Trends and Developments

In 2023, the private equity industry has confronted a complex landscape marked by macroeconomic uncertainties and geopolitical challenges. While the crises involving Silicon Valley Bank, First Republic Bank, and Signature Bank were relatively short-lived, they added to an already challenging liquidity environment. Fundraising remains fiercely competitive, and the debate over Environmental, Social, and Governance (ESG) issues in the United States has intensified, resulting in a patchwork of state-level legislation. Additionally, the U.S. Securities and Exchange Commission (SEC) continues to scrutinize private fund practices. In this environment, both sponsors and investors are exercising caution.

However, amidst these challenges, deals are still being completed. Lenders are adjusting their balance sheets, and creative financing solutions, like direct lending and co-investments, are filling the gaps left by a decrease in syndicated debt financings. Prominent funds are offering incentives and flexible terms to attract capital, while new managers are raising funds deal by deal. Despite the uncertainties, some bright spots have started to emerge.

Fundraising

The private equity fundraising landscape in 2023 is characterized by persistent inflation, pressure on public equities, and disruptions in sectors like banking and technology due to bank failures and government interventions. These conditions have made fundraising highly competitive, with sponsors across various sectors and regions vying for investor allocations. Investors, on the other hand, are grappling with the “denominator effect” and limited liquidity in their portfolios.

Established sponsors with a track record of delivering strong returns are still able to secure a significant share of investor allocations, especially for flagship funds that are less frequently available. However, flagship funds are taking longer to raise and require flexibility in marketing and terms. Emerging managers face tougher fundraising conditions, and many are resorting to raising capital deal by deal.

Sponsors are adapting by offering economic incentives such as loyalty discounts and early closing discounts that extend beyond the fund’s initial closing. They are also exploring custom solutions for anchor investors, including raising smaller “bridge” or “annex” funds. Additionally, investors are seeking staged commitments to improve cash planning and gain better insight into a fund’s early performance.

In the backdrop of a slowdown in the private market, sponsors are also dealing with increased regulatory requirements. The SEC’s new Marketing Rule has introduced complexity and cost for sponsors, requiring adaptation to this new paradigm. ESG rules, both at the international, U.S., and state levels, are evolving without uniformity, posing challenges for sponsors and investors in evaluating their impact and implementation on the private fund industry.

The private market continues to grapple with the repercussions of the banking crisis, with liquidity and capital access remaining tight, particularly in the venture, growth, and tech sectors. These sectors are now struggling to replace the capital sources provided by regional banks. The slow fundraising pace is expected to persist in the second half of 2023, making strong performance and creativity essential for attracting capital. Building and maintaining relationships between sponsors and investors is expected to be crucial in this environment.

Fund Finance

The first half of 2023 has been an intriguing period for the fund finance market. The near-collapse of Silicon Valley Bank, Signature Bank, and First Republic Bank, major lenders in the fund finance space, prompted fund borrowers to navigate covenant restrictions and seek alternative credit sources. Despite this, there is still strong demand for liquidity among funds.

Traditional bank lenders, however, are facing challenges due to macroeconomic events, including interest rate hikes and regulatory changes. They have become more selective in extending credit, favoring syndication efforts and adjusting their balance sheets through swaps and guarantees.

Subscription facilities remain popular, and back-leverage loans and NAV facilities are on the rise as buyout funds seek financing for acquisitions and portfolio management. Insurance companies and similar investors continue to be a source of capital, with rated feeder structures and collateralized fund obligations evolving.

Sponsors are also looking to innovate in the fund finance market to meet their liquidity needs, potentially leading to further developments in this space.

Funds Regulatory

The SEC’s Regulatory Agenda for Spring 2023 and its rule-making activity underscore its rapid pace of rule-making. The agenda includes various proposed and newly adopted rules that impact private funds.

Newly Adopted Rules

In August 2023, the SEC introduced the Private Fund Adviser Rules, which bring significant changes to the private funds industry by regulating contractual terms and imposing conduct and disclosure requirements on advisers.

Newly Proposed Rules

The SEC is considering rules related to predictive data analytics, registration for internet advisers, ESG disclosure requirements, cybersecurity, and safeguarding rules. These rules aim to enhance transparency and accountability in the private fund industry.

Rules with Expected Adoption Dates

Rules related to outsourcing by investment advisers, regulation of best execution, and updates to the accredited investor definition are in the pipeline. These rules may have a substantial impact on the industry and require attention from market participants.

Private Funds Transactions

While the markets have stabilized compared to the volatility of 2022, high interest rates, infrequent distributions, and challenging fundraising conditions continue to affect the secondaries market.

Single-asset GP-led transactions have been slow due to pricing disparities between secondary investors and sponsors. However, there is optimism that growing liquidity needs among investors will eventually drive an increase in GP-led secondaries volume.

Buyers in GP-led transactions are negotiating for discounts to net asset value (NAV) and lower management fees, leading to a buyer’s market. Non-traditional buyers are entering the space, emphasizing asset-level diligence and representation-and-warranty insurance.

LP portfolio sales have surged as investors seek liquidity, particularly in portfolios with diverse holdings. Sponsors are asking buyers of LP interests to make stapled commitments to their newer funds.

Co-investment remains attractive, adapting to economic conditions and evolving deal-making technology. Sponsors are increasingly turning to co-investors for follow-on capital, and private credit has thrived, with sponsors and investors building lending platforms.

M&A

The private equity M&A landscape in 2023 has yet to witness a significant rebound. Economic uncertainties and regulatory scrutiny have deterred some transformative acquisitions, as sponsors face challenges in securing financing amid prolonged approval processes.

Despite these hurdles, deals are still happening, especially in sectors like healthcare and infrastructure. Direct lenders and co-investments are playing a crucial role in financing acquisitions with acceptable terms, albeit at lower leverage ratios.

Fund-to-fund and continuation fund deals have remained popular, but caution prevails in the current environment. However, as older fund assets come to market, there may be an uptick in deal volume, potentially driven by more agreeable pricing.

SEC Enforcement

In 2023, the SEC continues to focus on enforcement actions against entities advising and auditing private funds. Notable actions have included cases related to cross-trades, valuation practices, and management-fee calculations.

The SEC brought actions against firms for improper trading, inadequate audit practices, and fee calculation discrepancies. These actions emphasize the SEC’s scrutiny of gatekeepers in the private fund industry.

Expectations are that the SEC will continue robust enforcement against private fund advisers, particularly in cases involving conflicts of interest or issues with fee calculations.

In summary, the private equity landscape in 2023 is marked by challenges and opportunities. Fundraising remains competitive, regulatory changes are on the horizon, and market dynamics are evolving. Navigating these complexities will require adaptability, creativity, and a keen focus on compliance and performance.

To secure exceptional talent for your private equity firm or portfolio company please reach out to Raw Selection’s Managing Partner Alex Rawlings at Alex.Rawlings@Raw-Selection.com to discuss your requirements and how we can help you identify the best talent.