INVESTMENT TREND
In contrast to the remarkable levels of deal activity seen in 2021, 2022 was a more challenging year for private equity investors. Faced with the headwinds of increased inflation, Russia's invasion of Ukraine causing geopolitical instability, high energy prices, uncertainty around supply chains and rising interest rates, 2022 saw a measure of slowdown in PE deal pipelines in line with broader M&A deal activity.
As we look ahead to 2023, investors remain cautiously optimistic about the opportunities created by volatility in the markets and as they seek new avenues to deploy capital. After all, history has shown that the best performing vintages of private equity funds are often those invested during downturns and that private equity outperforms other asset classes by a greater margin when recessionary forces are at play.
Bridging the gap between sellers and buyers on valuation of assets will be critical after years of seller-friendly deal terms and record-high exit multiples. Price discipline and deep sector experience to diligence assets will be key. In addition to intensified levels of diligence, we may see the return of value adjustment mechanisms such as earn-outs and seller notes. Also, in line with historic trends, U.S. investors will seek opportunities to spend their dollars on UK assets and businesses during periods of downturn, particularly where UK businesses have resilient, recurring cash flow, given the weakness of the pound against the dollar.
Private equity investors will also continue to pay close attention to takeprivate and corporate carve-out transactions. Large take-private transactions remain an efficient way to write big equity checks where historically public market valuation has lagged behind private valuations. As listed companies and other large corporates carry out strategic reviews and focus their attention on core business areas across fragmented business lines, private equity investors remain poised to execute carve-out transactions.
Increased cost and general availability of debt financing has slowed deal activity in the short term, but this could pave the way for more coinvestments and other forms of private equity investments. Liquidity remains at the top of the agenda for GPs and LPs, and, with exits looking potentially more challenging (particularly in the large cap space given the uncertainty around the availability of debt financing), fund managers are using GP-led secondaries and continuation fund vehicles to realise liquidity and hold onto quality assets while simultaneously returning capital to LPs. Additionally, investments where leverage is less critical such as growth equity investments have experienced a large volume uptick with many PE sponsors raising dedicated growth funds to meet investor demand.
In summary, while 2023 will not be an easy environment in which to execute deals, we anticipate the high levels of dry powder to translate into selective investments in a wide range of private equity investment strategies ranging from buyouts to co-investments and secondary transactions.
REGULATORY
From a regulatory perspective, 2022 saw fewer significant individual changes than 2021. However, the regulatory topics impacting fund managers continued to evolve.
This was particularly the case for European ESG regulation. The European Union's Sustainable Finance Disclosure Regulation (SFDR) remained front and centre for managers, regulators and investors, and whilst some aspects are clearer at the end of 2022, much remains uncertain. ESG will continue to be a key area of focus in the United Kingdom and the European Union during the course of this year and beyond, with the implementation of more detailed technical standards under SFDR at the start of 2023 and the consultation on a new disclosure regime for UK FCA-regulated firms.
2022 saw the bedding-in of new rules impacting how fund managers market their funds in the European Union which were introduced in 2021. These rules have various consequences and will continue to evolve during 2023. For UK-regulated firms, the start of 2022 saw the introduction of a new capital regime for many private fund advisers, including the need to have more detailed remuneration policies in place. The FCA has also renewed it focus on the importance of culture within the financial services sector, including the asset management sector, and this will continue during 2023 and beyond.
Looking ahead to 2023, in addition to the above, key areas on which asset managers in particular should focus include public remuneration disclosures, financial crime, operational resilience, the regulation of the crypto-asset market and the consumer duty regime.
FUNDS
According to data from Preqin in November 2022, global private equity fundraising has decelerated to its slowest pace in 20 years. In Europe, the slowdown was most prominent in H2 2022 where, except for one Nordic sponsor, the rest of the region's largest 15 private equity fund closes occurred before the summer. Looking forward into 2023, GPs are hopeful that renewed LP allocations will restart their fund closings in Q1, but the competition for LP airtime remains high and there continues to be an oversupply of managers chasing capital in the market. The denominator effect caused by the public market volatility is also affecting LP commitment sizes and forcing GPs to pursue new pockets of capital in the form of private wealth clients, retail investors and family offices. However, accessing these alternative pools is not without its legal, tax and regulatory complexities and GPs will need to spend time and resources on working through structuring and operational issues and it remains to be seen how much might be raised from these sources in practice. Despite the fundraising slowdown, to date headline management fee / carry rates have remained relatively stable, although behind the scenes larger investors are certainly negotiating much greater discounts than has been seen in recent years. GPs may find it necessary to be more flexible depending on how the economic and geopolitical environment progresses. Two trends which seem certain to continue in 2023 are GPs seeking to extend their fundraisings beyond the typical 12-month period and a continued LP focus on ESG-related matters.
