The private equity (PE) sector experienced headwinds in 2022. However, with record levels of dry powder, multiple capital strategies and a strong focus on value creation, firms are positioning for long-term strategic growth in the period ahead. “Will 2023 be a better year for exits for PEs?”
Host: Luke Pais, EY Asia-Pacific Private Equity Leader
- Bridget Walsh, EY Global Private Equity Leader
- Alex Lynn, Hong Kong Bureau Chief for Private Equity International Group
Luke Pais (Luke)
Wish you all a happy and healthy 2023 and welcome to Money Multiple. Money Multiple is a show where we explore trends, topics, and pathways for private capital investors in Asia to deploy capital and improve returns.
We are at the start of what I predict to be a very interesting year. This comes on the back of a volatile 2022, where overall deal volumes were down about 30% in Asia-Pacific (APAC).
Moreover, corporates and private investors faced a number of challenges, such as slower growth, rising costs, supply chain disruption, labor shortages and high interest rates. Given this backdrop, we will use this episode to talk about what to expect in the next 12 to 18 months.
Joining me are two very experienced private equity practitioners with a global perspective. I'd like to welcome Bridget Walsh, EY Global Private Equity Leader; and Alex Lynn, Hong Kong Bureau Chief for Private Equity International Group. I'm your host, Luke Pais, EY Asia-Pacific Private Equity Leader.
This first section is going to be around broad global trends. So, Bridget, let me start with you. As we have discussed, 2022 was a difficult year and anything but predictable. It appears that these effects will cascade into the current year. How do you see activity shaping up in the next 12 to 18 months?
Bridget Walsh (Bridget)
Thanks, Luke. It's a very interesting time for private equity, where you've got challenging headwinds; at the same time, this type of environment creates really interesting opportunities for private equity. The great thing about the private equity model is the ability to evolve and innovate. As we look forward to 2023, starting with the financing market, the traditional lending markets to PE have been largely closed for the last six to nine months as interest rates have moved higher and investors have become more risk averse. However, private equity is flexing. We're seeing them move toward middle market deals where packages are easier to pull together, valuations tend to be lower, and firms are able to write higher equity checks for transactions. We're also seeing a lot more add-on deals, and that's a trend that's likely to continue for the foreseeable future.
Over the last decade, for example, add-ons have averaged about 50% of total PE activity, whereas right now that there are about 60% of the total PE market – so add-ons to existing portfolios, companies are taking up about 60% of the total PE market. And there’s also PE funds, as we've seen a significant decline in the number of the value of PE deals over the last six months. But, we need to put that in context despite the drop off in announced deals, deal values closed in 2022 well above pre-pandemic averages. Indeed, it was the second-most active year of the last decade with PE firms announcing transactions valued at just under 730 billion US dollars. So, Luke, context is everything.
And I think you asked me to talk about APAC as well, Luke. We fully expect APAC to continue to be a major growth driver for private equity. You've got favorable demographics and spending patterns coupled with current PE, I suppose underrepresentation relative to the US and Europe. So, there's a lot of interest we're seeing from foreign funds. And that should provide really strong tailwinds for the continued growth of APAC-based funds. Luke, does that resonate with what you're seeing on the ground?
Thanks Bridget. I think a number of those messages are absolutely relevant to APAC as well. So, Alex, let me turn to you. APAC is clearly of great interest to global fund managers. However, APAC is a number of submarkets, each operating at a different pace, with value always shifting between markets. What are your views on what to expect in 2023 in an APAC context?
Alex Lynn (Alex)
Obviously, to your point, APAC isn't exempt from global challenges, but nor is it one sort of homogenous region. Obviously, it's a collection of very different markets with some of these economic challenges acting out in different ways across the region. If you take China for instance: obviously, we've been seeing China reducing interest rates over the past year. South Korea and Australia, on the other hand, are hiding them, and Japan as well has been sticking to this kind of ultra-low interest rate environment as well. So, it is apples and oranges in some ways. If we look at APAC deal value, it was down about some 60%, according to figures from Decker. If you compare that to the global average, that is 45%. So obviously, deal value has fallen more sharply than it has globally. And this reflects in some ways what's been happening in China with the zero-COVID policy and firms not being able to get on the ground and to do deals.
