RiskMap 2024 | Martin Tornberg | Head of Private Markets and Financial Sponsors
Developments in 2022 and 2023 have stalled the engine of private markets investments. High interest rates and geopolitical events have affected deal flow negatively, both at entry and exit. Sellers’ expectations have continued to be based on old-order conditions, when ample cheap leverage and expectations of multiple-expansion drove high transaction valuations. Geopolitical flashpoints have resulted in volatility in commodity prices and impacted sector valuations. Household finances, consumption and savings patterns have changed in the face of high inflation and high interest rates.
Together, these factors have led to moribund public equity markets with little fresh capital and lower trading volumes, effectively closing off the conduit for liquidity through public offerings. Further, private equity allocations have dried up in the wake of the denominator effect and the return to a reality where fixed-income investments are seen as having a better risk-return profile than equities, whether public or private. The certainty of successful fundraising is all but gone, or the process is at least taking materially longer.
All of this has made deal teams more cautious when considering new investments, and they’ve begun shifting gears to focus more on improving portfolio company operations, and resilience to new market conditions and external shocks – and for good reason: 2024 may well be the year that macro conditions normalise and deal flow finds a “new normal”, but investors will likely find themselves edging forward rather than charging headlong.
RiskMap, our annual forecast of business risks, shows that investors need to have a range of issues in mind as they consider transactions in 2024. Three of our Top Five Risks are of particular relevance for investors.
Uncertainty paralysis: US politics and China’s economy
While both the US and China will be caught up in domestic issues in 2024, it is the economic downshift in China that will likely have the most immediate relevance for investors. There are two key points here.
Firstly, adverse domestic economic conditions affect all firms doing business in China – domestic and international. While international capital is being welcomed, investors are questioning – almost for the first time - the long-term ability of their portfolio companies to generate profits in the country.
Secondly, geopolitical competition will continue to drive shifting incentives and deterrents to doing cross-border business and deals involving China. The ability to benefit globally from operations and investments on either side of the border is increasingly being questioned, through challenges around intra-company sharing of IP and data (due to privacy, national security and national competitiveness concerns) or expectations of a rapidly developing sanctions landscape. Investors need to have plans in place for a multitude of scenarios, both for new investments and for portfolio companies.
However, there are opportunities as well: investment interest in locations not aligned to global superpowers is heating up, with Middle Powers attracting unprecedented amounts of capital relative to traditional markets, thanks not only to natural resources and favourable policies, but also because of the ability to stay non-aligned, mitigating geopolitical risk. Getting to know these investment destinations will be high on many investors’ agenda during 2024.
Trust deficit: digital integrity frays
Advances in generative artificial intelligence have underscored the efficiency gains of digitalisation. Indeed, digitalisation as a vehicle for value-creation has been a common theme for a decade at least. But now, the double-headed spectre of the potentially negative effects of artificial intelligence, and value-draining cyber-attacks continue to drive (at an accelerated pace) a need not only for portfolio resilience but also agility to adapt to a rapidly changing and – sometimes geopolitically driven – reactive regulatory landscape.
Regulatory change in this field itself has potentially at least two effects on investments: it increases the cost of compliance, and – more importantly – it may threaten the very investment thesis if, under emerging regulations, initially assumed benefits can no longer be expected. Monitoring the digital risks and associated regulation will be critical in 2024 and beyond.
Climate disruption: the global threat multiplier
Operational risk levels due to climate events will be higher than ever next year. According to the UN, 2023 is set to be the hottest year on record, and wildfires and flooding – among other events – are destroying value in an increasing number of locations, pushing insurance premiums up and making companies think carefully about locations of new investments.
The response to climate change and sustainability issues are also impacting investments. Regulations regarding corporate diligence responsibility over supply chains, and reporting requirements regarding sustainability efforts are being given more bite. Supply of strategic inputs into the sustainability value chain, such as critical minerals crucial to the energy transition, are increasingly a strategic issue for governments. This can potentially fuel further economic nationalism - either as matter of national security or to boost domestic economic output - and will without doubt impact opportunities for trade and investments.
The above risks sit squarely on top of “normal” business risks. Mitigating these kinds of emerging risks effectively calls for risk management resources often beyond the capacity of companies focused primarily on their core business. Investors therefore need to take a structured approach to emerging risk management for new investments, and work with their portfolio companies to support risk management across all major risk domains. Uniquely, investors can draw on (and disseminate) lessons learned from their portfolio companies, as well as best-practice gleaned from their own access to insight from fund-level or external subject matter experts.
The ability to demonstrate steady handling of risks like these is a differentiator in itself in the eyes of investing institutions and other stakeholders. Managing them well could help the sector take its foot of the clutch, rev up and return to driving growth.