• Multiple expansion in private equity not expected to drive returns as much in past
  • Earnings growth expected to be a key driver of private equity returns in 2023
  • Buy-and-build strategies may be key to unlocking stronger revenue growth

We’ve heard various share and fixed income markets forecasts for 2023, but what is going to be the principal driver for private equity (PE) markets this year?

Morgan Stanley Investment Management said earnings growth will form the engine room of private equity returns in 2023 with manager selection a vital component.

Choosing experts in profitability-enhancing operational improvements and strategies that capture synergies are forecast to be best placed to generate alpha.

In a positive tailwind for the sector it is well placed for growth and cashed up with dry powder  at record levels of $3.6 trillion to sustain high transaction volumes.

 

Less emphasis on multiples more on buy-and-build

Morgan Stanley Investment Management Alternatives Specialist Patrick Reid said higher borrowing costs and less buoyant IPO and strategic buyer demand are hindering PE multiples.

In simple terms, a P/E ratio conveys how much investors are paying per share for every dollar of profit a company makes. If a company is trading at 10x PE, you’re paying 10x its yearly profits.

The higher the P/E ratio, the more you’re paying for the stock and vice versa. There’s a whole post about how Price Earnings Ratio works here if you want to know more.

“Monetary tightening, fiscal retrenchment and supply-side disruptions are shrinking global demand,” Reid said.

“The economic slowdown, coupled with higher inflation and rising interest rates, has pushed global equity markets into bear market territory.

“Rising interest rates may trigger reduced leverage and lower multiple expansion, limiting the contribution to performance from these key return levers.”

He said capturing value at entry in transactions is going to be important in an environment of rising interest rates because multiple expansion is not expected to drive returns as much as it has over the past 20 years.

“Buy-and-build strategies are key to unlocking stronger revenue growth and maximizing operational efficiencies, as they help to grow scale and capture synergies,” Reid said.

This investment approach is repeatable and often enables add-on acquisitions at below headline valuation multiples.

 

Dry powder remains at record levels of $3.6 trillion

Reid said fundraising may slow, but dry powder remains at record levels of $3.6 trillion, which should sustain high transaction volumes.

For the uninitiated, dry power is the cash reserves corporations and private equity funds have available to use when an attractive investment opportunity comes along.

“Amid continued competition for quality assets, deal origination at attractive value-at-entry levels is not a given, and GPs must remain selective and disciplined to create value,” Reid said.

He said earnings become increasingly important as a source of value creation due to multiple compression and rising debt costs.

He said said Morgan Stanley will continue to build on “PE’s exceptionally robust performance” over the past decade.

“We focus on profitability-enhancing operational improvements and strategies that capture synergies best placed to generate alpha.”

“General partners (GPs) must implement best-in-class operations and capture synergies and scale through strategies such as buy-and-build.”

Investors continue to increase their allocations to alternatives to meet their long-term investment objectives.

“Partnering with founders in the midmarket — particularly those seeking support from financial investors for the first time — and reducing operational vulnerabilities may make businesses less sensitive to economic headwinds,” Reid said.