Volatility can bring opportunity
2022 was never going to match the “confluence of unbelievable conditions” that triggered 2021’s bonanza of deals, according to Harold Varah, Global Co-Head of the Financial Sponsors Group at RBC Capital Markets. But the sheer volatility of the year made it unexpectedly difficult – and a deep recession in 2023 would limit clients’ ability to monetize their assets.
However, private equity has always shown ingenuity in dealing with market challenges. As Varah points out, clients have about $4 trillion of dry powder in hand – and the current challenging macro environment is exactly the kind of backdrop in which it performs well.
“Funds deployed during periods of economic uncertainty or pullbacks always outperform funds deployed during periods of calm or economic growth,” he says. “As they think about their ability to deploy across asset classes and pools of capital that didn’t exist during the last financial crisis, I think it’s a really compelling time for a lot of them.”
With the cost of debt having effectively doubled in 2022, the return of a well-functioning credit market will be key to the timing of a full market revival. This in turn depends on stabilization of interest rates, potentially in the first half of 2023.
Whenever it happens, it will be quality deals that lead the way. Early transactions following market dislocations tend to favor bank balance sheet usage over leverage, says Graham Tufts, Global Co-Head of the Financial Sponsors Group at RBC Capital Markets: “When the market comes back, it tends to be the best credits that come out first. And of course, we now have a pool of private debt providers that can also support those transactions.”
“Larger funds continue to be able to drive massive amounts of fundraising, with huge IR functions across all their asset classes”
Harold Varah
Global Co-Head, Financial Sponsors Group, RBC Capital Markets
Big funds are well positioned
Fundraising has been difficult for smaller firms in 2022, Varah notes: “It’s much harder to raise that inaugural fund unless you have a tremendous track record.” That means the larger funds will grow further in 2023. “They continue to be able to drive massive amounts of fundraising, with huge IR functions across all their asset classes.”
Meanwhile, large limited partners will continue to be more discerning in where they put their capital, says Ram Amarnath, Global Co-Head of the Financial Sponsors Group at RBC Capital Markets. He predicts that alternative assets will remain popular: “Alts as an asset class are not going away, because they have served investors really well. It’s not correlated risk; it actually is an inflation hedge. It has a lot of the attributes that any smart portfolio construction likes.” Private debt capital will also remain part of the mix for LP investors, he says. “I would not be surprised if we see some consolidation in 2023 among some of the less capitalized private capital funds.”
“Alts as an asset class are not going away, because they have served investors really well. It’s not correlated risk; it actually is an inflation hedge.””
Ram Amarnath
Global Co-Head, Financial Sponsors Group, RBC Capital Markets
IPOs out of action – for now
The current environment has blocked off some exit routes for investors. IPO values tumbled in 2022, while IPOs that went ahead in 2021 have not secured further monetization. This can be frustrating for investors keen to raise larger funds and deploy them across multiple asset classes.
For Amarnath, IPOs are no longer the standard exit route that they used to be. “Today the private markets are comparable to the public markets, so there are only so many companies that can go public,” he observes.
However, he predicts a comeback for IPOs during the year: “The best companies will come out first and they’ll usually have good discounts. IPO investors will make money, and when they start making money again, you’ll start to see more IPOs.”
For now, IPOs remain challenging, Tufts adds: “That’s why you see sponsors showing a preference for trading between each other as opposed to necessarily going to the public markets. You’ve got that certainty of valuation – it’s a complete exit.”
“I think there will be some aerospace and defense opportunities that come out as spending goes back into those segments and demand recovers”
Graham Tufts
Global Co-Head, Financial Sponsors Group, RBC Capital Markets
Regions, sectors and themes
Regional variations are pronounced at present, with Europe suffering the biggest knock-on impacts of Russia’s war in Ukraine. Again, our experts believe European deal volumes will revive in 2023. “It’s a robust financing market historically, and there’s just as much dry powder floating around the system in Europe to keep that market healthy,” says Tufts.
Amarnath sees opportunities in the Canadian market next year for healthcare, technology and infrastructure sectors. The panel predicts a strong year for these sectors globally, while consumer, retail and leisure will remain challenged.
Tufts also sees potential in industrials, as supply/demand balance is restored after pandemic disruption: “I think there will be some aerospace and defense opportunities that come out as spending goes back into those segments and demand recovers.”
Finally, ESG will remain a big focus. As Tufts notes, most private equity firms now either raise dedicated ESG funds or hire ESG heads to lead deployment of capital: “There’s a lot going on in that space and it’s here to stay,” he concludes.