The last couple of years have been somewhat turbulent for PE funds. 2020 threw a huge pandemic-shaped spanner in the works of deal volumes and then, as one might expect, once the shackles of lockdown and uncertainty dissipated, we saw an explosion in deal activity. Not all of it as considered as we’ve seen in days gone by. Pendulums swing furiously after all…

So, where are we now? Well, post-pandemic things looked encouraging. However, it turns out disruption is now the norm. War in Ukraine, fresh on the back of the greatest disruption since WWII, has put the economy into a tailspin. Economic uncertainty returned and the M&A market, once again, looks like it will soften significantly.

When it comes to disruption, it turns out that infection is one thing; inflation, however, is something else altogether.

Rising costs are forcing PE firms to re-examine their portfolio companies. Inflation, ongoing supply chain disruption, increased customer cost-consciousness, security of supply and stockpiling are weighing heavily on Operating Partners’ minds. We now see this impacting deal flows in much the same way as the early days of the pandemic, which stifled deal activity as PE funds looked to shore up their portfolio companies and firm up cashflow and forecasts.

In a somewhat ironic turn of events, given how we saw hugely inflated prices and some due diligence gaps in the post-pandemic deal frenzy in 2021, we’re now seeing a drop in the quality of assets available, incredibly challenging financing, and a notable mismatch between sell-side and buy-side valuations, which is likely to be exacerbated by a drop in IPO valuations that will clearly impact exit options. With growing expectation of an economic down cycle, we can expect to see a sizeable slowdown in deals for the remainder of this year and, with everyone fundraising – in a far less agreeable market – focus will be further distracted from deal-making.

Amid a gathering economic storm, ESG should not be overlooked 

The multi-layering of disruptive forces seems to know no bounds at this time, and ESG has emerged as an additional factor that will play an increasingly influential role in deal-making and how PE approach the market.

Much has been written and discussed about the impact of ESG on Private Equity firms. Initially there was some scepticism that it would ever be truly embraced by funds. Encouragingly the reverse has largely been the case, and ESG has become an important part of the PE sector, promising to become even more so.

However, are we seeing its focus start to shift? For a long time it has felt that the overwhelming focus for ESG was on the ‘E’ – understandable given the impact of climate change and high profile comments from notable figures such as Larry Fink. More recently the ‘S’ has become more prominent as challenging discussions around representation, diversity and other social factors have hit the Boardroom.

Now, with the increasing use of sanctions in response to the war in Ukraine and rising regulatory scrutiny and intervention in business around the broader ESG agenda, we’re seeing a sharper focus applied to the ‘G’.

These three intertwined components will present profound challenges for Private Equity to strike an authentic, carefully considered, and sustainable balance amongst their portfolio companies – and in their own purpose and values set as an economic downturn approaches. Defensive strategies to protect margin and cash flow will, of course, prove critical in effectively weathering the storm, but care should be taken not to leave these longer-term transformative levers out to rust in the rain.