secondary market solutions like continuation vehicles, portfolio strip sales and net asset value loans. These innovative approaches aim to inject much-needed cash into limited partners’ pockets. Consequently, general partners are inclined to explore these alternative options to alleviate their cash flow constraints.

Challenges in fundraising

Discussing the current state of fundraising in the private capital industry reveals significant challenges. A lack of investment opportunities and exits has hampered general partners’ ability to secure new funding. This has also left limited partners facing financial pressure despite the absence of a full-blown recession. Global private capital raised mid-2023 has fallen by 30%, with a 45% drop in funds successfully closing deals compared to 2022. The dry powder issue exacerbates the situation, as many firms raised significant funds quickly, compounding cash flow challenges. LPs must manage $1.1trn callable by GPs for buyouts, creating total exposure of $3.7trn across private asset classes.

Moreover, competition for LP capital has intensified, with 14,000 private capital funds seeking $3.2trn, while $3.7trn in dry powder remains available. For every dollar that will be raised, three dollars are being sought. This supply-demand imbalance has not been seen since the 2009 global financial crisis, making it extremely challenging to raise capital.

A return to substantial dealmaking is crucial to address this challenge, allowing liquidity and the liquidation of 26,000 portfolio companies. This would funnel capital back into LP pockets and reignite the fundraising engine, enabling the industry to continue its growth trajectory.

Outlook for 2024

After a turbulent year in 2023, where many deals came to a standstill, buyout leaders don’t foresee an immediate surge in activity as we enter 2024. However, there is optimism for a potential recovery thanks to the prospect of interest rate cuts and smaller valuation gaps.

There’s a significant gap between the needs of businesses and the state of capital markets. Despite a sudden decrease in liquidity, several sectors still require investment and growth, including high-quality companies, sub-sector consolidation, technological advancements, environmental protection and energy transition. Private capital remains essential, and 2024 is an opportune time for well-capitalised, flexible and long-term investors. Capital markets are currently not meeting companies’ requirements, and it may take some time for the liquidity crunch to normalise. 

Many anticipate an increase in deal activity over the next six months, particularly in add-ons, secondary buyouts, technology investments, and distressed asset restructuring. This contrasts with 2023, which had two distinct halves in private equity activity. The first half had limited and subdued PE transactions and exits due to a stagnant IPO market. However, the second half saw a growing number of secondary transactions, carve-outs and private-to-private deals, culminating in a robust fourth quarter, marking the highest value of new acquisitions since the PE downturn in 2022. This trend sets a positive tone for buy-side activity in 2024.

Regarding exits, more firms may seek liquidity opportunistically, building upon the focus on alternative liquidity avenues seen in the previous year. This includes increased reliance on secondary sales and continuation funds, a leading prediction for 2024.

Furthermore, 2023 witnessed the emergence of private credit, which funded over 80% of private equity deals. These players in the financial market have substantial dry powder and are poised to continue expanding their influence throughout 2024.

Unless unforeseen shocks and adverse developments occur, 2024 is expected to be a year characterised by steadily increasing market activity and growth in the private equity sector.

is chief investment officer and deputy CEO of AM Investment Management and partner at Antwort Capital.

This article was published for the Delano Finance newsletter, the weekly source for financial news in Luxembourg. .