Some markets though have been a little bit brighter. So, Japan seemed to have a great 2022 in terms of deal value. So, in the first three quarters of the year, it already exceeded the 2021 total, which is reflective in some ways of a weaker yen and opportunities from corporate carve-outs, which I think we’ll go into more detail later. Southeast Asia and India as well have benefited a little bit from what’s happening in China with Pan-Asian firms spreading their capital around the region a little bit more. So, this year, I think we’ll expect something similar, but the figures should be improved given that China is reopening. There’s a little bit of turmoil obviously around that now, but as that levels out, then there are going to be many firms with a lot of dry powder wanting to put that to work.
Thanks, Alex. China in the last few years has taken the biggest share of investments in the region when it comes to private equity. The last 12 months has seen a significant drop. Do you see funds reallocating capital to other regions, or do you expect this to be a temporary pause in China?
I think it is easy to overstate this shift of capital away from China. I mean, yes, from what we’ve heard, some Pan-Asian firms are putting that money to work in other markets, as I say, in India and Southeast Asia. But China will still represent a very significant part of these portfolios. Historically, it’s been a massive driver with returns, and it is the biggest market in terms of the deals that are out there. So, I don’t think China private equity will diminish in significance at all for these firms.
From the conversations that I’m having, some firms are actually seeing this as a great opportunity. With fewer China funds being raised and obviously some firms being a little bit more reticent to invest there than they were historically, competition should actually be a little bit lower. So, obviously, you have an opportunity to buy assets that may be well priced and obviously, you’ll have to spend off your funds. So, it could be a great time to invest in China if you have the willingness and the capital to do so.
Let’s talk about fundraising and dry powder. Capital continues to accumulate in the hands of private equity GPs (general partners), and I think this shows quite a great deal of trust in PE as an asset class relative to other classes, but it also puts a great deal of pressure on multiples and returns. What are your thoughts when it comes to fundraising in 2023 and maybe as we look forward into 2024?
If we look at preliminary figures fund from our own fundraising data, Asia-Pacific fundraising, it was down about 26% last year from 2021. Again, if we compare that to global figures, that was only down about 14%. So, it has declined more sharply than in other markets as we saw with deal-making. And this is going to be in no small part due to what’s happened in China. It’s obviously the biggest market and you have this kind of one-two punch of geopolitical tensions, which aren’t new, but are ongoing. And obviously, this zero-COVID policy concern has diminished among North American LPs (limited partners), which as we know are the biggest sources of cap private, some of their appetites specifically for China-focused funds as opposed to pan-regional. So, I think going into this year, some funds will be optimistic, the appetites will resume a little bit now that deals can start to be done, people can travel, people can shake hands, and hopefully build some new LP relationships.
I think one of the interesting trends that we did see last year is that less than half the number of funds had closed as of December than in the prior year. This means that the average fund size is getting much larger and capital is essentially getting concentrated in a smaller number of funds. So, there’s sort of a flight-to-quality or flight-to-perceived safety in Asia.
One other interesting thing to note is private credit conversely has had a great year last year. PAG, in December, for example, a very big, very famous Pan-Asian firm, which raised one of the region’s largest ever private credit funds. It was US$2.6 billion. So, that fund brought 2022’s fundraising total to well over US$11 billion. And that’s a record. So, I think this could actually end up this year having positive implications for both PE and for private credit. According to the same Decker report that I mentioned earlier, it was saying that APAC GPs now actually use private credit to finance buyouts more than they do bank financing. So, even if we do see banks continue to be representing them to be a little bit more cautious, hopefully in Asia, deal financing shouldn’t be as much of an issue with all of this dry powder and private credit to deploy.
Thanks, Alex. So the large GPs are getting larger and as part of that is they are implementing multiple strategies. The word that comes to mind is “flexible capital”. Bridget, with your global vantage point, can you talk us through some recent examples where you see this creativity and flexibility at play?
