Private equity beginning to feel the heat 

Deal pipelines are weakening in several industries, particularly technology, and debt is becoming more expensive, says Shanu Sherwani. Courtesy photo

Deal pipelines are weakening in several industries, particularly technology, and debt is becoming more expensive, says Shanu Sherwani. Courtesy photo

Even though indicators suggest global private equity business transaction volume 2022 will be the second-highest year total after 2021, uncertainty means that financial investors are unlikely to continue current level of activity into the second half of this year, writes private equity analyst Shanu Sherwani in his guest column.

According to the most recent private equity report from Bain & Company, despite record levels of dry powder, the global private equity business is beginning to feel the heat of the changing economic tide, with both deal volumes and fundraising levels down from the previous year.

The number of transactions topped the 2,000 mark, indicating that 2022 may still be on track to post the second-highest year total after 2021.

However, due to the increasing influence of geopolitical and economic uncertainties and the cyclical nature of the private equity industry, it is not anticipated that financial investors will continue the current activity level in the second half of this year.

Deal pipelines are weakening in several industries, particularly technology, and debt is becoming more expensive. Furthermore, in recent transactions, I noticed that banks are asking additional questions about a company's vulnerability to inflation and rising interest rates, making it more challenging to close transactions. Similarly, public market difficulties in 2022 have already affected exits. Global buyout-backed exit value reached $338 billion in the year's first half, a 37% decrease from the same period last year. The value of global IPOs, including buyout-backed and other offerings, decreased by 73% from the first half of 2021 to $91 billion.

The current pause in withdrawals will likely spread to other markets as this period of volatility continues. Bain & Company's latest private equity report shows that the exit fall off will increase the average portfolio hold length.

Competitive fundraising

When it comes to fundraising, a similar picture can be painted. Even if a few substantial funds were still able to close during the first half of 2022, overall fundraising activity indicated a significant drop, notably among buyout funds. The amount of capital raised by private equity firms in 2022 as of June decreased to $337 billion from $ 449 billion during the same period in 2021, according to preliminary data from PEI (Private Equity International). This comprises closed-end funds, co-investments, independently managed accounts, and vehicles for joint ventures. As LPs continue to concentrate capital in a smaller number of more significant funds, the number of funds closed by over 40 per cent, from 1033 to 622.

Smaller and middle-market firms competing with more prominent, more established managers for capital should find second-half fundraising competitive. Many investors, including significantly larger institutional investors, may already be fully allocated for the year due to the number of sponsors raising fresh funds. These investors seem to favour more prominent, more established managers, who often require substantial commitments and may be fundraising for multiple products at once. Private equity firms may postpone closings until next year to access investor pipelines that are full for 2022 but may have funds in 2023. Smaller and middle market sponsors who planned to launch new funds in 2022 will now do so in late 2022 or early 2023 to avoid a lengthy fundraising phase.

In their search for yield amidst a bear market and bleak economic outlook characterised by inflation, supply chain imbalances, and a hawkish Federal Reserve, more and more high-net-worth investors are gravitating toward alternative investment funds, such as private equity. Analysts expect private investors to invest heavily in private equity to diversify their portfolios in 2022. Due to increased competition for capital, sponsors may be more receptive to customised structures such as feeder funds in exchange for higher investor commitments in their master funds. 

Macroeconomic uncertainty

Furthermore, the market expects continuation funds to become increasingly popular for exits. These options are for sponsors wishing to offer liquidity to investors while retaining control of portfolio firms with value-creation potential beyond their customary hold duration. By paying investors cash, sponsors expect it to be reinvested in new funds.

Inflation and geopolitical events like Russia's invasion of Ukraine have long-term impacts. While these events haven't harmed the fundraising market yet, continued macroeconomic uncertainty could dampen future private equity allocations. If that happens, analysts expect sponsors to continue using warehousing vehicles and other creative techniques to invest in new transactions while they wait for additional funding.

Even though not all the funds raised have been put to work by the funds, the amount of "dry powder " has reached its highest level ever, at $3.6 trillion. Investors see a large amount of dry powder simultaneously as an untapped opportunity, but private equity funds see it as a chance to make money. It is known in the market that deals made after a recession tend to give good returns, something that both general partners and limited partners learned after the global financial crisis.

Research from Bain & Company has shown that the internal rate of return on investments made during recovery years has always been higher than the long-term average, especially for investments in top-quartile deals.

Geopolitical and economic worries linger as we enter the year's second half, and global markets have slowed appropriately. While private equity fundraising and M&A activity remained generally strong in the first half of the year (though comparatively weaker than in 2021), the macroeconomic environment, market volatility, and increased regulatory oversight present challenges to which the private equity industry must adapt.

Diversification benefits

As the demand for capital from sponsors remains high, we may see increased competition in fundraising in the second half of the year and increased use of bespoke structures tailored to investors' demands and warehousing vehicles as alternative sources of capital. Meanwhile, analysts expect continuation funds and fund-to-fund transactions to continue to be popular as general M&A activity slows. More broadly, analysts anticipate that parties will use more inventiveness in structuring and bridging valuation gaps to complete deals, including in the secondary market and M&A and leveraged finance transactions.

According to Bain & Company, the sector will need to prepare for a "time of storm" and proactively manage value generation and portfolio changes, which is crucial to surviving this turmoil and capitalising on the upcoming economic rebound. However, private equity can provide diversification benefits no longer available in typical stock and bond portfolios. Over the past 20 to 25 years, the belief that bonds and equities have a negative correlation has been the primary driver of portfolio diversification, particularly for pension plans. Analysts do not believe that will continue as inflation compels asset allocators to think strategically about diversification sources. Private equity, in my opinion, is an ideal source of diversification beyond standard public market portfolios.

Shanu Sherwani is a board member/chief investment officer in top quartile private equity and real estate funds in Luxembourg and a partner at Antwort Capital.