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Escape usually brings up the pause menu, and the main purpose of the pause menu is to give you an option to return to the main menu. But since you're already on the main menu, the pause menu is disabled. What are you trying to do with escape on the main menu?
What issue was preventing you from setting up local multiplayer? All you need to do is add two players and start the game. In the case that you want one player to use the keyboard and another player to use a controler, or both players to use the same keyboard (instead of both players using controllers) you have to edit the controls slightly. Using the controls wizard (run setup) this should take a few seconds.
The reason you need to do this to play with one controller and one keyboard is because Party Panic has no way of knowing you want to play with two players - so it auto assigns the keyboard and the first controller it detects to player 1. To ensure that at least one player will be assigned correctly. But if you want to use those inputs for two players you must remove the controller from player 1, and assign it to player 2. The video above shows exactly how to do this.
Thanks for the guide on setting up controls for player 2. Never would have worked that out on my own!! With that we've managed to setup a splitscreen multiplayer just fine. Thanks!