After an exceptional 2021 for private markets, 2022 was a year of two halves for the industry. The first half was robust. The second was relatively slower because of lower availability of debt, rising cost of debt, and dislocation in asset prices. Also, many LPs faced overallocation challenges in their institutional portfolios, resulting in the denominator effect. These factors led to a year-over-year decrease in deal volume and fundraising. On the other hand, dry-powder inventory1“Dry-powder inventory” is the amount of capital available to GPs expressed as a multiple of annual deployment. spiked. And within asset classes, private equity and real estate had more challenging times in 2022 on various counts than private debt, infrastructure, and natural-resources strategies did.
In this debut episode of Deal Volume, McKinsey’s podcast on private markets, host Brian Vickery, a partner in McKinsey’s Private Equity & Principal Investors Practice, discusses emerging industry trends and highlights from the 2023 edition of the firm’s Global Private Markets Review2“McKinsey Global Private Markets Review: Private markets turn down the volume,” McKinsey, March 21, 2023. with senior partners Alejandro Beltrán de Miguel, Gary Pinshaw, and David Quigley. An edited transcript of the conversation follows.
Regions, sectors, and strategies in focus
Brian Vickery: I’d love to get reflections on what you are seeing in your day-to-day interactions with your clients that might be different than what we’ve published in the McKinsey Global Private Markets Review 2023: Private markets turn down the volume report.
Alejandro Beltrán de Miguel: I will highlight four things. First, even though there are still positive mood and outlook on what the future could be for alternative investing, my sense is that things are taking longer than expected. Some funds told us that the debt market will open up in the first quarter of 2023, there will be more deals, and the multiples will go down, but you actually see that this is taking a little bit longer than expected. Again, the mid- to long-term views are still positive, but there is a little uncertainty within the industry about how long it would take.
Second, it is hard to talk about the overall view of the industry right now. There are many different realities. Consolidation is really happening. There is a big difference across the best performers and the worst performers. We are serving a few midsize funds that are trying to raise money with probably not the best track record; fundraising is becoming very hard for them. Meanwhile, it is not that difficult for the top performers that have bigger—and probably fewer—funds.
Third, we are seeing completely different realities across geographies and asset classes. Europe is less developed, for instance, in venture capital and growth. However, if you look at the Asian and North American markets, they are growing, and there is more money coming into these asset classes. There is also a lot of appetite for infrastructure investing and private credit, as banks are reducing their exposure to the debt balance into the corporate sector. In terms of liquidity solutions, I agree there is more demand for secondaries, with a bigger pipeline and deal flow.
Fourth, firms are also focusing more on portfolio work and these types of assets.
Brian Vickery: Could you talk a little bit more about your final point about the importance of portfolio value creation? What are companies doing in the current environment?
Alejandro Beltrán de Miguel: In an analysis done a few years ago, we found that the key return differentiator was what firms do with the asset during the holding period.3Unpublished McKinsey research. More and more, we see more focus on portfolio work and how funds can improve performance during the holding period. Many funds that traditionally did not have strong operating-partner groups are now setting them up. There is much more active management by GPs of their portfolio companies. And we also see them focus on a bunch of completely different things, like data and analytics, sustainability, costs, and resilience.
Brian Vickery: Gary, what reflections would you like to share on how Asian private markets have fared?
Gary Pinshaw: Asia is now the second-biggest private-market region in the world at $2.5 trillion, surpassing $2.3 trillion in Europe. If we look within Asia, venture capital and growth are actually the largest in the world, even larger than in North America. Against the broader backdrop of a slowdown in the number of deals, fundraising, etcetera, on the ground here, we are seeing a lot of excitement and activity around infrastructure; environmental, social, and governance [ESG] topics; and energy transition. As the report demonstrates, ESG-agenda-directed funds now have surpassed $100 billion of assets under management globally.
Asia is now the second-biggest private-market region in the world at $2.5 trillion, surpassing $2.3 trillion in Europe.Gary Pinshaw
We are seeing a lot of investments happening, shifting from brown to green. This includes moving from traditional fossil-fuel businesses to more environmentally friendly ones, including things like refineries retransformed into, for example, ethanol plants. We are also seeing green business building. So investors are taking the lead and helping incubate, grow, and expand new businesses that are environmentally friendly at the core. We are also seeing enabling technologies—and this could be from emissions and technology, investing in assets like that, and also from trading platforms.
Additionally, given the supply chain challenges both in Asia and across the world, as well as within energy transition, we are seeing efforts across various critical components of the supply chain and decarbonization. In a nutshell, Asia is a number of countries—some in the developing stage, some more developed. But we are seeing these pockets of real and significant investment right now, and I do believe this is here to stay for at least the next decade or two.
North America weathers macroeconomic challenges
Brian Vickery: Looking at the data in Asia, it’s just a different private market landscape than what we see here in North America. Asia seems to be a lot more oriented toward growth, venture, and building for the future versus harvesting and fixing what exists today. David, what are your thoughts on the current private market landscape in North America?
David Quigley: Up to the point that the banking issues emerged, it felt quite like a new dawn. In late January, North America private markets started to see the beginning of new processes. And I saw that grow throughout February, with quite a lot of focus across aerospace and defense, healthcare, life sciences, consumer goods, and certain parts of financial services—particularly payments, where we’ve seen quite a lot of interest. As you noted, the market had been down in terms of both processes and the number of participants in each process. We started to see both of those pick back up.
At this moment, I think we’re all trying to get our head around what the banking issues will mean, particularly for ongoing interest rates and the availability of debt. I certainly agree with the point that we’re going to see more private-credit opportunities in North America.
