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More deal activity, but work is still to be done

As we enter the second half of 2024, the corporate transactions landscape is showing promising signs of revival supported by a growing confidence among sellers and buyers. Improvements in, and more certainty around, key economic influences eg falling inflation, the definitive election outcome, the drop in interest rates and the prospect of improved GDP growth in 2025 is helping provide much more confidence in the financial projections of companies. While we may not revisit the frenetic pace of the period immediately post the pandemic where ultra-low interest rates, exuberance, and historically high economic growth buoyed activity, 2024 Q4 and 2025 are poised for a marked improvement from the first half of the year. Private equity investors however, must increasingly focus on their portfolio companies to maximise the returns on exit.

Pressure to exit and improve returns

The private equity (PE) ecosystem, in particular, is welcoming this improvement in sentiment. With a significant portion of the UK PE portfolio exceeding the typical holding period (43% of the UK portfolio has been held for longer than 5 years), there is mounting pressure from limited partners for PE managers to deliver exits. 'DPI is the new IRR' is an increasingly heard adage. DPI, or distributions-to-paid-in, is an indication of how much capital has been returned to the investors in PE funds versus what they have invested in those funds, with this expression signalling the pressures being placed on PE firms to make more exits. 

However, exits remain a challenge. Market volatility continues to discourage IPOs, and some firms are delaying exits to present a better ‘last 12 months’ financial performance picture as these companies emerge from a period of stress. 

To add to the pressure, IRR is still extremely important, with the standard industry target being 25%. Considering that this formula is a function of both time and difference between purchase and sales price, if the timing is extended then the pressure to drive up the value difference simply increases. 

Maximise value at exit and increase ability to execute deals

To navigate these challenges, PE firms need to increasingly turn to operational and strategic expertise to support their portfolio companies. By deploying operating partners employed by the PE firm, interim managers, or external help, they can grow their portfolio companies' revenue and margins, lay out a growth story, optimally prepare companies for exits eg simplify the corporate structure to avoid unnecessary deal complexity, and reduce their risk profile to avoid any ‘shocks’ to timing and/or value. This hands-on approach is crucial for achieving the desired returns in a landscape where valuation multiples have come off from their peak seen in 2020 and 2021.

Add-on acquisitions will remain a key strategy, with activity levels remaining higher than those seen before the pandemic. Despite higher capital costs, consolidation opportunities are still available, particularly in business services like facilities management and IT services. However, PE firms are now tasked with ensuring that the strategic and operational benefits of these acquisitions are fully realised, moving beyond multiples arbitrage to enhance the value of their combined entities.

Fund raising in European mid cap funds is under pressure until exits improve

The fundraising environment presents its own set of pressures, especially for smaller buyout and venture capital funds whose technology centric portfolios have been particularly hard hit with pressured valuations and the weak IPO markets which has slowed their exits significantly. Within the middle market (funds valued between $500m-$2.5bn) Europe has seen an encouraging slight uplift from 2023 while North America continues its decline albeit these are now at 2019’s quarterly levels. Until successful exits are achieved, fund raising pressures will continue.

The private equity market is due a material uptick in deal flow looking beyond H1 2024. And once those deals are done, the private equity managers that lean into supporting those remaining portfolio companies will be the best placed to make the desired returns and continue to raise capital – the market conditions are just not supportive of investors that remain passive.