With policy uncertainty and market volatility set to endure, we identify three key themes for entrepreneurs to consider as they seek private market capital in 2023.

1. Scarcer capital availability will likely persist—but entrepreneurs should beware of diluting their net worth

2. Founders facing distress should engage early with trusted advisors—and stronger entrepreneurs may find attractive opportunities

3. Sustainability looks set to become even more important in private markets—so entrepreneurs should develop their environmental and social credentials

Executives & Entrepreneurs

Authors:Matthew Carter, Strategist, UBS AG London Branch; Karim Cherif, Head Alternative Investments, UBS Switzerland AG; Antonia Sariyska, CIO Sustainable Investing Analyst, UBS Switzerland AG

 

This report has been prepared by UBS AG London Branch and UBS Switzerland AG. Please see important disclaimers and disclosures at the end of the document.

Sustainability

Entrepreneurs that looked to tap private capital experienced a complete about-turn in conditions as 2022 progressed.

At start of the year, competition for investment in the most dynamic private companies was exceptionally high. In the first quarter of 2022, US venture capital (VC) firms deployed USD 80bn across 4,770 deals, according to Pitchbook as of 3Q22.

Managers sitting on around USD 0.5tr of dry powder— based on Pitchbook data—were eager to deploy capital quickly—within hours in some instances so as not to miss deals. For entrepreneurs seeking external investment or even a business exit, 2022 started as a “seller’s market” where founders could cherry-pick whose money they wanted to take.

But drought followed the deluge.Mounting concerns over economic growth, geopolitics, and financial stability led to a more challenging VC funding environment. Indeed, steep declines in public tech.

valuations and a frozen initial public offering (IPO) market have led to a slowdown in VC funding activity. At the current pace, VC exit deal value could reach a six-year low, below the USD 100bn mark.

With policy uncertainty and market volatility set to persist, there is room for concern as some businesses continuously need financing to keep up their growth. We identify three key themes for entrepreneurs to consider as they seek private market capital—whether investment or even an exit —in 2023.

1. Scarcer capital availability will likely persist—but entrepreneurs should beware of diluting their net worth

Given that major central banks will remain determined to bring inflation down by tightening global liquidity conditions, we expect that entrepreneurs will continue to face challenging financing conditions in 2023—especially compared to 2020 and 2021, when markets had access to pandemic-related stimulus.

Entrepreneurs would therefore do well to scrutinize—with trusted advisors such as corporate finance and wealth planning specialists—their commercial and personal capital needs. If they need to raise funds, how much is truly necessary? And what is it needed for? In early 2022, several companies secured 1–2 years of funding with clear milestones, and are in a position to potentially avoid seeking follow-on investments and dilute current shareholders when capital market conditions are least favorable.

We believe it is important for entrepreneurs and their management teams to remember the long-term consequences, and potential costs for exit valuations and personal wealth, of defending near-term valuations.

While 2022 saw several high-profile downrounds for privately held businesses, entrepreneurs and their venture capital backers were generally not willing to accept lower valuations. By and large, new funding rounds over the course of 2022 were at the same valuations compared to previous rounds or included enhanced sweeteners to entice further VC funding. Examples of such incentives include greater use of fully participating preferred equity (a capital structure that provides VC firms with a higher share of eventual exit proceeds beyond the repayment of their initial investment), enhanced dividends, or the offer of warrants.

However, we would note that entrepreneurs using such sweeteners to hold today’s valuations steady risk giving more of any eventual exit proceeds to their backers. Without a solid financial plan for life after a business exit, today’s decisions may risk an entrepreneur’s long-term financial objectives.

All in all, we suggest that entrepreneurs work early with trusted advisors to understand the long-term implications of capital raising and its terms. We also see value in weaving these conversations into a succession planning process that covers the business, personal wealth, and objectives to support others.

For more details on how to talk and plan for succession, please see Entrepreneurs and their succession part 1: It’s time to talk and Entrepreneurs and their succession part 2 : What’s the plan?.

2. Founders facing distress should engage early with trusted advisors —and stronger entrepreneurs may find attractive opportunities

The combination of high energy prices, supply chain disruptions, and tighter financing conditions will likely mean a rise in entrepreneurs facing financial distress in 2023. Companies already reported greater survival challenges in 2022.

In the second quarter, the number of UK company insolvencies hit the highest level since the third quarter of 2009, up 46% on the average quarterly figure for the prior four years, according to the Office for National Statistics.

