Irrespective of one’s view on whether the FX and Gilts markets’ reaction to the UK mini-budget announced on September 23 2022 was proportionate to the threat posed to the UK’s fiscal position and Sterling, the crisis of confidence and volatility triggered by the mini-budget has served to focus attention on the UK’s particular set of economic frailties. The focus of this piece is the possible short-term implications for fundraising and capital deployment by UK managers, of current market perception of the UK and the UK’s worsening short-term macroeconomic outlook.
Prior to the events of this September, 2022 there had already been a slow-down in global fundraising and capital deployment and the UK was no exception to this trend, which we expect to continue in the short term.
UK Fundraising Environment
Private equity funds are susceptible to the so-called “denominator” effect, when there is a significant public markets correction. A steep decline in public markets’ values has the effect of increasing large institutional investors’ relative allocation to private equity (private equity funds tend to value their privately held companies on a quarterly basis leading to a time lag before private valuations start to align with their public comparators). This effect in turn puts pressure on institutional investors to reduce their exposure to private equity funds through various methods (e.g. selling fund participations in the secondary market (although this is not a quick process in the world of closed-ended funds) or reducing the number and/or size of their new commitments to funds).
Given the volatility of Sterling and UK inflation expectations (and therefore the relative unattractiveness of Sterling returns to international investors) and market doubts regarding the UK government’s management of the economy, we expect UK managers with UK focussed funds to be especially affected by this denominator effect. We therefore anticipate a rise in private equity fund secondary transactions and other liquidity solutions as investors seek to rebalance their portfolios. Fundraising efforts by UK managers are also likely to be hampered by the slowdown in exits, reducing liquidity to fund new commitments and momentum for successor fund fundraises. With regard to open-ended funds, there have been reports of funds imposing redemption gates (i.e. using discretion under fund documentation to suspend/ delay satisfying redemption requests), which is likely to reduce capital inflows to such funds. For those managers pursuing listed fund strategies, stock market conditions have presented significant challenges to both IPOs and secondary fundraisings. In an already slow IPO market so far this year, the position has become even more difficult with a number of recent closed-ended fund IPOs, which would have been likely to have got away in more stable market conditions being postponed or pulled at the last minute.
These factors and the negative macroeconomic picture is also likely to encourage a flight to quality, as the macroeconomic environment increases the risk profile associated with investing with younger less experienced managers, who may lack a proven track-record investing through economic cycles.
Clearly, a weak Sterling and low equity market values (the FTSE 250 is down approximately 26% this year) presents a buying opportunity especially for USD denominated funds and we will therefore watch for opportunistic acquisitions by US private equity funds, amongst others. In particular, we would expect to see: (i) the current trend of public to private deals in the UK to continue, as private equity funds are tempted by low public market values; (ii) corporates with deteriorating cash flow positions seeking to divest non-core businesses to raise cash, which should result in bolt-on opportunities for private equity backed portfolio companies; and (iii) increased interest from international real estate investors in UK opportunities. On the other hand, the rising cost of capital and therefore availability of leverage is likely to have a dampening effect on such activity, whilst also encouraging greater equity levels in the deals that do get done. This should encourage greater participation by institutional investors in co-investments alongside funds, as managers tap their limited partners, sovereign wealth funds and funds of funds/ secondary funds for equity cheques. In the venture investment space, the cost of capital is likely to push venture capital funds’ focus towards businesses that are less reliant on external financing.
We can probably expect to see a disproportionate share of M&A activity within the financial sector itself, as: (i) financial businesses with strong balance sheets have a history of outperforming in rising interest rates contexts; (ii) the inflationary environment and rising energy prices are likely to make consumer and energy heavy industrial businesses relatively unattractive as acquisitions for private equity funds; (iii) the share prices of UK asset managers have fared particularly poorly in 2022, increasing their attractiveness as potential targets; and (iv) recent poor investment performance by asset managers and investor outflows is likely to put pressure on fee revenue and therefore costs/ budgets etc, which may encourage certain managers to seek a buyer or merger opportunity. Taken together, these factors can be expected to encourage further consolidation in this market.
Our expectation is therefore that macroeconomic and fundraising environments will continue to be challenging for UK managers in the short term, but that the current market dislocation will create opportunities, for, in particular: (i) those international private equity and real estate investors with USD denominated dry powder; (ii) M&A activity within the financial sector; and (iii) those institutional investors able to analyse and take advantage of secondaries and co-investment opportunities offered to them.