I love that term, Luke, “flexible capital.” I think it could be our term of FY23. When we look at the types of deals that we are seeing and expect to see over the next six to 12 months, we do see private equity being really flexible in their approach and leaning into certain types of deals. I think the first one I’d like to mention is take-privates. There are a lot of really interesting opportunities in this space now that valuations have reduced, especially in the tech sector. With all the IPO activity that we saw in 2020 and 2021, there’s a lot of value to be had for the right assets and firms have been really active in this space. Just to quote some statistics, in a typical year, we expect to see take-privates account for about 20% of the global investment capital a private equity deploys. Last year, it was about 40%. So, that’s a very significant uptake. And this sort of activity was prominent in Asia-Pacific.
Another trend, Luke, is infrastructure, and we’ve seen a few deals already in that space but can expect more. And that’s where a PE firm can come in, work with a corporate to provide financing at scale for capital-intensive projects, and where corporates are able to lower their cost of capital while keeping cash on their books. The semiconductor, telecom, transportation, renewables, and digital infrastructure spaces are just a few of the areas where this type of deals can make space, with some real headline ones in North America recently in infrastructure. We’re predicting much more private equity activity across the globe here and in APAC.
And then the other area, as Alex quite rightly mentioned, that underpins all of this is the growth of private credit. Three to four years ago, private debt was probably 10% to 20% of the overall financing market for private equity. It was about one-third in the first half of 2022, and it’s about half in the second half. And for most of the deals in the US and Europe, almost all private equity financing at the moment is coming from private credit funds. So, that’s almost certainly to be one of the most lasting legacies of this market, is the elevation of private debt as a funding mechanism for PE transactions.
Alex, what is your call for big investment themes in APAC in 2023?
PE firms, in general, seem pretty excited about the carve-out opportunities in APAC this year. I was at an industry conference the other day and it kept coming off in conversations. Japan is obviously the big one; that’s an ongoing trend in Japan, these corporate carve-outs. We saw in October last year a consortium led by Bain. They carved out Hitachi Metals and I think it was reportedly more than US$5 billion, that deal. So, that obviously contributed to the impressive deal statistics last year in Japan. Again, the weaker yen has made those conditions more favorable. There’s a lot of global funds in Japan with US dollar-denominated funds to deploy. So, that’s obviously an opportunity there. The yen is starting to come back a little bit, but it’s still way down. So, I think that trend should be ongoing for some while yet.
I think other markets as well, Korea and Australia, you’ll see some of that carve-out activity. Again, to Bridget’s point, I think the firms that I’ve spoken to are pretty excited about the opportunity to take some businesses private. Obviously, with public valuations down, the premiums that they’re going to have to pay on those should be much lower. So, it could be a good time to deploy that dry capital, dry powder.
Both take-privates and carve-outs tend to be incredibly complex, and I think private equity buyers need to have a very clear and well-articulated value creation thesis. While this is probably true in every transaction, it is even more important in the case of a carve-out transaction. Bridget, can you share with us your thoughts, maybe even an example of a well-executed carve-out?
As Alex mentioned, these types of environments really do naturally lend themselves to carve-outs. We’re finding the corporates are focusing on the core business in this time and divesting non-core assets. And PE funds can do really, really well in this space and actually compete for some of the larger assets where the level of complexity is much higher and maybe prohibits other buyers. We’ve had great experience of this over the years. And most recently, I’ve worked on a US$5 billion carve-out in here in EMEIA, one of the biggest that we’ve ever done from one of our large consumer goods companies. The key to that is a really clear execution plan because when you think about it, you’re standing up a management team, you’re standing up all of the infrastructure, the IT systems, etc. So, execution is everything, and that’s what we really built value creation teams to help with. And when we talk about value creation, PE firms really have more levers to pull than they’ve ever had before. You know the traditional levers on the revenue and growth side like commercial acceleration and price optimization, but equally on the cost and operational excellence side like cost take-outs and supply chain resilience.
