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Since the pandemic ended, we have seen private equity (PE) investment activity buffeted by strong tail and headwinds, which have played out in different measures as time passed. In the last 12 months however, the headwinds have been particularly strong which has seen 2023 deal count drop from one quarter to the next – with 2023 Q1-Q3 down 14% from the same period in 2022.

But as those headwinds start diminishing and with some assistive tailwinds, greater certainty is being provided to an asset class primed for activity. As a result, as we head into 2024, PE deal count in the UK will not continue that decline, but rather stabilise in H1 and start rising towards the end of the year, continuing upwards in 2025.

The tailwinds – momentum is picking up

A number of macro-economic factors will turn in favour of deal activity and start releasing pent up demand for investment activity. These will either improve confidence or eliminate the transaction impediments that we experienced in 2023.

Reducing inflation and levelled interest rates

Interest rates have finally peaked, and falling inflation is bringing more certainty to financial projections. This in turn is providing the market with some of the much-needed confidence to press ahead with transactions and deploy the substantial pool of PE dry powder that is still close to an all-time high.

Dry powder still significant

The figure of dry powder available is still sitting close to $1tn globally. Much of that is aimed at the very large end of the market in the US, but a substantial and historically high sum of $70-80bn is based in Europe and aimed at the middle market.

Pent up deal flow

PE exits are down 17% in 2023 Q1-Q3 compared to the same period in 2022, and 18% for 2021. In turn this is shifting the portfolio base along the investment lifecycle, with more companies in the ‘maturity and exit’ stage (owned by the PE house for 3+ years) than ever before.

In fact, there are 1,900 UK-based PE-backed companies sitting in this cohort, where their backers will be looking for an exit in the next four years. Considering that 25% of UK-based exits since 2019 have been to other PE houses, that’s a meaningful source of future deal flow where willing sellers will align more easily with eager buyers.

Valuation expectation gap is narrowing

The PE market has, until recently, been experiencing a valuation gap between buyers and sellers. This has been due to uncertainty around the direction of key market variables, such as inflation and its impact on input costs and output prices and revenue. This has stifled deal flow. The gap was pronounced at the beginning of 2023, but our transaction advisory teams have seen this narrowing, which bodes well for activity going into 2024.

In the meantime, PE firms are using different deal structures, such as earnouts and seller notes, to bridge the difference and close transactions. In the case of Aurelius Capital’s November 2023 acquisition of The Body Shop, £90m of the £207m purchase price was contingent on the business hitting certain undisclosed milestones.

Opportunity for a great vintage

There’s a cohort of investors specialising in helping businesses weather economic storms and get onto stronger footing. With significant strategic, tactical and financial support, these PE investors take the chance to ‘buy low and sell high’ when markets improve. The acquisition of The Body Shop by Aurelius is, again, a case in point.

The business had languished under its corporate owner Natura and The Body Shop was being buffeted by affordability challenges among its target markets. Aurelius was therefore able to buy the company for £207m when Natura had paid £880m. It will take significant effort from Aurelius to improve the business – but that’s what it takes now to make a return in an environment of high cost of capital. PE firms are recognising this and are increasingly building operating partner teams, hiring experienced industry executives and partnering with strong advisers to do so and make a great vintage.

The headwinds – still present but waning in strength

Various factors will counter the deal-stimulating effects of the tailwinds, with the result being a somewhat restrained number of transactions in the next two years.

Inflation and ‘high’ interest rates endure

On the flip side of the inflation and interest rates coin is that although the worst seems to be over, they are still much higher than recent experience. Labour shortages and related upwards pressure on wages is keeping inflation above the Bank of England’s (BoE) 2% target. Similarly, the BoE has made it clear that it will be cautious about dropping interest rates too soon to avoid stoking inflation back up again. We therefore expect these rates to only start falling from August onwards and will probably finish 2024 at 4.5% from the current 5.25%.  

