Perspectives on a slower era in private markets

| Podcast

If 2022 was a tale of two halves for private markets, with robust fundraising and deal activity in the first six months followed by a slowdown in the second half, then 2023 might be considered a tale of one whole. Performance in most private asset classes remained below historical averages for a second consecutive year, with rising financing costs and an uncertain growth outlook taking a toll on private markets. Fundraising continued to decline from its 2021 peak as the denominator effect persisted—in part because of a less active deal market. And decade-long tailwinds from low and falling interest rates and consistently expanding multiples seem to be things of the past.

Enter a new era of investing, in which revenue growth and margin expansion are more important than ever.

In this episode of Deal Volume, host Brian Vickery, a partner in McKinsey’s Private Equity & Principal Investors Practice, sits down with senior partners Fredrik Dahlqvist and David Quigley to discuss emerging industry trends and highlights from the 2024 edition of the firm’s Global Private Markets Review. An edited version of their conversation follows.

Ongoing resourcefulness and resilience

Brian Vickery: Reflecting on the conversations you’re having with clients, what are some trends from 2023 and 2024 in terms of private market investing?

Fredrik Dahlqvist: One of the most fascinating trends of the past year was the resourcefulness and resilience of the industry. Let’s not forget that we didn’t see many minority exits to manage the accounts payable, nor did we see secondaries, solutions, or continuation vehicles prior to this market. We’ve also seen a huge comeback in active management in the portfolio companies the industry currently owns. I’ve been fascinated by companies’ ability to react to and manage the changes in the market, as well as profit from them.

This environment led to a wider opportunity set but also one that wasn’t necessarily available to everyone. That led to uneven market growth and development throughout the year.

David Quigley: I’d highlight three additional trends. One is, whatever way you look at it, the deal cycle is speeding up and exits are heating up.1

Second, we’re seeing a much closer relationship between the corporate world and our private capital world in terms of both carve-outs and partnerships.

And third is the importance of real value creation driven by top-line growth, cost optimization, and management of the balance sheet. We’re in a different world when it comes to cost of capital. That means we’re going to need to pull hard on all levers on the P&L and balance sheet to make this work.

The next cycle of value creation

Brian Vickery: You both are serving clients in this industry every day. What are you seeing that might not show up in the numbers?

David Quigley: One thing you don’t see in the numbers is that funds are investing a lot more in deep relationships, whether it be with external advisers or executives. This will be really important to the next cycle of value creation. It’s not clear in the numbers yet, but many are growing into the valuations that were there.

Fredrik Dahlqvist: Something else we were glad to see is more thoughtfulness and productivity in the transactions that were made during the year. We expected to see more public companies go private, and we did. And there are more of these—and even more complex transactions—to come.

I’m quite impressed with the industry’s thoughtfulness around manufacturing exposure to where it wants to sit in the deal market. This could be through platforms on the infrastructure side, perhaps more on the core plus side, or thoughtfully partnering with capital solutions with corporate partners. Or, again, supporting businesses to realize their full value. That’s a product of thoughtful, value-driven investing, which has always been the hallmark of the industry.

Brian Vickery: One thing I’ve been following with my clients is the evolution of how they allocate their time. The year 2021 was all about dealmaking: most of our clients were spending almost all of their time doing a transaction on the buy side or selling some of their companies.

Over the past 12 months, their focus has shifted. They’re spending more time with portfolio companies, thinking about the thematic way they want to put money to work over time and being more thoughtful about investment opportunities.

Tech investing and the implementation of generative AI

Brian Vickery: We can’t have this conversation without talking about generative AI [gen AI]. The year 2023 was marked by enormous hype about gen AI. Our clients were calling to ask how they should be thinking about it, what the key use cases are, how they could triage, and where they should invest in new technologies to make themselves and their portfolio companies better. I think in 2024 we’re going to hear a lot less about it, but people will actually use the technology to create value. So we’ll go from hype to implementation. I’d love to hear if you both agree with this.

