As we hit the 2023 halfway point, our experts have some observations and key trends to share as we prepare for H2.
Growth markets and sectors
In terms of growth markets, the US has traditionally used more financial engineering for growth over some others; however, its friendly trade arrangements should still see more growth opportunities.
Japan is another market where deal-making is on the rise (after many years of slower activity) and Japanese private equity will continue to attract international and domestic investment. Drivers of this increase in deal activity include corporate governance reforms from 2014 onwards that are now gradually taking effect, the devaluation of the yen in the past year, and greater recognition among Japanese boards with private equity now being acknowledged as a potential buyer.
Paced by the UAE, the private fund sector in the Middle East is experiencing rapid growth, along with some profound challenges—chief among them, regulatory demands and increasing operational complexity. Opportunities lie within emerging technologies, the rise of the importance of ESG and a surge in family wealth.
With regards to growth sectors, real estate is still popular but its growth is likely to be contained more within specific sub-verticals, such as residential, commercial and industrial, as the industry is still continuing to re-adjust and recover post-COVID.
Despite market uncertainty, deal flow is holding up and resulting in fundraising appetite for secondary strategies. As private equity deal financing is feeling the impact of banking system disruption, the secondaries market is set to take on new importance in the volatile investment climate.
Private credit and debt markets poised for continued growth
Due to a decline in bank credit and liquidity (similar to that in 2008), there is more opportunity for a continued increase in the private debt market. With a reduction in bank appetite, lower risk correlation and a higher need for liquidity, the debt markets continue to thrive and capitalize on market conditions. While fundraising has been challenging, it has proven to be resilient, and with other sources of financing—from the banks, for example—the industry will look to alternative lenders as a stable option when it comes to financing. The concept of private lending via funds appeals to investors and borrowers by offering a more flexible alternative to bank lending as well as representing a source of steady, stable returns at attractive, risk-adjusted rates, even during volatile times. Read our "Navigating Private Credit: Look Before You Launch" whitepaper to discover more.
While fundraising is relatively stable and resilient for private debt, the fundraising climate is challenging for the other private markets— weighing particularly heavily on newer managers. LPs appear to be slowing the pace and are being choosier, and firms will need to be strategic and adaptable in their fundraising efforts in the remainder of the year.
Geo-political tensions in China are looking to continue into the near future, changing the dynamic of private market activity in this region. Investment funds are generally reducing cross-border allocations due to sensitivity and concerns around geopolitical tensions. According to Bain & Co’s Asia-Pacific Private Equity Report 2023, Greater China “suffered the biggest contraction in deal activity. Covid lockdowns, declining growth, and Sino-US tensions contributed to a 53% drop in Greater China deal value from a year earlier”. With weakening returns to capital investment in China, productivity is at an all-time low in the region and growth will be dependent on being able to boost these declining productivity levels.
The rise in interest rates is proving challenging to the private equity market as valuations have generally stayed the same. Higher interest rates continue to result in a decline in deals, exits, and fundraising and play into how European private markets have traditionally grown Alpha. There will now, more than ever, be a greater focus on efficiency and growth engineering.
There are also headwinds ahead in the mid-market sector, with businesses feeling the impact of the higher operational costs and delaying capital investments as a result. The biggest priority for these companies is to manage cash flow and liquidity risk management.
Technology as a market continues to address the problem of lower staff numbers and, while multiples have come under scrutiny in the short term, growth is ahead. More and more, businesses are looking to intelligent automation (IA) to streamline and optimize business processes and decision-making. By adopting IA, businesses can make smarter decisions to better tackle operational challenges and boost efficiency.
Software and technology companies as proving to perform better under private equity investment over public markets as they fuel growth, innovation and drive returns for private equity investors.
Demand for ESG-focused private market investments is higher than ever and, according to Dow Jones, ESG investments are set to double globally by 2025 and will make up 15% of all portfolios. Regulations are increasingly complex and fast-moving with UK and EU leading the way in strong regulatory frameworks, and now the US, UAE and Asia are starting to catch up and adopt stronger regulatory standards. As investor demand is driving more transparency, the governance part of ESG is a real focus. When it comes to mitigating the risk of greenwashing, firms—now more than ever—need to show commitment to good governance to ensure they are ready to respond and adapt to future change, emerging regulations and to protect their reputation.
Schroders have also highlighted that the global response to climate change will accelerate materially in the next seven years with countries likely to rapidly step up the decarbonization of power generation. Private markets are now seeking out investment opportunities that will play a meaningful part in the fight against climate change.
The private markets are experiencing turbulent times but, despite market volatility, deal activity and investment, is still very much on the agenda for the rest of 2023. GPs must be able to adapt their strategy and find a way to navigate the challenging fundraising climate to continue growing and taking advantage of new opportunities that will arise. To remain ahead of the game and on top of operational complexities, outsourcing continues to be of importance as third-party providers are making investments into offering more innovative products and services as well as cutting-edge technology.
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Jonathan Sherman (Managing Director), Jamie Villiers (Senior Director), Sara Gilbert (Director) and Kader Maiga (Director) also contributed to this article.
Written by Ian Kelly
Managing Director, Head of International Private Markets