Weak economic growth

UK economy will likely continue to stagnate in 2024, with GDP growth looking set to be just 0.5%. This will discourage some sellers and buyers who’d rather wait until the picture is rosier. Looking further ahead, GDP growth is expected to be 1.2% from 2024 to 2025 – so not much rosier. But the average annual growth rate between 2009 (after the Great Financial Crisis) and 2019 (pre pandemic) was only marginally higher at 1.4% and deal activity relatively robust on a historical basis to that point, so a stagnant economy alone won’t hold back deal flow. In fact, the prospects of medium-term future improvement will add to confidence levels.

Some confidence in the middle market

An encouraging signal of positivity can be found in 91̽»¨’s Middle Market Business Index (MMBI), which tracks the overall confidence of UK middle market businesses. The latest index score sits at 141.5. This is somewhat of a drop from the 146 recorded in Q3 but is still significantly higher than the 100 baseline theoretically marking whether the real economy is contracting or growing. With that said, that positivity could be relief, having weathered the inflationary and interest storm.

IPO markets dormant

IPO markets are effectively shut, with less than six UK-based exits in 2023. The FTSE 250, and the US equivalent for middle market companies, the Russell 2000, were both flat year-on-year until the end of November where there was a slight uplift. However, there’s volatility in that surge, so it’s uncertain whether that exit path is likely to open and trigger transaction flow on the front end. The upside of this for the buy-side of PE is that alternative exit routes will be chosen by those exiting shareholders who may turn to other PE firms more than they would otherwise.

Looking at this another way, the poor performance of the stock markets coupled with high cost of debt is spurring on large corporates to carve out some of their business units, eg under-pressure Johnson Matthey PLC’s carve out of its diagnostics business Tracerco to Sullivan Street Partners in 2023. Lowered public market prices are also creating a source of deal flow in the form of take-privates and will continue to do so in 2024. Inflexion’s acquisition of Instem PLC (IT and tech services) and Francisco Partners’ acquisition of Blancco Technology Group PLC (mobile device diagnostics software) are recent examples.

The average daily Price:Earnings ratio of the FTSE 250 index for the month of Nov ’23 was 20% down from a year previously. Lower relative valuations like that indicate that we can expect further take privates to be struck unless the stock markets see meaningful uplift.

General election’s negligible impact

Even if a new capital gains tax is introduced in 2024 if a Labour government wins the next election, deal count is unlikely to be bolstered significantly as it was in early 2021, when a new tax was expected. This is because a lot of those owner-managed businesses that would have been impacted by it already underwent a transaction then.

A view of the US

In comparison, the US economy’s inflation rate has been tempered more quickly than the UK’s and now sits at a lower level, albeit not at the targeted 2% yet (the US unemployment rate is only 3.7%, which continues to put upwards pressure on wage rates and related services inflation). Capital markets have priced in an interest rate drop in the first half of 2024, and the economy is expected to grow quicker than the UK, at 1.5% per annum on average during 2024 and 2025 vs 0.8% in the UK. Until then, the stubborn inflation and elevated interest rates will keep transactions count growth in that market at a moderate, albeit quicker, rate than in the UK.

This will be welcome news for UK-based companies with commercial interests in the US and looking to raise capital there. A recent example of this is the acquisition by Kentucky-based MiddleGround Capital of UK-based specialist automotive transmissions manufacturer Xtrac. Remarkably, this was MiddleGround’s first European platform acquisition, but what helps explain that is the US motor sport industry which is a key customer base.

With that said, there’s still a significant number of buyouts of UK-based companies by UK-based PE investors, with 2023’s deal count lower only than the record years of 2021 and 2022. So, UK companies can continue to feel optimistic about accessing local capital.

Overall, the PE industry has been through turbulent and weathering times, but it’s riding this out. 2024 and 2025 will be far from 2021 and 2022, but transaction levels will improve, and PE will continue to be a key capital source.