David Quigley: I agree with that very much. I think we could see some reengineering of the cost base for portfolio companies of private capital–held institutions. Sometimes they may shift their procured services; we’ve heard many times from asset owners that they may wait and see if they can actually procure the services. Other times, there may be an opportunity, particularly in business or B2C services, to take true cost out and get service levels up at the same time. I think the answer is going to depend a lot on the nature of the business and the nature of what’s actually done in it.

Fredrik Dahlqvist: It’s fascinating to see how gen AI is being deployed in the portfolios. There are some obvious winners, such as software development, customer service, and support functions, where automation saves costs and can even fill gaps where the right talent isn’t available. I think the industry is still trying to figure out how to deploy these technologies in their deal processes, but things are moving quickly. And it’s clear that we will see this reflected in our own product development on the transaction side. The players that, with market participants, amass data and control its quality and apply it to their processes on both sides will give the portfolio an advantage.

Brian Vickery: Two years ago, we would’ve said that technology was the fastest-growing part of the private capital—or at least the private equity—ecosystem. We saw that boom in venture capital. Same for growth equity: tech-heavy strategies and tech-oriented buyout funds were getting bigger faster, with really strong performance to back them.

That environment has changed a lot in the past 18 months. Technology valuations have come down, and raising money in technology-oriented strategies, particularly in venture capital, has gotten very challenging. I think that’s the state of the market as we see it today. What are you seeing out there in tech, and how are you talking to your clients about it?

David Quigley: First of all, the underlying adoption of tech in B2B and in consumer—that isn’t really changing. So at some level, I think we’ve got more of an investment cycle issue than we do an underlying issue in terms of adoption or innovation of technology. We see it in most service models. You don’t have a conversation about a service model asset without discussing the underlying technology base. It’s true in most of these asset classes. Even thinking about core widget manufacturing, we always look for the customer interface layer. How is that powered? So, at some level, I think it’s been a difficult couple of years to be in tech investing. But that doesn’t mean the next 20 years will be difficult.

Fredrik Dahlqvist: I think, particularly for Europe, there’s this notion that productivity increases can underpin GDP growth, and this is an important force.2 We’ve been talking about an aging population for a long while, but we haven’t systematically been investing against this. In this environment, technology that supports automation and increases workforce productivity is going to be a megatrend. To David’s point, I think the only way Europe, for example, will be able to continue to sustain this growth is through tech hubs and productivity-enhancing technologies—including, of course, solutions driven by gen AI. And the technology sector can play a part in spearheading solutions.

What to watch for in 2024

Brian Vickery: What should our private-market clients be thinking about in 2024?

David Quigley: There’s a lot more optimism in March 2024 than there was in March 2023. Value creation is going to be rooted in true performance, not multiple expansion. That’s a real shift. And interest rates may moderate somewhat, but they’ll likely still be higher on average than they were in the past decade. That means we’ve got to drive value creation and growth and manage the balance sheet. We’ll need to lock in plans for creating value before closing transactions.

The investing part of this market is driven by returns, and early intervention drives higher returns. So I think this year we’ll see earlier interventions in the investment cycle in an effort to create more value.

Fredrik Dahlqvist: We have to talk about the deal market. Judging from the sell side, banker books, and, of course, the enthusiasm around being able to acquire into this cycle at lower multiples, we’re pretty optimistic that deal markets will come back. I think it will be a gradual move, but we’re already seeing green shoots from our side. While we don’t have a perfect view of everything that’s going on in the market, I think we’re going to see a much more active market. Our clients are doing dividend recapitalizations, and we’re seeing the credit market become much more supportive. In the back half of this year, we may see the same development on the deal markets.

Brian Vickery: What’s one thing you’re most excited about for the year ahead?

Fredrik Dahlqvist: During 2023, many fund operators put a lot of time, effort, and hard work into driving fundamental performance in the portfolio companies. I’m really excited to see the earnings momentum build during 2024, and, to David’s prior point, to see folks being able to either defend or extend their valuations and even multiples on that basis. And, hopefully, we’ll also see our clients transacting in a more welcoming capital market.

David Quigley: It’s not hard to be excited about seeing the denominator effect in the rearview mirror. And I’ll borrow a line from one of my favorite brands: “It is a time to go deeper.” Deeper on everything—into value creation and into the commitment to grow these businesses.

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