Investment Opportunities in a Period of Financial Uncertainty

Authors: Michele Paolo D’Angelo, Partner, Oliver Wyman; Francesco Morino, Associate, Oliver Wyman.

The European private equity (PE) market—coming on the heels of a stellar, record-setting year in 2021—experienced a near reversal of fortunes in 2022. European private equity firms suffered a sharp decline in the year just ended, with deal volume and aggregate deal value falling 20% and 45%, respectively, compared to the previous year. And despite the number of transactions remaining higher than pre-COVID, the aggregate deal value fell below 2019 by -15%.
European buyouts in 2022 fared even worse, with aggregate deal value in 2022 50% lower than the previous year and even 4% lower than 2020, the of year COVID, the record low since 2013; add-on acquisitions exhibited even more extreme slowing, with aggregate deal value declining by two-thirds vs 2021.
All of this came after a year of frenzied PE activity that saw the number of transactions peak (with more than 3,000 deals in the EU alone) and the highest aggregate deal value ever (roughly US$250 billion).

Cheap money, low inflation

Fueling the momentum in 2021 were low-interest rates and a favorable economic outlook. Indeed, until the end of 2021, major economic inputs such as the cost of money and cost of production inputs displayed little volatility and easy access. The only exception was sea freight transportation costs, which grappling with supply-chain disruption in 2021 climbed four to eight times higher than in 2019.
Market agents’ optimism and favorable economic conditions reflected in an average increase of transaction valuations. Deals with disclosed transaction value and with target companies in Europe had an average EBITDA multiple c. 10% higher than both 2019 and 2020. The retail, manufacturing, and automotive sectors saw the biggest jumps in average deal value.
In that bubbly market, sellers quickly became accustomed to above-trend valuations; similarly, buyers with easy access to financing were swimming in an environment with solid economic indicators.

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Russia – Ukraine conflicts and rising rates

The rise in interest rates in 2022, the first in more than a decade, in tandem with the Russian invasion of Ukraine, sent reverberations among investors and private equity activities. Private equity firms with an investment focus on Europe raised less than two-thirds the capital of what they were able to raise in 2021 and 2020 (-37% vs both years) back to pre-pandemic levels.

The slowdown in fundraising began in the second quarter of 2022, when the European Central Bank (ECB) announced its first interest rate hike and after it was clear that the conflict in Ukraine war would continue for longer than most expected and would directly affect Western Europe and emerging Eastern European countries as well as influencing global political equilibrium. As a result, private equity fundraising fell to the lowest level since 2018.

Concurrent with the absence of new capital, PE unallocated capital (or dry powder) investing in Europe stood at a historical high at year-end 2022—almost four times higher than the capital raised that year (versus an average two-to-three times of the past 10 years).

The mismatch between investor expectations and sellers, with the former discounting global uncertainty and high cost of capital and the latter expecting 2021 valuations, led to falling valuations and the slowdown in transactions.

This misalignment is visible if we look at the enterprise value-to-EBITDA (EV/EBITDA) ratios of the deals done in 2022 compared to prior years (after removing key outliers in those years under consideration). EV/EBITDA fell between 25% to 30% in 2022 vs 2021, with lower valuations across the board, with few exceptions.

An analysis of transactions with a disclosed valuation over the past four years (2019-2022) finds that:

• Digital media, internet, and telecom companies were heavily penalized, selling at EBITDA multiples roughly 60% lower in 2022 than in 2021. Similarly, established industries like food retail and manufacturing (industrial automation and industrial products and services) saw valuations approximately 50% lower than previous years. Targets in the chemical industry suffered a similar trend with average valuations falling by about 70% in 2022 compared to previous years.
• Computer services and software, and financial services companies together with energy and infrastructure companies suffered of a smaller decrease in valuation, with EV/EBITDA falling in the range of -5% to -20% vs the past three years average.

From great turbulence comes opportunity

That said, from out of the turbulence, some segments emerged stronger. Automotive and industrial electronics companies saw valuations double, while real estate, transportation, and fashion retail displayed solid +25%-40% increase in EBITDA multiple valuation followed by biotechnology and pharmaceutical industries that ranged from 15% to 20% improvement.

In this context, we are highlighting near-term opportunities for financial investors.

The telecom industry, in our view, represents fertile ground for private equity investors.  Fully integrated players along the value chain operate in a cash-intensive segment; the National Recovery and Resilience Plan (PNRR) liquidity injection is a temporary palliative that will terminate after 2026 and make these players a juicy opportunity for restructuring investors.

At the same time, we expect infrastructure-focused private equity to shift their attention from the network’s backbone into the so-called “last mile” that is currently operated by telecom companies. Similar to the liberalization of gas market in Italy of the 2010s, the last mile represents an attractive opportunity both for financial and industrial investors with scope economies (such as utilities, carrier companies, and media companies), and will result in a decoupling of the telecom company and the underlying infrastructure.

A different trend with respect to traditional media is seen in content creation companies. Here, the market is new and fragmented. Moreover, given the specific competencies required – TV calls for different expertise versus cartoons, movies, or blockbusters – financial investors have a role to play in market rationalization and exit strategy for incumbent media players.

The  evolution of the Energy industry can be served from multiple angles by financial investors. The rising industry around the energy transition is composed of business-to-business (B2B) and business-to-consumer (B2C) firms (such as energy efficiency companies, appliance installation and repair outfits) that tend to be local small-medium enterprises (SMEs) with fast growth following the 2022 energy crisis. Private equity firms can act as partners to sustain the evolution of this segment of the industry and play a role in the consolidation of this highly fragmented market, building a stronger, more organized national presence that would be attractive for traditional utility players.

Construction of electric batteries represent another business of the future in Europe driven by the need of energy storage and as a response to the growth of the electric vehicles (EV) market. EVs impose the need for widespread charging infrastructure, with traditional utility companies seeking collaboration with infrastructure financial players to accelerate the rollout, and the proliferation of small-medium enterprises along EV construction (and collateral goods) value chain. This could result in a non-organic and fragmented environment where financial investors can employ a buy-and-build strategy.

A changing geopolitical landscape has impacted the defence industry, which is seeing demand surge as NATO members (especially in the EU) meet the 2% GDP defence spending target. EU countries have raised their defence equipment spending by more than 40% over the next decade, with a specific focus on electronics. The defence industry value chain is fragmented and made up of companies with specific competencies, with players with strong engineering capabilities showing the highest potential due to the demand expected for the next decade.

Finally, since the Covid pandemic, logistics has grown in prominence, proving its resilience despite the slowdown of international trade. Logistic and port infrastructure are being targeted both by industrial players seeking to vertically integrate and by infrastructure private equity firms that recognize the opportunity to structure a market that is currently unintegrated. Opportunities come both from ordinary and special situation transformation strategies that make the segment appealing for a broad range of investor.

Despite last year’s slowdown and a weak start to 2023, we see opportunities in the European and Italian markets for private equity investors whose foci range from growth to restructuring across multiple industries. A deep dive into each of those industries is likely to uncover a trove of targets suited to each investor profile.

 Source: Oliver Wyman

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