Private Equity: Rise and fall?

Private equity “blew the doors off” in 2021, says consultancy Bain & Co when summing up what was a record-breaking year for the asset class. But the landscape has since shifted and the backdrop has changed.

Following the “stimulus-fuelled market frenzy of 2021”, last year was a turbulent year for risk assets, says Preqin in its 2023 global report on private equity. The investment data specialist noted that the global private equity market is now in an adjustment period and anticipated significantly weaker levels of activity this year in terms of deal-flow, as well as in performance and fund-raising.

Also, while its 2023 alternative assets report acknowledged the strong returns that private equity has delivered to investors over the long term, Preqin said it expects performance to dip this year.

The surge in activity has ebbed, as major new challenges have made an entrance, while others in the background have moved to centre stage.

The challenges for the market have arrived thick and fast during the past few years. These include geopolitical tension emanating from the war in Ukraine and China’s focus on Taiwan, along with burgeoning inflation, rocketing interest rates and market volatility.

And that’s not all. According to Bain & Co’s global private equity report for 2023, a host of other macro-economic trends have been having an impact too, such as natural resource shortages, global food pricing and supply disruption, recession risks and technological disruption.

Seen it all before

However, despite the tumultuous times, Bain’s outlook is upbeat. “Despite the recent drop-off in deal, exit and fund-raising activity, 2022 was still the second-best year in history, and the underlying fundamentals remain sound,” the company reports.

While it points out the challenges faced by private equity, it also highlights the robustness of the sector: “Unlike the 2007–08 period, when the global banking system nearly collapsed, nothing appears fundamentally broken this time around. While all signs point to a shift in the economic tide, the magnitude will be nothing the private equity industry hasn’t dealt with before.”

Putting the macro-economic worries to one side, the year has started on an encouraging note. In its end of first quarter report on private equity, Preqin pointed out that there’s an ample amount of dry powder in the market globally – a healthy $1.54trn (£1.24trn). Total dry powder will climb to $1.92trn (£1.54trn) by 2027, it estimates in its 2023 global private equity report.

This positive outlook on private equity is evidenced in the plans of institutional investors. According to a global report on private markets published by State Street in May, nearly two-thirds (62.5%) of major institutional investors surveyed plan to make private equity their largest allocation in the next few years. The research also revealed that despite the tough macro environment, private equity is still the most popular private market.

One of the people behind the research said they surveyed more than 500 institutional investors about challenges and opportunities in investing in private markets and found strong support for ongoing investment in this asset class. “In fact, 68% of respondents indicated that they would continue to invest over time and only 25% of respondents indicated that they would allocate less over time.”

Family offices are putting their faith in private equity too. Goldman Sachs’ 2023 family office investment insight report, also published in May, revealed that family offices are planning to increase their allocations to private equity. Its research, which surveyed family offices that most resemble institutions (more than 70% of respondents had a net worth of at least $1bn) found that nearly half (41%) plan to do so in the next 12 months.

The researchers said the ongoing focus on private equity was “unsurprising” and attributed it to the ability of the asset class to access innovative companies earlier in their lifecycle than in public markets, as well as to its history of outperformance.

Reflecting on the reasons for the continuing popularity of private equity, despite the challenging backdrop, Martin Dietz, head of diversified strategies at LGIM, says there are clearly some positives about the asset class in general. “A lot of private equity is about buyouts and that, in principle, is about looking at relatively stable smaller companies. We see this type of company as one that tends to do quite well over the long term.”

Advantages and rewards

Private equity has a wide range of plus points, says John Euers, co-head of M&G Alternatives. “Most notably its track record of delivering strong, absolute return across cycles, over the past decade, resulting in three, five and 10-year pooled private-equity buyout returns of 20.9%, 18.3% and 17%, respectively, according to data and analytics specialist Burgiss.

“With private-equity fund valuations typically taking place on a quarterly basis, these funds are often insulated from the mark-to-market swings that take place in other asset classes and over time, have demonstrated lower volatility than public equity markets,” Euers says. “In addition to this, investors are often attracted to the diversification offered by private equity.”

Euers also explains how investors’ perceptions of high risk can be addressed: “While private equity is an asset class that is maturing, some investors may perceive it to be a high-risk strategy through the belief that they will be investing in early-stage ventures that feature binary outcomes.”

This, he says, can be overcome by carefully selecting funds with a track record and through careful due diligence on their strategy. As an example, Euers notes M&G’s portfolio consists of more than 3,000 underlying companies, so benefits from a high level of diversification. “No one deal will determine the overall performance of the portfolio,” he says.

