How to respond to current market uncertainty?

After almost a decade of continuous growth, private equity (PE) dealmaking is set to slow down in 2022 compared to last year’s record‑breaking numbers.

The decline in M&A activity reflects the radically changed macroeconomic environment that dealmakers are operating in following the pandemic, characterized by record inflation, persistent supply chain disruptions, geopolitical instability and tightening financial conditions. Economic are signaling an impeding recession, with significant impacts on portfolio companies’ growth and profitability in the coming quarters and years.

Moreover, the era of cheap financing that fueled PE dealmaking over the past decade is winding down with interest rates hikes and banks showing less appetite to fund leveraged buyouts or refinance existing debt. The higher cost of borrowing and uncertain economic outlook have made some PE more prudent when bidding for new assets. For example, increasingly we are see a widening valuation gap between buyers and sellers, with many deals stalling as a result. In this M&A environment, PE firms will become more reliant on value creation activities – rather than leveraging and/or buy-and-build strategies – to drive up profits and generate above-market returns for their investors.

Critically, a deeper value creation playbook will have to tap into levers that address the new market reality, including higher raw material costs, wage pressures and soaring energy prices, as well as the scarcity of talent across the business.

The good news is that PE firms and portfolio companies are not starting from scratch. During the first Covid shock in 2020, they were quick to stress-test and prepare their investments for the upcoming economic slowdown. At that time, many management teams cut down on discretionary expenses or set up working capital and cash-saving programs for better cost efficiency. This has also enabled them to increase the break-even elasticity of their businesses for when demand swung back after the peak of the pandemic. Faced with a similar scenario of turbulence and disruption today, PE firms should start preparing their portfolio companies with the same urgency they showed in 2020.

PE should adopt a structured approach to assess the impact of an economic downturn on portfolio companies, alongside understanding the measures available to PE and management teams to immediately act upon the changing conditions. Key steps should include:

Understanding the impact of a potential downturn:

A review of existing business plans to assess their robustness against different inflation and recession scenarios. This should include looking at specific performance drivers and sensitivities to understand the risk factors that companies are exposed to.  We recommend a three step process to include 1) review of existing business plan/financial model, 2) identification of performance drivers & sensitivities and 3) scenario analysis.

Developing response measures:

As part of the action plan, tangible countermeasures are developed and made available for each scenario. Trigger events will also be clearly defined to allow rapid implementation of the mitigation measures. Recommended actions span various areas and levels of complexity: from price increases and to right-sizing of the cost base and reduction of supply chain complexity, to name a few

Conclusion PE should acknowledge that the world is once again changing quickly, with risks emerging on several fronts. To weather the upcoming turbulence and to take full advantage of the recovery to come, they should take initiative to get ahead of the wave. A thorough diagnostic and response planning exercise will help portfolio companies to not only navigate the storm safely but also to adjust value creation plans to exploit the altered market opportunity. This will allow them to preserve the valuation of their investments and deliver above-market returns to their investors – even during challenging times.