Entrepreneurs currently or prospectively facing financial difficulty will likely find their bargaining power to be limited in the prevailing environment of economic slowdown and policy uncertainty. While there may be opportunities to work alongside private managers that specialize in distressed situations and restructuring, terms may be less entrepreneur-friendly and reduce the potential financial returns available.

It is therefore important that entrepreneurs work closely with advisors across their commercial and personal interests to address potential funding or liquidity crises early.

In such cases, it often makes sense to work with specialist advisors with subject matter expertise in crisis resilience and restructuring as opposed to, for example, working with the usual attorney or accountant.

Entrepreneurs may be so preoccupied with securing their firm’s future that they overlook their own personal asset protection. For more on how to secure one’s own asset protection and to build financial resilience ahead of time, please see Should business owners boost their asset protection? and Three ways to build financial resilience in an uncertain world.

Conversely, entrepreneurs with strong balance sheets and an eye for opportunity may see more scope to acquire good companies with weak debt-servicing fundamentals in their sector. While some entrepreneurs would prefer to use their subject matter expertise and excess capital to make direct investments, 2023 may also be a year of investment opportunities for credit and distressed managers that have the expertise to navigate such situations.

Historically, distressed debt managers have earned higher returns during periods of higher corporate default rates. Middle-market private loan default rates currently remain low, at close to 1%, but we expect them to pick up into the mid-single-digits over the next 12 months.

3. Sustainability looks set to become even more important in the private market space, so entrepreneurs should develop their environmental and social credentials

Founders looking to attract private equity investment should understand the growing consensus around the importance of climate action and decarbonization, as well key social issues such as equity, diversity, and equality. Although some private managers tackle environmental and social issues to generate commercial and societal returns—i.e., impact investors—many are increasingly focused on integrating such considerations into their investment decisions. This is because ESG effects increasingly pose risks to portfolio companies’ operations and supply chains, or offer further opportunities for growth and revenue generation.

We therefore believe that entrepreneurs might intensify their efforts to gather data showing their company’s environmental and social credentials, and the commercial/ sustainability consequences of their activities.

The most immediate priority—based on experience with private fund managers—is for entrepreneurs to measure their firm’s carbon footprint and its derivatives, both in absolute and relative terms as a point of competitive (dis)advantage. In addition, metrics such as employee diversity or compensation gaps are assessed as factors affecting staff turnover, innovation, and productivity. Not only are such metrics helpful to fund managers in making investment decisions, their reporting is increasingly becoming a key requirement by fund investors.

In From public to private: three incentives to get ahead of sustainability regulation, we considered how early adoption of sustainability may help entrepreneurs to grow their business, secure the best cost and terms of capital, and capture new markets where sustainability credentials are a key selling point. And in Three ways sustainability transparency can affect your business exit, we outline why sustainability may increasingly affect entrepreneurs’ exit plans, while including practical tips to improve, measure, and evaluate sustainability performance.

For entrepreneurs looking to make private market investments, we note a recent increase in buyout strategies with explicit objectives around environmental and social impact, which—when done credibly—can also drive real- world sustainable change.

More generally, we expect continued interest in private equity investments given their historical ability to outperform public equity markets across multiple cycles (Fig.1).

Fig. 1: Global private equity has outperformed public equity markets across multiple cycles

Vintage year internal rate of return (IRR), global PE vs. public equities, in %

Global private equity

Source: Cambridge Associates, UBS, as of October 2022

We expect value-oriented buyout strategies to perform well next year. As businesses streamline costs, focus on core assets, and spin off nonperforming assets, we expect to see increased opportunities for buyout funds to invest in take- private deals, carveouts, and divestitures. Carveouts and divestitures in 1H22 increased to 13% of total US private equity middle-market deals compared to 11.2% in 2021, and we expect this to be a growing trend into 2023.

For a summary of our outlook for 2023 and the decade ahead, please explore Year Ahead 2023 - A Year of Inflections here.

Conclusion

With policy uncertainty and market volatility set to endure, we identify three key themes for entrepreneurs to consider as they seek private market capital in 2023.

  1. Scarcer capital availability will likely persist–but entrepreneurs should beware of diluting their net worth
  2. Founders facing distress should engage early with trusted advisors—and stronger entrepreneurs may find attractive opportunities
  3. Sustainability looks set to become even more important in private markets—so entrepreneurs should develop their environmental and social credentials. 

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