These Five Factors Are Shaking up the Private Equity Industry
February 15, 2023
In the years following the financial crisis of 2008, private equity trends have shown that the market has enjoyed solid performance, benefiting from the combination of a strong economy and low interest rates. Now, a variety of factors — economic uncertainty, rising interest rates and inflation among them — have cooled private equity activity.
“We’ve had a very solid run for years,” says Karen Rode, partner, Wealth Solutions at Aon. “Things are in a little bit of upheaval right now because people don’t know where the economy is going and what regions of the world are going in which direction. I think there’s a little bit of a pause right now and people are readjusting their thinking.”
That uncertainty is understandable. Aon’s 2022 Executive Risk Survey found 79 percent of global business leaders expecting a recession in the next year, with inflation and an economic crisis among the top concerns as well. But despite the current pause in private equity activity, there are opportunities to be had in investments and preparing for when the pace of market activity picks up.
As market participants evaluate current private equity trends, they’re focused on a number of key considerations. The economy is a top concern, as are inflation and interest rates. For investors, there might be questions around portfolio allocations as the value of various investment classes has shifted. The current challenges also provide investors with an opportunity to evaluate private equity managers.
Despite the Economy, Private Equity Continues to Perform
Current economic conditions and recession fears may have slowed the private equity market, but they haven’t stopped it. Fundraising continues, albeit not at previous levels.
In the current economy, private equity investments have tended to fare better than public equity investments, according to Rode. “Control and governance are the two big differences between private and public holdings, and will always be the big drivers of value, whether you’re in a down market or an up market,” she says. “The alignment of interest is much stronger in private equity than it is in public. The ability to move and make decisions for the long term without being second-guessed every quarter over earnings drives private equity versus publics.”
In an inflationary environment, businesses with the ability to raise prices may be able to increase profitability. Others who don’t have the same pricing power will be hurt, Rode says.
Inflation can also be a factor in valuing companies for private equity investments. “Valuing a public company or a private company is always an art rather than a science,” Rode says. Private equity funds will look to factor inflation into cash flow models for possible targets and seek to determine how inflation might affect those target companies’ revenue going forward.
“It’s absolutely going to impact valuations, because you’ve got different people trying to project the future and then discount it back,” Rode says.
The Impact of Interest Rates
While a strong economy contributed to private equity’s solid performance for the 14 years following the 2008 financial crisis, an extremely low interest rate environment in that time supported that performance as well.
“Low interest rates significantly supported private equity because leverage was very much available,” says Rode. “It supported all kinds of deal flow, and the cost of putting leverage on a company was very low. Plus, it provided considerable financial flexibility.”
Now, the private equity market faces rising interest rates as central banks look to tamp down inflation. These new, higher, interest rates could mean that fundraising becomes more challenging as investors focus on other allocations strategies.
Dealing with a Shifting Allocation Mix
Some investors might see shifts in their asset allocation levels in the current market, Rode says, as private equity investments are often outperforming investments in publicly traded equities. In those cases, the percentage of private equity investments might now be exceeding investors’ allocation targets.
Rode notes that setting an allocation range may be more helpful than determining a fixed allocation target. This provides an investor some flexibility when allocation levels shift, rather than being forced to sell off investments.
“One of the last things you want to do is sell into a market that’s down, because selling private equity funds on a secondary market is a loser’s game,” says Rode. “If there’s a buyer for it, it’s because there’s value you’re giving up.”
Investors who are concerned about private equity allocation levels may not want to exit private equity altogether. “History has shown that recessionary-type environments are some of the best performing years, so it’s really not the time to back out,” Rode says. “The best route is to be able to scale back.”
A Chance to Evaluate Managers
While current conditions might be challenging for the private equity market, they provide a valuable opportunity for investors to evaluate fund managers.
“When the market’s strong and everybody’s doing really well, it’s hard to determine who the better managers are,” Rode says. “It’s when there are hiccups along the way that it becomes apparent who the really good managers are versus those just benefiting from strong markets.”
The current market might also offer investors a chance to gain access to strong managers who were previously fully committed and unavailable. “It’s a good opportunity to build out a portfolio of solid managers,” Rode says.
Private Equity’s Value Persists
Despite challenging conditions, the private equity market has a history of bouncing back, Rode says. Meanwhile, deals will continue, likely at a slower pace. “I think in another six months, deal flow will start to pick back up again, but we are going to be at a pause for a little bit,” she says. “Private equity firms will continue to find good deals, and I think there are still a lot of good deals out there.”
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