What will the private equity market look like in 2023?

I expect the slow pace of deal-making will continue, but I see good news ahead, especially for fans of Rick Astley, George Michael, and everything 1980s.

There are three frequently cited reasons for pessimism in corporate deal-making as the pandemic lifts: high interest rates, recession fears, and uncertainty about consumer and business patterns. Who wants to jump into an acquisition when the cost of borrowed money is high and the ability to forecast cash flow is hazy?

Private equity activity set a record in 2021 followed by a steep dive in 2022, with third-quarter activity falling 55% from the second quarter, according to EY.

I’ve witnessed this drop-off through my role as an M&A consultant at Strategex, where we perform due diligence and value creation work. The biggest reason I’ve seen for the falloff in M&A transactions isn’t higher interest rates, recession or revenue uncertainty, though they are contributing factors. The best explanation is that prospective buyers and sellers aren’t agreeing on valuations: M&A is out of equilibrium, and until both sides accept the economy as it currently exists, we’ll see a slower deal pace.

M&A is out of equilibrium, and until both sides accept the economy as it currently exists, we’ll see a slower deal pace.

I say this because there is still demand from PE firms with billions of dollars of dry powder they need to deploy. And there are still companies willing to sell. But some of those sellers are holding on to outdated expectations about what they could get when the cost of money was dirt cheap and buyers were willing to pay up to 20 times earnings. While that era is over, the disconnect in expectations lives on.

In my M&A experience, which includes small and medium-sized target companies, I’m seeing a lot of deals negotiated and letters of intent signed. Then comes the 90-day race involving a deep examination of the business, and that’s where the wheels fall off. When money was cheap and markets were buoyant, buyers could make the numbers work. Now, sellers are having to adjust their prices to get to the finish line: “What do you mean I’m worth five times less?”

Expectations on both sides must change, which is why 2023 looks soft for PE. Egos, valuation models, and risk profiles need adjustment. This will happen because economic conditions don’t have to be perfect for deals to get done. Deals just have to make sense.

Back in the late 1980s, a hot era for M&A—and pop songwriting—interest rates were much higher than today, yet private equity seized the day. The very concept of a leveraged buyout took hold when rates were over 10%.

Back then, according to scholar Margaret Mendenhall Blair—professor emerita at Vanderbilt Law School—high interest rates drove M&A as much as they hindered it because the high cost of money dampened opportunities for companies to invest in their own operations. Concurrently, high rates frustrated investors, who put more pressure on corporate managers to boost returns, whether through stock buybacks or alternative investments.

Circumstances change, but the point is perspective drives deal-making just as much as future cash flows. On a relative basis, money is still cheap to borrow, but an entire generation of business executives has never seen rates at 6%. It will take time for them to adjust. Soon enough, the pace of deals will pick up because M&A is crucial to corporate growth, just as M&A was in the ’80s.

You gotta have faith.

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This article was originally published by Forbes.

Anthony Bahr is Managing Director of our Customer Due Diligence practice. When he's not advising private equity clients on customer risk, he guest lectures on consumer behavior and research methodologies at Cornell University, Loyola University Chicago, and the University of Pennsylvania.

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