Market & PE Trends

The rapid rise in interest rates has reshaped PE market dynamics, making debt financing costlier and scarcer. This compels PE funds to seek lower purchase prices for similar returns. As sellers are naturally reluctant to accept these lower offers, transactional activity has fallen during H2 2022 and Q1 2023, and this “standoff” is likely to continue until participants adapt to the new rate environment, possibly by year-end.

KKR’s Response

Despite the above, KKR’s portfolio is performing well overall. Consumers have accepted price increases, and gross margins are holding. Overall revenue growth is continuing, in the low double digits. The firm has made efforts to adapt to the new environment by judiciously hedging its exposure (and that of its portfolio companies) to rising rates. In line with the market, new deal flow has slowed as the gap between buyer and seller price expectations persists.

Public vs Private Valuations

KKR's valuation approach combines both relative (multiples-based) and fundamental (DCF-based) methods. Higher interest rates mean a higher discount rate - hence valuations have declined from a purely DCF perspective. However, privately held firms can be expected to display a more muted cycle with respect to valuations than publicly traded ones. While KKR remains interested in “public-to-private” deals, obstacles to performing due diligence (e.g., access to individuals) may slow progress.

The Ascent of Private Debt

As traditional lenders become more cautious, KKR deploys higher equity (up to 100%), later refinanced with private market debt. The private debt market, although small in relative terms, is gaining traction, and is now equivalent to the syndicated loan market in size. The current banking crisis may mark the point at which private debt matures into a true “solution” rather than a fall-back option, solidifying its place in the private equity landscape.

The Role of Carve-outs

Carve-outs - whereby a company divests a non-core business - have been a theme for KKR since 1999. In Europe currently, there is a continuous stream of these potential carve-outs from big corporates. Prominent KKR carve-out deals include Flora, Wella, and the upcoming FGS purchase from WPP.

Sector focus

KKR maintains a focus on three sectors underpinned by long-term demand drivers: Environmental, Social, and Governance (ESG); Healthcare; and Digitization and Software. These are supported by long-term drivers (government policy, demographics, and global megatrends). However, in the prevailing economic environment, KKR has recalibrated its approach from growth to value, and is less inclined to pay high multiples.

Consumer Sector Trends

The European consumer appears resilient, reflected in KKR’s consumer brands' strong performance (Flora, Wella). Recent announcements by luxury goods companies appear to indicate that the higher-end consumer segment is also in good health.

Exit Strategies

The IPO markets have been closed for several months, and secondary sales have also declined. This has naturally led to a slowdown in monetization and exits. However, this is not untypical for this stage in the cycle. While KKR would not hesitate to purchase businesses where they observe the potential for revenue growth and margin increase, “multiple expansion” is no longer a prominent factor in assessing the attractiveness of potential targets.

Selling to Corporates

Corporations are currently in a robust financial position, with many holding substantial cash reserves, and several seeking growth through M&A. While it's still early days, this trend is expected to develop. The “hype” around continuation funds, which began in early 2022, may have cooled somewhat, but holding onto high-quality, long-term assets for extended periods remains a viable approach.

A Good Time to Invest

The post-Covid period of rapid growth and portfolio turnover was unusual for PE, and we are now transitioning back to normal. While some PE funds may be reluctant to invest due to psychological factors such as the numerator effect, it is important to note that currently, leverage, pricing, and assumptions are all decreasing, creating a favorable opportunity for perceptive PE funds to acquire businesses at attractive valuations. In other words, 2023-2024 have the potential to be very good vintage years.

Changes in Asset Allocation

The stock market recovery should be treated with caution. Other attractive opportunities exist, in particular private debt (referenced above). With interest rates on the rise, incorporating fixed income into a portfolio in some form is now necessary, and attractive yields are possible without the associated risk prevalent in previous market conditions.

Pressure on Banks

Europe's banking system is currently very stable. This is largely due to effective regulation, which means banks are better prepared than in the 2007 Credit Crunch. European banks also have limited exposure to real estate, unlike U.S. regional banks. Although there may be challenges ahead, the recent bank failures should be considered as unusual events, rather than indicative of a larger trend.

Guidance to Young Graduates

The current PE landscape may appear daunting due to shifting market dynamics and challenges. However, the field of PE remains unique, presenting opportunities to invest in diverse businesses. Investment decisions in Private Equity are not merely transactional. Often, to succeed, it's crucial to have a genuine interest in business and base investment decisions on that curiosity.

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