The worldwide PE industry is ablaze. After a brief hiatus as the covid-19 virus immobilised the global economy, the dealmaking fever returned in H2 2020, according to data from Mergermarket and Dechert LLP. This momentum does not appear to be slowing as we reach 2022.
The figures speak for themselves, regardless of how the industry is measured. In Q1-Q3 2021, there were 4,605 buyouts globally, breaking the previous annual record. Globally, the industry is on track to break records in terms of value. The $1.17trn in transactions from January to September 2021 surpassed every previous full-year number since 2015.
Monetary and fiscal stimulus at historic levels have boosted the economy and mitigated the pandemic’s effects, driving public equity and private capital market prices skyrocketing in the process.
Like dealmaking, fundraising has been abundant. Private equity firms reportedly raised $630bn in the first nine months of 2021, Mergermarket and Dechert LLP reported. According to current trends, fundraising could top $1.2trn this year and next. I also expect more private investors to access private equity funds. Given the competitive nature of institutional fundraising, it is not surprising that private equity firms, which generally target large institutional investors, will now target private investors.
Deals driven by technology
Technology is also playing a significant role in deal flow, increasing prices. Whether it is pure technology assets or businesses in industries undergoing a secular digital revolution, technology as a theme is driving demand and pushing multiples higher in an already costly environment. Bargains are hard to come by.
TMT (technology, media and telecom) accounted for $84bn in deals in Europe, Mergermarket and Dechert LLP said. However, European investors have also focused on cyclical industries such as pharma, medical and biotech, with $67.6bn invested in industrials and chemicals and $35.1bn invested in mining, utilities and construction.
Aside from the fact that technology contributes less to GDP value added in Europe than in the US, there are other factors to consider. Europe and China had stricter rules than the US. The pandemic hit Europe harder than China, which had slowed the virus’ spread until a flare-up in July 2021. As a result, Europe’s economy has slowed. EU GDP fell 6.8% in 2020 compared to 3.5% for the US. China, on the other hand, expanded by 2.3%. So, assuming all else is equal, there are more opportunities to invest in crisis-hit companies in Europe.
In line with this, I believe the covid-19 crisis will increase distressed deal flow in Europe. That doesn’t appear to have happened yet, at least not in a meaningful way. The European Union has given money to businesses and kept defaults low. Many believe that distressed companies will be sold to private equity firms when financial and fiscal support is withdrawn.
Higher entry fees and inflation
Few GPs will grumble about having too much money at their disposal. However, extrapolate it to the entire PE business, and mountainous reserves of dry powder become an issue. It always leads to increased competition and higher entry fees, making obtaining the promised returns more difficult if multiples do not rise during the holding term.
However, other significant challenges are at play, notably region-specific economic and political considerations. Uncertainty regarding the sustainability of current growth rates is expected to persist and will likely increase significantly when covid-19 infection rates fluctuate. Over the last nine months, inflation has also been a critical issue for investors across asset classes.
Within private equity, general partners will be hesitant to invest in assets with fixed, bond-like characteristics, such as real estate leases, which are particularly prone to inflationary effects. As prices and costs rise, significant secular trends, such as technology and healthcare, will be in high demand.
There will also be a growing trend in Europe of GPs selling assets to “continuation funds” that are also self-managed. Most PE analysts anticipate one of the crisis’s after-effects to be the sale of successful portfolio companies to successor funds, which generally occurs via a GP-led secondary deal.
While these transactions necessitate careful monitoring of investors’ interests, they provide significant benefits to both investors and the general partner. They enable general partners to keep control of high-quality assets through a continuation fund, rather than selling them and finding a new firm to allocate investments. Investors gain from the choice of cashing out of the existing fund, which the secondary buyer finances, or rolling over and reinvesting their pro-rata portion of the assets in the continuation fund, so retaining investment exposure to the assets.
As a result, investors can earn higher returns than on assets sold to third parties, and GPs can earn more carried interest.
Environmental, social, and governance (ESG) issues have quickly risen to the top of the corporate agenda. Previously nothing more than a talking point, prominent institutional investors have challenged corporations to act on climate issues.
As a result, private equity will have to go with the flow as portfolio firm customers, employees, and LPs demand more sustainable and socially responsible business behaviour.
In March of this year, the European Union announced its new Sustainable Finance Disclosure Regulation, which requires private equity firms, pension funds, hedge funds and other asset managers to adhere to specific disclosure criteria for climate, diversity and governance investments. Not only must European private equity firms comply, but so must any managers that actively advertise their funds in the EU.
The private equity industry has various reasons to be optimistic in 2022. Deal flow and capital raising are at all-time highs. In recent years, every business, from retail to financial services to healthcare, has been revolutionised by technology, but the pandemic-induced remote working environment has dramatically hastened the development. Private equity will continue to hunt for up-and-coming technological advancements with the potential to disrupt and revolutionise industries as part of its longer-term investment growth strategy.
The industry has widely recognised ESG participation as a meaningful strategy to drive returns, as it can produce value while simultaneously limiting risk. Even though the general forecast for 2022 remains positive, rising anxiety over inflation and the possibility of interest rate hikes could stifle dealmaking. However, the industry’s capacity to adapt and pivot to take advantage of opportunities in the face of rapid change enables it to handle these potential headwinds successfully.
Shanu Sherwani is a private equity analyst. He advises several top quartile private equity and real estate funds in Luxembourg.