Another benefit of investing through a broad portfolio of private equity funds is vintage year diversification, Euers says. “This means that our managers are buying and selling investments at different times, so we are not overly weighted to a particular point in the cycle.”

Looking at the opportunities, rewards and risks for institutional investors of allocating to private equity – and more broadly, private markets, Peter Vincent, regional head of client investment solutions for EMEA at Franklin Templeton Investments says. “Private markets provide an expanded universe of investment opportunities as public markets continue to shrink and become more concentrated.

“They have matured such that many companies can stay private for longer, reducing the ability for public-market investors to access the full breadth of companies powering the global economy.”

Vincent adds that private markets offer the potential for an illiquidity premium and higher manager alpha. “But this must be weighed against liquidity risk, manager dispersion and fees,” he says.

New entrants

It’s not just institutional investors, asset managers and family offices who see the potential of private equity. In May 2022, government-founded workplace-pension scheme Nest launched a private equity mandate, appointing Schroders Capital to manage it. This was followed by awarding a second mandate to HarbourVest in July.

Nest said it anticipated having around £1.5bn deployed in private equity by early 2025, with a longer-term target to have around 5% of the portfolio in private equity. A year later, in May 2023, Nest confirms these estimates remain the same.

As an update on progress, Jess Menelon, investment policy analyst at Nest, says: “We’re happy with the deals our fund managers HarbourVest and Schroders have found for us so far. “Deployment is going well with £460m, around 1.5% of our total portfolio, already invested as at mid-April, and we are continuing to build our exposure to the asset class in line with our objectives.”

For any institutional investor keen to introduce private equity to their allocation plans for the first time, there are significant considerations to be aware of, as one private assets analyst points out: “Private equity investing is typically characterised by negative returns as the funds incur management fees, transaction costs and other expenses while waiting for the invested capital to generate returns.

“Institutional investors allocating money to private equity for the first time should diversify their investments with other private investments that are potentially quicker to gain value and to distribute money back, such as secondary investments and private-credit strategies.”

Under the surface

Despite the optimism about private equity, there are some significant lingering niggles in the market. State Street’s global research on private markets reported that investors remain somewhat jittery about the deal-making environment.

More than half (51%) of respondents believe that private-equity valuations have not yet adjusted to new market conditions. Although private equity is not alone when it comes to accurate valuations – it is something rearing its head among many asset classes and sectors.

A potentially more worrying trend is that just under a third (32%) also expressed concerns about a private equity bubble risk due to falling revenues and profits of companies going to IPO.

That said, this has been an issue hanging over private equity for some time. The question is, as investors fear, whether now is the time for the private equity bubble to burst.

Reflecting on the current big issues for institutional investors around allocating to private equity, M&G’s Euers says: “Macro uncertainty, higher interest rates and reduced debt availability have resulted in lower deal volumes, and therefore lower liquidity, which further compounds over allocation issues.”

He says several limited partners are slowing or stopping their commitments to new funds. And in some instances, they are being forced to sell private equity portfolios at discounts to generate liquidity and rebalance their portfolios. “The upshot is that many institutions are being highly selective when it comes to backing the current vintage of managers, many focusing on a smaller number of relationships,” Euers adds.

This is having an impact in the market itself. “As such, we are seeing a bifurcation in the market where some managers are deemed to have successful fundraising campaigns (six to 12 months) at or above their target fund sizes whereas others are seeing a prolonged fundraising period, often needing to revise their fund targets to a lower level,” Euers says.

“At the extreme, we should expect some franchises to ultimately fail,” he adds. “This is not necessarily a bad thing, more an evolution of an asset class that should no longer be deemed an ‘alternative’.”

Vincent also highlights challenges that institutional investors are having to get to grips with. “Institutional investors are grappling with macro-economic uncertainty, ‘denominator effect’ issues, slowing distributions and reduced price discovery in private markets. All these issues are contributing to a slower fundraising environment and a preference for established manager relationships.”

And LGIM’s Dietz res a warning on the outlook for the rest of 2023: “We’re worried about economic conditions right now simply because rates have been hiked quickly in all the main markets − in the US, the UK and Europe − and we’re seeing the cracks showing up in the real economy.

“Central banks might try to control inflation as a priority in this cycle and risk a little bit of a recession or some sort of an economic slowdown at least − and that is potentially negative for everything that is risky, including private equity.”

If such a worst-case scenario plays out, then private equity could switch from blowing the doors off, to finding itself part of a market implosion.