The first quarter of 2023 marked the fifth in an unprecedented string of quarterly pullbacks in private equity investment. According to Bloomberg data, no other drop in the aggregate volume of PE-backed deals has ever run longer than three quarters.
In Q1 2023, M&A deals slowed to $559 billion across approximately 12,200 deals, amounting to the third-lowest M&A deal volume in a single quarter this decade. $181.8 billion of that amount, covering some 4,200 deals, involved at least one PE firm. That marks a 17% decrease in the volume of private equity deals from $218.7 billion in Q4 2022, and a 59% pullback from the $439 billion invested in Q1 2022.
Drilling down further, about 2,900 of the first-quarter PE investments were venture capital (VC) deals, worth $80.1 billion. Q1’s VC deal volume actually increased 6% from $75.3 billion in Q4 2022, but declined 53% from Q1 2022. Despite the increase in volume, VC deal count in Q1 2023 was down 7% from Q4 2022 and down 40% from Q1 2023.
Pullback Spells Trouble for Portfolio Companies
Economic turmoil hits hard for investors of private companies because it hinders their ability to accurately create financial models for their inherently illiquid, long-term equity investments. Interest rate fluctuations continue to negatively impact private equity investors on a global scale, as the amount of capital invested across most regions and industries shrinks. Investment managers and advisers have been forced to be deliberate with investment strategies, informed by recent developments in M&A markets and regulatory landscapes.
Portfolio companies aren’t holding up too well while investors struggle to get their arms around these market trends. For evidence of that, look no further than the number of companies that initiated bankruptcy proceedings in the new year.
2023 is expected to see the bankruptcy of 78 PE-backed companies, the most since 2020. Though that number appears small, the effects of these events can have cascading consequences as businesses scramble to implement new strategies to account for lost business relationships and financing opportunities. Creative debt solutions mitigate some issues, as buyout firms are utilizing options such as net-asset-value (NAV) lending to provide both liquidity to portfolio companies and distributions for investors.
Regulations Increasingly Consequential for PE Firms
Private equity is coming into the spotlight for regulators, as annual investment activity in the asset class more than doubled from $489.6 billion in 2012 to $1.3 trillion in 2022, according to Bloomberg data. The effects that new PE investors have on industries they enter isn’t entirely known, due to the private nature of their operations. Regulatory bodies are moving quickly to understand how new rules would affect stakeholders in industries sensitive to private equity investments.
In February, the Biden Administration announced plans to crack down on private equity investors in the nursing home sector whose practices harm patient welfare. The Centers for Medicare & Medicaid Services proposed a rule to require additional disclosures of ownership and management information to regulators, while the Department of Health & Human Services and other federal agencies examine the role of investment ownership in this context. President Biden continued the long-running fight to eliminate two major tax breaks related to carried interest fee structures and 1031 exchanges. Although the elimination of these rules would upend many investment strategies, neither appears likely to be cut in the near term.
Additionally, the Securities and Exchange Commission continued efforts to finalize new rules that would affect investment management disclosures. At the start of the year, the SEC released its Fall 2022 Unified Agenda of Regulatory and Deregulatory Actions (Reg Flex Agenda), with 52 rules, many of which are relevant to private fund managers. The SEC is also working this year on rules that would increase mandatory disclosures relating to custody of client assets, cybersecurity, foreign investments, and ESG disclosures.
SVB Collapse Complicates Investment Decisions
Q1 2023 saw the first bank failure in years with Silicon Valley Bank, which rocked global markets with its rapid deterioration. The timing is bad for smaller venture and private equity firms, because the event removes key sources of financing just as credit becomes harder to obtain.
The bank played a significant role in the investment community, gaining darling status among internet and media companies. But SVB was already in a precarious situation, given the shocking lack of FDIC insurance for its deposits. S&P reported that the vast majority of domestic deposits at Silicon Valley Bank and Signature Bank exceeded FDIC insurance limits, with 93.8% and 89.3% of their deposits, respectively, exceeding FDIC limits—a notable deviation from typical proportions in the industry.
As a result of banking turmoil, existing lenders are now extending smaller credit lines and moving toward one-year maturities, down from the previous three-year standard, in a move that lowers banks’ costs.
Many of the trends evident in the first quarter of the year are setbacks for the growing investment management industry. But as the effects of recent developments come into focus and investors become more adept at predicting what’s around the corner, there’s still good reason to expect growth in the long term.
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