Private firms to face difficult 2023, though PE opportunity is present

While private companies generally performed well last year, the listed firm's top economic forecaster Nicholas Brooks says conditions will be choppier.

Private companies are expected to face a rocky 2023 as the full effects of last year’s upheaval take root. However, private equity – with its continuing high levels of dry powder – could land on some opportunities.

Privately owned firms performed well in the first half of 2022, with evidence indicating performance held up well through most of the second half as well, according to ICG’s US and Europe Private Company Trends report.

Despite ongoing geopolitical uncertainty following Russia’s invasion of Ukraine, earnings of the private companies tracked by ICG’s private company database rose by 15 percent in Europe and 12 percent in the US.

Nicholas Brooks, ICG’s head of economic and investment research, gave three reasons why financial metrics remained robust last year.

There was a lot of pent-up demand, he said, particularly for services that experienced shutdowns during the pandemic. This is an area that private companies tend to be quite exposed to. “I think that was a surprise, in some ways. Those tailwinds were even stronger and lasted longer than anyone expected,” Brooks told Private Equity International.

When interest rates rose, they came from a very low base. While there was a lot of discussion in the market about the potential impact of interest rates on the outlook, the real impact on economies and countries last year “was really quite small”.

Looking forward to 2023, Brooks expects demand growth to slow as a number of economies enter, at least, shallow recessions. Additionally, while ICG expects that inflation will fall – and probably quite sharply – in the second half, costs still remain high.

“It’s possible we’ll see a bit more of a margin squeeze in 2023 relative to 2022, so slower demand and potentially some pressure on margins, which… may weigh at an aggregate level on EBITDA,” Brooks added.

Not everything is equal

What will be critical to consider over the coming months, according to Brooks, is differentiation at the country level and the “huge dispersion” at the sector level.

“Certain sectors are more vulnerable in this environment,” Brooks said, listing off heavy industry and energy-intensive businesses like chemicals, food and packaging as examples.

On the other hand, in a similar vein to what was seen during the pandemic, higher value-added and non-cyclical businesses such as healthcare, education and some segments of technology – for example, less capital-intensive technology sectors – will “likely come out okay”. Private company exposure tracked by ICG’s private company database falls into the latter category.

At the country level, Brooks warns against taking an aggregate value of Europe, for example, amid the uncertainty being felt by investors.

“Every country is different,” he said. Some countries have very limited exposure to natural gas, and some have very little heavy industry and are more orientated towards higher value-added, less cyclical services businesses. There are also different mechanisms in terms of energy pricing within countries. “All of that, I think, means that there will also be a lot of differentiation in performance at a country level.”

Private equity’s opportunity

Given the bifurcation of private company performance in the current environment, Brooks anticipates those less cyclical, value-added companies will continue to command a premium valuation. Investors will be willing to pay up for firms that fulfil those criteria.

However, there could be opportunities in distressed parts of the market. Although we are “still in early days” this year, and there are some sectors that may need a stronger correction in pricing, recent corrections could throw up some interesting opportunities for funds that have the appetite, he said. “I think it’s going to vary quite widely.”

In its report, ICG said private equity and debt are well positioned to bridge this funding gap, as market volatility remains high and banks continue to retrench.

“There’s a lot of dry powder, there are a lot of interesting companies, and I think there’s going to be a lot of potential value-added deals being done,” Brooks explained. “As investors start to feel more confident about the medium-term outlook later this year, I think you’ll start to see money being put back on the table again.”