So, for example, periods of increased volatility always elevate the importance of cash discipline, Luke. And we’re really seeing huge demand for those services around cash and also how to optimize working capital in order to free up locked-in cash that can be used for acquisitions, repayment of debt, etc. And as you know, Luke, globally, we’ve strategically built these value creation teams to focus on this phase of the private equity industry. And I really do feel that we are in that value creation phase of private equity at the moment to really get those multiples in this environment. So, I think to summarize, when we think about this environment, we know that: one, debt is getting more expensive and coming with more covenants; second, multiple expansion for companies acquired over the last couple of years is more challenging and it’s therefore operational restructuring and these value creation levers that become the competitive differentiations. And that’s certainly the case, whether it’s a carve-out or take-private or even an acquisition of a family-owned business, a huge area of focus at the moment and a real value driver.
I wanted to touch upon one specific value creation lever which is environmental, social, and governance (ESG), I think that has been front and center in recent times. Is it fair to say that private equity has been slower to embrace ESG? Is this a function of linking ESG to returns delivered on investments?
I would say ESG is top of our private equity clients’ minds at the moment. They’ve made heavy investments in building out their capabilities here. They’ve hired very senior people, for example, to lead the effort and build a framework that integrates ESG into all levels of the private equity complex, whether that’s the general partner, the fund, or the portfolio companies. And that’s really important because when you consider all the portfolio companies that the private equity funds control, they can be a massive lever for positive social change. And I’m a huge believer that actually private equity is going to affect a huge amount of the ESG change that we globally are trying to achieve. And they’re in the middle, I would say, of shifting the way, they look at ESG from a purely risk management consideration for private equity to a real actual value driver. And I would say that’s the biggest shift that we’ve seen. We see private equity firms acquiring best-in-class companies from an ESG perspective, but we also see them acquiring companies that are less sophisticated here but starting them on their journey. And while private equity firms are engaged here because it’s the right thing to do, they also expect to see an ROI (returns on investments) on those investments.
Luke, there’s a growing body of evidence that companies that have their ESG house in order perform better than those that don’t. And of course, private equity is very attuned to this. These companies are rewarded by the higher market with increased topline growth, and they tend to be better managed overall. We recently undertook a survey of PE investors as part of our global divestment study, and it showed that more than 70% of private equity investors reported that they expected to capture an ESG premium in the businesses they were exiting.
Looking at live examples where we’re working with operating partners who’ve acquired a private equity asset and they’re saying, “We’ve got to refresh this supply chain, we’ve got to look at new ways of manufacturing.” But they’re actually using that as a way to bring ESG in and do it in a more ESG-friendly way. Again, with an eye on that multiple and exit, their belief is that will be rewarded by the market.
And Alex, what are your thoughts in terms of APAC GPs embracing ESG?
I guess, historically, APAC GPs have slightly lagged on ESG adoption relative to markets, like Europe for instance. I think as well to Bridget’s point about the risk management versus value creation driver, I mean, I think the risk management perception of ESG is perhaps still a little bit stronger here. But one thing to note is, obviously, the fundraising environment becomes more challenging for private equity firms and also the end of cheap money, this period where it’s reasonably easy to make returns simply through leverage. That’s obviously coming to an end. So, now there’s much more of a bonus on firms to obviously prove their value creation credentials and also obviously to drive returns. So, I think what we may see is a bit of a categorizing effect here, where firms do realize that if ESG can be used as a value creation tool, that they better start taking it seriously. And those that are able to demonstrate they can use ESG as a value creation driver I think ultimately could end up not only doing better from a return’s perspective, but also in securing LP commitments.
I think it’s also important to consider the fact that climate crisis is becoming much harder to ignore here in Asia. If you take a look at Australia, we had those terrible bushfires a couple of years ago, and flooding in places like Indonesia. So, I think as well with events like this, ESG is going to be forced up the agenda even further. And things like net-zero pledges and so on, perhaps people will start having to think about those a little bit more.
