Recent deal-making activity is a tale of two halves of the calendar year. According to Bain & Company’s recent Global Private Equity Report 2023, dealmaking reached an all-time high over the first 18 months of 2021 and the first six months of 2022. However, according to industry sources, the Federal Reserve’s interest rate hike in June 2022 hampered the pace of dealmaking, causing many dealmakers to back off. There were a number of significant worries, including a war in Europe, which produced an increase in commodity prices and a disruption in supply networks, as well as instability in financial markets, which led markets to oscillate. Finally, credit markets reverberated with a great deal of fear regarding the direction of the actual economies.
When the term “recession” was coined, dealmaking came to a standstill almost immediately, as it does in many markets. In addition, this uncertainty caused banks to pull back before publishing any unfavourable statistics, meaning that no significant transactions were conducted. It’s not that interest rates haven’t risen to levels not seen in 15 or 20 years or that supply chains or other macro factors haven’t occurred before; it’s just that we don’t know when they will stop, and with that level of uncertainty, predicting what a given variable will do in the future is difficult.
Dealmaking slowed down
Overall, these factors slowed dealmaking in the fourth and first quarters of 2023, and the slowdown accelerated in the fourth and first quarters of 2023, according to the Bain report. Alternatively, this follows a phenomenal fundraising streak over the last 7 to 10 years. In fact, during the previous six years, the private equity industry has seen over a trillion dollars in fresh funds committed yearly, which is quite astounding. Combined with a slowdown in the deal markets, we now have a record level of dry powder, totalling $3.7trn. The good news is that the industry has plenty of firepower to invest against good opportunities, and people are just waiting to see how some macro factors will play out.
When some of these macro factors stabilise, we’ll see new investments return to much more normal levels, perhaps not the 2021 go-go period where a trillion dollars of deals were completed in a single year. Nonetheless, a transaction slowdown has had a second cascading effect on the exit market. In the second half of 2022, exits decreased to less than 50% of levels just 6 months before the beginning of the year. Due to the lack of exits, it has proven difficult for limited partners (investors) to continue funding new general partners seeking re-ups.
In 2023, LPs are particularly concerned about a cascade effect on future fundraising, which has recently been put under strain by two factors: The first big aspect is a liquidity shortage caused by the velocity of capital in the private equity market in recent years, whereby GPs instead of coming back every four years and requesting 20%-30% more money for a larger vehicle are coming back every one to two years and requesting 50% more capital. The issue with a rapid capital cycle is that if something stops, you become cash-strapped, which many LPs currently face.
The other impact is that GPs hold onto assets longer, so if you look back at a typical recession, GPs may keep, on average, an asset a year or two longer than they would otherwise. This extra year or two means that LPs incur additional costs but do not receive a distribution in return, which impacts their returns. In addition, another factor affecting the PE market is what we refer to as the denominator effect, in which many public markets will be down as much as 20% in 2022.
As a result, LPs who did not allocate any capital to the private equity industry saw their allocation percentage increase to the private markets sector due to the decline in public market valuations. LPs, particularly institutional investors, reached a limit on their private asset allocations due to the above factors. LPs have a hard limit on how much they will invest in private equity, and if that limit is reached or exceeded, no further commitments may be made. Some LPs can circumvent this by increasing their commitment level and obtaining authorisation. However, the majority cannot do so and therefore draw back once they realise where private asset prices are heading.
Private markets typically take longer to be marked to market than public assets, and in general, the fourth quarter mark is the audited mark that is most rigorously scrutinised by the industry when determining the fair value of their private assets. Overall, the crash crunch, valuation uncertainty, and denominator impact concerns are forcing limited partners to hold off on further commitments until this time of uncertainty has passed.
Valuation, allocation questions
On the other hand, returns have fared quite well, and by returns, I mean both realised and unrealised gains. Even if many public assets have been marked down, how well these private valuations hold up will be decided as the second quarter progresses, but there is reason to be optimistic. As it turned out, many of the vintage years before the recession in 2009 and 2010 averaged around 10% IRRs, so the most crucial lesson GPs learned coming out of the Great Recession was to hold on to an asset almost at any cost and keep working it until financial markets improved.
The second reason for optimism about returns when these assets are eventually sold is that, if the industry learned anything from prior recessions, PE funds have been investing in different types of assets that are more resilient to macro shocks over the last decade, such as healthcare, B2B critical software and financial services. Investors in private equity are far more confident that they have allocated capital to sectors that will sustain a certain degree of recessionary activity. These economically resilient investments will be tested, and we will all find out when these assets are sold whether or not the returns are as rosy as we all hope.
However, in the absence of a Black Swan economic event, there is nothing fundamentally broken in the private equity industry right now, as most dealmakers I speak with are optimistic that if anything happens to disrupt deal markets for the long term, it won’t be a macroeconomic event.
Shanu Sherwani is deputy CEO at AM Investment and partner at Antwort Capital