The narrative of private equity (“PE”) in 2023 unfolds as a captivating tale marked by unforeseen financial intricacies and unexpected turns. Our analysis delves into the multi-faceted PE landscape, presenting a comprehensive view of the industry’s evolution and its consequential impact on market dynamics. The exploration of pivotal themes, encompassing central bank influence, challenges in buyouts, fundraising dynamics, shifts in mega-fund trends, and the emergence of AI integration, serves as the framework for understanding the intricate layers defining this period.
Central Bank Influence and Market Dynamics
Rates were hiked in 2022 but remained low in the first quarter. The fed funds rate was still under 4.5%¹, and credit continued to be easily attainable. When the year commenced, PE firms were optimistic about 2023 for moderate growth in M&A and capital raising. However, inflation proved to be persistent, and central banks raised interest rates more than anyone anticipated, leading to a nuanced shift in market dynamics. The bank failures of Silicon Valley and others led to tightening credit from regulated sources. Public market valuations fluctuated and then dove, and private equity found itself adjusting strategies in response. The combination of credit tightening and valuation mismatches made it an interesting year that rippled across M&A activity, fundraising, exits, and restructurings.
Challenges in Buyouts and IPO Market Shifts
The challenges encountered within buyouts, typically stalwart performers in PE, marked a departure from projected norms. Conservative stances adopted by lending institutions resulted in notable declines in deal volumes and valuation challenges, particularly in sectors with low cash flow and high multiples. Simultaneously, the waning allure of Initial Public Offerings (“IPOs”), evidenced by a significant decline in deal volumes, especially in the over $500 million buyout and growth deals segment, marked a departure from the previously bustling IPO scene. Investors found themselves in a more contemplative setting, witnessing a shift from the typical blockbuster narrative.
₁Forbes – Oct 17, 2023
Fundraising Dynamics and Mega-Fund Trends
A subplot unfolded as global private equity fundraising contracted by 11% to $1.2 trillion². After a decade of relatively easy fundraising, this contraction came as a shock to PE executives unaccustomed to facing such challenges. Smaller funds meant lower GP budgets and layoffs in the PE industry. 2023 marked the lowest growth in PE dry powder since 2009. In a tale of contrasts, mega-funds exceeding $5 billion thrived, securing a record $445 billion in commitments—a remarkable 51 percent increase from 2021³. The exception to this was the Carlyle Group. The firm’s flagship fund began fundraising in 2023 and had a hard close in Q3 2024, falling short of its $22 billion fundraising target, settling for a $14 billion fund⁴.
Continuation Funds Gain Prominence
General Partner (GP)-led transactions, particularly continuation funds, gained popularity, representing 52%⁵ of all secondary transaction volume. Continuation funds provided benefits that traditional exits might not, allowing existing investors to lock in gains on successful portfolio companies. The number of transactions went up ~30% in 2023 from the prior year according to PitchBook.
Private Equity Faces Challenges
Globally, buyout funds generated $558 billion in deal value during 2023, to December a 51% decline from the same period a year ago. The number of deals also fell to just over eleven thousand, about a 25% decline. The lower decline in deal count indicates a greater share of add-on activity. Add-ons continued to represent a significant share of the global buyout market, accounting for 9% of total deal value in the first half and 56% of deal count⁶.
₂ PE Hub – Nov 17, 2023
₃ McKinsey annual PE report
₄ Wall Street Journal
₅ Orrick Insights – Sep 28, 2023
₆ Pitchbook data and Bain & Co annual report
Focus on Restructurings
PE firms have sharpened their focus on the liquidity of their existing portfolio companies. Higher borrowing and labor costs have left companies with floating interest rates and borrowing arrangements unprepared for the current levels of cash-burn, forcing PE firms to concentrate their efforts on portfolio assets that can meet their capital requirements during this period of expensive debt. An increased demand for liquidity has subsequently led to the question of how much support PE firms will give portfolio companies through capital injections (and if they will be willing to do so without a short-term positive return). Increasingly, in some cases, restructuring is seen as a viable alternative solution.