Separately, it’s been a tough fundraising year. In some ways, when we look at the numbers, it feels like it’s been tougher than the numbers would show. And I think part of that is just the tonality shift between LPs and GPs. Therefore, for GPs, this has felt like a tough round, even if data shows us that larger funds based in North America have seen relatively good success.
Brian Vickery: One of the questions I get asked most often is the influence of what’s going on in banking in the private-market sector. The other thing I’m asked is when deal volume will resume and how robust it is. In my view, we are starting to see “green shoots” in the area: more client inquiries are happening, and managers are doing more work on assets.
David Quigley: What I’ve not seen is processes that were under way getting halted as a result of what’s happened with banking. I’ve had my eye pretty closely on that. So actually, processes are continuing to move forward. And I think people are weighing what is occurring carefully.
What I’ve not seen is processes that were under way getting halted as a result of what’s happened with banking. So processes are continuing to move forward.David Quigley
Finding opportunities in Asia
Brian Vickery: Gary, when we look at the data over several years, private-market fundraising across Asia has fallen for several years in a row now—and particularly in China. How should global investors think about the opportunities to put money to work in Asia? And what’s the story that those global fundraising numbers may be missing?
Gary Pinshaw: Yes, Brian, you’re spot on. Fundraising for private markets in Asia has been in decline since 2017, when it peaked at close to $288 billion. It was down to just over $100 billion in 2022.
I think that must be looked at relative to the amount of dry powder. So there was a massive buildup in the amount of dry powder, or committed capital, that was ready to be deployed. Since then, especially in China, the slowdown in fundraising is actually due to the dry-powder volume. If you take China out of the equation, fundraising growth has been flat to positive in many other parts of Asia.
There are three key reasons for the decline in China. First is this focus on deploying the stockpile of capital. Second, 2018 saw China regulators limiting nonfinancial entities from borrowing capital to invest in private equity. The third reason is around the unfortunate ramifications of the COVID-19 pandemic, not only on human lives and livelihoods, but also on the inability to do road shows for fundraising.
So yes, fundraising is down. I would say that opportunities are there, and with valuations becoming more in line with what has been said in five- to ten-year trends, we’ve basically seen a decrease here in Asia from 14 or 15 entry multiples to 11 or 12. With the moderation in entry multiples, we do think there’s going to be substantially more deals, at least, than in 2022 going forward.
You made the point earlier about how larger funds are disproportionately winning on fundraising; I think we have seen it in Asia. I remember how years ago, we’d say a megafund was above $1 billion; now it is plus $10 billion.
Advancing an ESG agenda in Europe
Brian Vickery: 2022 was another strong year for ESG topics and private markets. We are seeing as much money as we’ve ever seen going into dedicated strategies for—and more money from traditional vehicles being oriented toward—ESG-agenda-type or ESG-agenda-friendly investments. In my view, the genesis of this momentum comes from Europe. Alejandro, how are practitioners that you interact with thinking about ESG topics and private markets? What might the rest of the world learn from the Europe’s experience thus far?
Alejandro Beltrán de Miguel: Sustainability-related deals in Europe increased by 7 percent to a record of nearly $200 billion last year. Venture capital deals made up 40 percent of this volume. While the push for ESG-related action is not new, it has accelerated, given the macroeconomic context, geopolitical conflict, and higher energy prices. This means that industries need alternative energy sources and much more energy independence, and this will come with a lot of investment.
Sustainability-related deals in Europe increased by 7 percent to a record of nearly $200 billion last year.Alejandro Beltrán de Miguel
Regulations are also helping. There is the Inflation Reduction Act in the US, and Europe is pouring money into enabling the green transition of many industries. This will accelerate fundraising and deal volume. In Europe, most of the GPs are already incorporating ESG topics into their corporate policies, operating procedures, and investment decisions. LPs are taking this seriously when it comes to capital allocation processes.
What is even more interesting is the link between ESG topics and financial performance. People tend to believe there is no link between the two, but there is indeed clear correlation. We are increasingly seeing that while many funds may not be purely ESG-item focused, there is more emphasis on value creation and asset planning. Clearly, ESG items are becoming drivers of performance.
This will only grow going forward. More and more, we are seeing big companies trying to get into a different ecosystem and ensure green transitions of their businesses. They need capital, be it equity or credit. This is also creating big opportunities in the industry to really support clients’ transitions throughout this time.
What to watch out for in 2023
Brian Vickery: David, what are you spending the most time talking to clients about today, other than the banking sector issues? How will these issues affect private equity in 2023?
David Quigley: If we look back at this industry, the metric that I like to review is the dollars raised each year rather than assets under management. Looking back over the course of the last decade, it tripled. I see that continuing. You can see that in buyout, and you’ll see it in growth equity. Venture capital may take a moment, but I think you’ll see it across these asset classes.
More near term, I do think we are on a path to returning to a more normal transaction market. Certainly, buyouts are up from the floor. I see a lot more global activity in carve-outs and take-private activities. A carve-out is a more complex transaction type, so I think we might see more focus on completing those carve-outs and getting them stood up.
I think everyone is expecting some adjustment on asset prices, particularly to accommodate what would appear to be a longer and higher interest rate environment. But there’s a real sense that the deal-making volume has to return, in a way. This industry functions very much on the turnover of assets. To that extent, we may see some longer holds out of this period. I think we’re seeing that offset by managers placing more focus on alpha generation in the portfolio. I don’t know yet that we can call the number on overall returns. Finally, the market that is likely to take the longest to come back, but when it comes back will come back fast, is software-based investing.