PE investors see climate for dealmaking darken, but still some sun rays of opportunity: Torys survey

The 2023 version of Torys LLP’s annual survey of what private equity investors think about the climate for dealmaking shows that PE leaders believe there are “strong headwinds” that could present serious challenges. However, “those closest to dealmaking” see opportunities in dealmaking for this asset class.

“There are some dark clouds that are over the horizons, but there’s also rays of sunshine,” says Torys Guy Berman, a partner in the firm’s corporate group whose practice involves working extensively with pension funds and private equity.

“I don’t think the sky is falling, but from the survey results, the tone is that we’re not going to have the same robust market activity that we had over the last five years.”

The fourth annual survey, conducted between last Nov. 2 and Dec. 2, indicates that more than half of respondents believe the overall transaction environment will worsen compared to 2022. “Overall, there is somewhat less optimism than we have seen in previous years conducting this study,” the executive summary states. It notes the average size of transactions is not expected to increase from last year. Fundraising is expected to remain challenging, and “one-third of respondents expect it to become much more difficult.”

The survey also indicates PE investors think the economy “is not expected to significantly improve in the short-term,” as respondents expect inflation and rising interest rates to impact the overall transaction environment more than they did last year.

Not all doom and gloom for PE

However, there are encouraging signs. One in seven investment professionals expects to source their most attractive targets from distressed assets. And as the expected pace of interest hikes slows, the valuation gap between buyers and sellers may narrow.

“Very few of the professionals we surveyed reported higher vendor pricing expectations over the past year, and even fewer expect valuation multiples for new platform investments to grow in 2023,” the executive summary says, noting that this is a departure from previous years.

If that gap continues to close, it is conceivable that 2023 yields “an attractive vintage, similar to the vintages generated during previous economic downturns.” The result is PE firms “will have choice opportunities” that include distressed assets.

Berman says that given the private equity playbook involves leveraged finance, any increase in interest rates, as we’ve seen lately, makes deals more expensive. “That’s one of the negatives coming down the pipeline,” he says. “On the flip side, over the last four of five years, when we’ve asked our clients what their biggest challenge to making deals is, they mention high valuations.” The fear was that buying at the top of the market would impact the lifetime of the PE investment.

This year’s survey, however, didn’t indicate high valuations as a primary concern. “In fact, 61 percent of our clients said they expected pricing to drop, and that’s always a good indicator that there will be M&A activity.”

He adds that sometimes, downturns can yield “pretty good private equity returns.”

Still, the survey notes that fewer respondents expect to see greater returns on realized investments (15 percent vs. 48 percent last year and 28 percent the year prior). And regarding the average size of transactions, just 23 percent expected it to increase, a sharp decline from the last two years. Still, more than half (56 percent) expect the size of their transactions to stay the same, and none of the respondents expect transaction size to decrease.

Interestingly, Berman says, while 31 percent of private equity stakeholders expect the average size of transactions they make to increase over the next year, no pension fund respondents hold the same view. Says the survey summary: “These pension fund investors, who often invest in large-cap transactions, may be influenced by an increased tightening of the debt markets and the paucity of high yield debt financing, the impacts of which are not as severe for middle market investors.”

Much of the dampened sentiment can be attributed to the economic outlook. On the domestic front, only two percent of respondents expect the overall economic climate to improve, down from 23 percent last year. That figure is three percent for the global environment, down from 19 percent last year and 40 percent the year prior.

Predictions of more difficulty raising capital

Only nine percent also believe it will be easier to raise new funds in 2023 than in 2022—significantly fewer than the year prior, 42 percent and the lowest number in the four years of this survey.

Moreover, more than one-third, 38 percent of respondents, see the fundraising climate becoming much more difficult. A combined majority said fundraising would remain about the same (18 percent) or become a little more difficult (36 percent).

None of the pension fund stakeholders polled expect to increase their passive private-equity allocations this year, partly a testament to the impact of the denominator effect but also due to the more conservative outlook that pension fund stakeholders are taking.

The “denominator effect” at play

As well the “denominator effect could also affect pension fund investing,” says Berman. “So if you have allocated ten percent of your investible funds into private equity, but your assets under management have shrunk, you may still put then percent into private equity, but there are actually less dollars that you can invest in that class.”

The result is that some private equity funds have a little more difficulty raising funds than they have in the past, as “allocations remain the same, but the number of dollars to spend was lower.” Indeed, the survey shows that 74 percent of respondents thought it would be more difficult to raise new funds from their investors. And none of the pension fund respondents believed that they would increase the amount of money they put into private equity funds, even if allocations stayed the same.

Berman says that gathering the information that makes up the survey is valuable to Tory’s corporate law practice, as it can help the legal team “get ahead of the market” and show different prospects to existing and potential private equity clients to help them grow their businesses.

For example, he says, “when you see that the valuations of public companies have come down and access to capital is more challenging, our private equity clients – who have access to tremendous amounts of capital – can take the opportunity to take companies private or take significant stakes in those companies.”