AI Integration and the Shift To Value Creation
Private Equity firms began experimenting with the use of AI in making investment decisions. Many PE firms have begun to develop in-house teams that harness the power of large language models to process vast swaths of historic investment decisions and outcomes and predict how an investment will turn out. It is no longer a technological tool that sits in the back office, but a key ally that PE firms need to include in their fund investment thesis when talking with their limited partners.
A good example of the use of AI in the PE world is the formation of New PE by Gero Wittemann (former CVC Managing Director and former head of Hg Capital, USA) and Francesco Barosi (former Partner at Alix Partners) founded New PE. The thesis of the fund was to harness AI to use in decision making, thereby reducing the cost basis of the fund while potentially improving performance.
Simultaneously, the industry’s return to fundamental principles, emphasizing value creation through revenue growth, cost reductions, and operational efficiencies, underscores its adaptability and resilience amidst challenging market conditions. In the past few years, PE firms have been spoiled by low-cost funds, vigorous equity, and M&A markets which allowed the ability to deliver returns through multiple expansions and financial arbitrage. 2023 put an end to that party. With the cost of debt over 10% on average, and the exit markets muted, the ability to eke out an 18% return is as difficult as it has ever been. This is forcing PE to return to basics and focus on value creation through revenue growth, cost reductions, and operational efficiencies. Striking the right balance between cost reduction and fueling future growth is the parlor trick that PE firms are grappling with and are increasingly relying on their operating partners and external consultants to help with.
Private Credit’s Influence – Friend or Foe
One can argue that there is limited LP capital available. In a world where PE returns are targeting mid-teens and private credit returns are in the same realm on a senior and secured basis, why would any capital flow into private equity? The reality, however, is that most LPs have different buckets for private equity and private credit. They realize the importance of diversification and acknowledge the movement of investment across cycles.
In fact, the growth and diversity of private credit are a boon for private equity in a time of high rates. Traditional bank loans with strict covenants are a non-starter, but unregulated private credit allows lenders to sometimes be creative in their lending; in turn, PE firms can boost their targeted return on an investment.
Looking Ahead to 2024
A survey conducted by Churchill, a Private Credit firm, revealed that most private equity firms believe M&A activity will return to normalized levels in the first half of 2024. However, for this to happen, valuation gaps would need to be bridged. By pushing expectations of exit into the future (continuation funds), buyers and sellers are able to bridge valuation gaps and navigate rough financing waters.
Notwithstanding the slower 2023 in terms of deal count and deal value, the combination of historic amounts of PE sponsor dry powder, the dynamism of credit markets, and availability of strong operating businesses with challenged balance sheets creates capacity for 2024 investment. By focusing on strong—if distressed—platforms and other businesses, deploying creative credit alternatives, and innovatively sourcing capital, PE firms believe they can realize value, and this bodes well for the PE deal environment in 2024.
In 2024, the utilization of artificial intelligence by private equity firms is expected to broaden. The application of AI will rapidly evolve from the automation of back-office functions to encompassing enterprise-scale platforms. The technology’s expanded role will include facilitating due diligence, managing LP requests, and reporting. This sets the stage for a significant enterprise-wide transformation, bolstered by the technological maturity achieved by private equity firms over the past decade.
In 2024, the spotlight on private equity returns will be on strategic and operational enhancements as the primary sources. Firms, grappling with a slower pace of exit opportunities compared to historical averages, will channel their efforts into creating value within portfolio companies, with a specific emphasis on operational improvements. This strategic focus aims to find the delicate balance between cost-cutting measures and fostering future growth, anticipating a more favorable exit market in the near future.
The transformation window for private equity, spanning four to six years, becomes the opportune period for value pursuit across sales, marketing, operations, and finance. Firms will employ rapid diagnostics to narrow down opportunities that drive EBITDA, offering clarity on top-line, bottom-line, and capital efficiencies. Understanding the genuine cost drivers within the business is crucial, prompting decisive actions. MorganFranklin can assist with such transformations, using our proprietary methodologies driven by teams of industry experts with decades of experience.
