It has been a tumultuous six months since January 2022, when everyone was talking about a super-sizing of the private equity industry, whether it was record amounts of deals or funds raised as well as returns that tended to outperform all other asset classes. Indeed, all arrows appeared to be pointing upward a year ago, and everyone in the industry stated that it was the best of times. However, to say that we are in the worst of times as we approach the end of the year is an exaggeration, but the private equity industry must plan for all possible outcomes.
Macroeconomics is currently at the centre of many conversations about private investments, whether it’s a soft landing, an inflationary new normal, mild recession stagflation, or a severe recession. Numerous industry papers examined the significant themes for the coming year, such as what macro means for the private equity industry in the current environment and what might happen in the next six to eighteen months.
We were already dealing with the fallout from the pandemic supply chain challenges when a European conflict reignited macroeconomic concerns. Persistent inflation is gradually becoming an issue for a sector that has never had to deal with inflation for most of its existence. Furthermore, the United States is raising interest rates to combat inflation, creating a somewhat unstable environment. The possibility of a recession is again being discussed at industry meetings. Numerous possible macro outcomes exist, and people are trying to determine where the industry is heading.
Private equity has emerged stronger from the last 25 years’ crises, including the tech bubble of 2000, the global financial crisis of 2008/2009, the European debt crisis of 2012, and, most recently, covid. Returns, capital invested, capital raised and exits have significantly rebounded after various crises, and the private equity business has expanded. Private equity is a cyclical industry by definition. However, it has been a cyclical growth business over time and has proven to be extraordinarily resilient to the macroeconomic challenges it has faced over the last two decades. Given the context of 2022 and the year’s first half, the buyout market was on track to record the second-highest annual total value in history. That is, however, a very different historical perspective than the one we are currently viewing.
The number of transactions and activity levels is decreasing, and almost everyone expects this trend to continue in 2023. The IPO market is essentially closed due to the volatility of such equity markets. SPACs have virtually ceased to exist as an exit platform, and corporations have retreated from the market as they become increasingly concerned about their profitability and the possibility of an impending recession. When people are worried about a recession, as was the case in 2008 and 2009, they tend to hold on to their assets for longer. Inflation exacerbates this, causing margin compression for many companies in private equity portfolios.
Essentially, future uncertainties and volatile exit markets indicate that assets will be retained longer in general partner portfolios, which will impact fundraising. Looking at the fundraising markets over the last five to seven years, we can see that they have been quite robust, but their velocity has increased significantly. The industry has shifted from funds returning to the market every four years and requesting 20% to 30% more in their new fund, to funds returning to the market every two years and requesting 50% more in their new fund. In the current environment, the velocity of this capital has left many limited partners in the private equity markets feeling overexposed and cash-strapped. Although LPs are pleased to be exposed to private equity markets because they have performed so well, cash flow models fail when cash is constantly leaving and not returning to the business.
Fundraising is currently out of balance
This is not a trend that LPs have grown accustomed to over the last 10 to 12 years, making them even more reticent to make incremental investments and commitments in the private equity industry in a world where the money paid to LPs is likely to be strained owing to extended holding periods. As a result, fundraising is currently out of balance. We are witnessing challenging fundraising conditions, particularly for buyout funds and other types of private equity such as growth, direct lending, secondaries, and infrastructure funds. Analysts believe that the money LPs now have in the market will make fundraising difficult through the end of 2022 and into 2023. Not a long-term issue, but it is a short-term concern.
However, it is essential to remember that LPs have a long-term view of the private equity asset class. Most investors say they intend to maintain or increase their private equity market allocations over time. This is a short-term cash bottleneck, but LPs remain highly bullish on this asset class over the long term, as the private equity industry has historically delivered excellent returns. The good news for general partners is that the industry is well-prepared to weather the downturn in the long run.
Dry powder and private companies
There is currently a record $3.6trn of committed, but uncalled capital referred to as ‘dry powder’. According to Bain Capital’s mid-year private equity report, approximately $1trn is set aside for buyouts, with another $2.6trn for all other types of private equity. Numerous funds have been raised, and these funds still have years to invest their money. They can weather short-term storms and know they have enough dry powder to capitalize on good deal opportunities once we emerge from this macro destabilization period we are currently facing.
DealEdge’s data analysis shows that after the tech bubble burst in 2001, industry IRRs increased from 11% to the 40s in 2002 and 2003 and remained above 20% for most of the early 2000s. As a result, even though these are challenging times for the private equity industry, they do not turn out to be disastrous. History teaches us that there will be some solid investing years following any crisis. According to my recent conversations with limited partners and my assessment of their confidence in the business, diversification is a compelling reason for institutional investors to commit to private equity.
Diversification away from public and credit markets makes private equity and private markets more appealing. In the United States and many other countries, there are fewer public corporations than there were fifteen years ago, and more private companies are in the hands of professional investors, allowing them to generate alpha with the assets they control.
LPs are confident in private equity funds’ ability to create alpha and, as a result, continue to shift capital away from public markets and into private markets in search of this excess return. So, while there is uncertainty in the market, I often think back to June or July 2020, when we were wondering if this would be years and years of stagnation and poor returns. Yet, from all of those pessimistic predictions, we have had two years of about the most intense activity in deal markets ever, with incredibly high returns for GPs and LPs. Nobody predicted that in June 2020, so no one will predict what will happen in the future.
is chief investment officer at Am Investment Management and partner at Antwort Capital.