Value creation has many dimensions and topics. Bridget, given the current operating environment, do you see a reprioritization of initiatives from the revenue growth to the cost and cash management?
To be honest, Luke, there definitely has in the short term. I think when we had to deal with this financial crisis over the last few months, there was definitely a doubling down in funds, the initial phase to look into the portfolio. And that’s where we saw a great call on all the services we offer around cash management, cost out, et cetera. However, as companies and funds are now looking into the year ahead in FY23, we’re starting to see that being raised more to a topline focus. So, as you would’ve expected, I think the initial focus was on cost and cash. Again, these funds are very sophisticated around this. I think that those disciplines that have been put in place will continue, but also a real recognition again to get the multiple expansion that you need both. So, I think we’re seeing a little bit of a shift now back to the top line as well.
Thank you, Bridget. With that, I also want to spend a few minutes on exits. The pandemic delayed exits in 2020 and 2021, and the global environment in 2022 created further complexity. Can I get your thoughts on whether the next two years will be better exit years for PE and what GPs need to do to prepare for these?
Thanks, Luke. You’re absolutely right. That’s the other fundamental part of this private equity equation — the exit side. Last year, we saw about 40% decline in exit activity. In 2021, we saw almost 300 private equity-backed IPOs, which was by far a record. Last year, we saw just 20. But the good news is that for a lot of firms, there was not tremendous urgency here. And in fact, when I talked to my clients, a lot of them would rather be buyers than sellers in this type of market. And more importantly, I think if we put it in context, they’ve been so active over the last few years selling portfolio companies that thankfully there’s not a lot of pressure at the moment to offload portfolios in sub-optimal conditions.
And for those really needed liquidity, Luke, the secondary markets are very active and much more mature than in the past. Ten years ago, there was very limited liquidity. It was about a US$5-10 billion market. That was largely characterized by distressed sellers. But today, that market routinely sees more than US$100 billion in transactions and it’s been far more integrated into private equities thinking as a key liquidity tool.
And it’s another great example of the point we merit earlier about how the private equity industry continues to evolve and innovate. But where the downturn in exits we’ve seen really has had an impact is on fundraising. Coming back to what Alex was talking about earlier, last year, private equity fundraising was down about 15% globally, in part because of reduced distributions back to LPs, which make up about 80% in new commitments. That’s the dynamic we expect will continue into at least the first half of this year. The functional impact of this on deployment, at least from an industry level, is going to be to offset to a large degree the amount of dry powder the firms already have.
As you know, there’s more than US$1.2 trillion in dry powder. When you put it in that context, Luke, I don’t think private equity firms are going to be capital-constrained for the foreseeable future. And in fact, one of my colleagues was saying the other day that the opposite is true. There’s huge pressure to deploy this capital at the moment. In fact, he had a great saying, saying it was more physics than economics. There’s so much pressure in the system with this US$1.2 trillion floating around for funds to make investments as soon as they see opportunities out there.
I like the expression – more physics than economics. On that note can I get final thoughts from both of you.
I think in conclusion, this market, although challenging, plays to the innovative and evolving nature of private equity and I think private equity will, on the whole, find opportunities in this market. And a huge amount of that opportunity rests in APAC.
To be honest, what we’re going to see is this being a year of sort of haves and have-nots. So, I think it’ll be really interesting to see in China how this plays out. Obviously, it’s been very difficult to raise funds there and it will continue to be challenging, but I think we’re going to see those who can raise and perhaps some of those who perhaps won’t be in a position to do so after this happening. So, I think there could be a real shakeout of GP talent in Asia more broadly this year. And it’ll be interesting to see where that capital ends up.
Bridget, Alex, thank you for joining us and sharing some great insights. It certainly appears that 2023 is going to be a very interesting and promising year for private capital. However, there is a lot of work to do. Over the next few episodes, we will dive deeper into some of the topics that we discussed today, such as sector investment themes, value creation, sustainability, and exit readiness. Stay tuned and thank you for joining us at Money Multiple.
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