From an LP perspective, with the fundraising environment being at its slowest in several years, we expect more caution and less of an appetite for risk in the form of prioritising existing GP relationships over new entrants to the market. Greater scrutiny from LPs over fund terms, which have been trending towards GP-favourable positions in recent years, is inevitable, with larger, anchor investors being able to leverage their position to gain ground on key negotiation points, particularly on bilateral, 'side letter' undertakings. Opportunistic investments, whether on a direct or co-investment basis, will continue to have their place in a more distressed market for the larger LPs that still have the mandate to execute them; consequently, GPs will need to continue to think about innovative structuring options to accommodate them. With many GPs turning to access funds and feeder structures set up by third party intermediaries to provide private market access to high net worth and private wealth clients and increasing efforts from regulators and market participants to broaden access to retail investors (though several hurdles remain in this respect), the widening of the traditional institutional investor base is another trend to watch in 2023.
After the record growth in global GP-led secondaries volume in 2021, the GP-led market slowed during 2022 as buyers became more cautious and selective, with single-asset continuation vehicles involving trophy assets becoming the predominant type. While the volume of GP-led secondaries remained strong in 2022 and generally matched 2021's record level of approx. $130 billion, the second half of 2022 marked the resurgence of LP fund portfolio deals. Mainly driven by the denominator effect and slowdown in fund distributions, LP portfolio deals have proven to be an efficient tool for LPs looking to rebalance their over-allocations to private equity. In particular, large sales of fund portfolios by LPs (also known as "mosaic sales") have abounded on the market, where strips of fund interests were split amongst multiple buyers.
REAL ESTATE
The start of 2022 largely saw continued activity levels and key trends from 2021. Logistics and industrials occupier demand remained high at the outset, largely driven by e-commerce, manufacturing and third-party logistics operators, resulting in record lows of availability in the sector. Office transactions and leasing activity increased significantly compared to H1 2021, as firms implemented 'return to office' plans. Data centres, PRSs, student accommodation and senior living all remained resilient, as they did throughout the pandemic. It was shaping up to be another strong year in terms of investment volume. However, macroeconomic and geopolitical volatility soon brought about a slowdown. 'Trussonomics' – seemingly the straw that broke the camel's back – against the backdrop of the ongoing war in Ukraine, inflation and already rising interest rates caused investors to adopt a wait and see approach rather than catch the proverbial falling knife, and we saw a pause for breath in Q3 and into Q4. At the turn of the year, there is a growing sense that sentiments, and with them the markets, are settling, and investors are readying themselves for active capital deployment as 2023 opens up.
Distress is likely to permeate the real estate market more widely during 2023. With COVID-19-related supply chain disruption now compounded by the market headwinds mentioned above, 2023 feels like an inflexion point. We expect an increasing number of quality assets in troubled situations to come to market. Likely sources could include borrowers struggling to meet rising debt-servicing costs and/or financial covenants as valuations fall. Be prepared to see open-ended property funds searching for liquidity in the face of continuing redemption requests as well. For investors with capital reserves to deploy, this could present fertile ground for 'special situations' and opportunistic investment options. However, with much dry powder held back during H2 2022, opportunities will remain competitive. Investors will need to be agile and open to finding value where they might previously not have expected it and be ready to transact quickly with conviction.
Enticed by enhanced returns following interest rate rises in the United Kingdom and across Europe, several equity investors pivoted to establish real estate debt platforms in 2022. With further rate rises expected, private capital debt allocations look set to increase further in 2023. As traditional lenders adopt a more cautious approach, the ability of these equity-turned-debt providers to measure risk using their investor expertise should provide an important source of liquidity for borrowers grappling with higher debt costs throughout 2023.
Despite expectations of turbulent markets in 2023, there is clear optimism that sector-specific pockets of the market will remain resilient. Real estate life sciences looks set to remain strong with lab capacity trailing surging demand in the United Kingdom and across European clusters. With a boom in British biotech fundraising expected in 2023, the 'Golden Triangle' hub between Oxford, Cambridge and London will be of particular interest to real estate investors. Given the challenges facing the office sector, 2023 presents an opportunity for bold, creative investors to repurpose stock as lab space, with London boasting a number of sites well suited for development as campus-like estates. Certain residential subsectors also look robust. BTR/PRS benefits from inflation hedging, skyrocketing rents and structural tailwinds, but with investors heavily focusing on location, quality and ESG credentials, resilience will not be ubiquitous. Optimism is also high for UK PurposeBuilt Student Accommodation, which, as well as typically running countercyclical to economic downturns, is suffering form a chronic undersupply of beds and booming student demand.
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