Rising to the Challenge: Slowing Investment Cycles Test Private Equity Strategies

Private equity crossed a threshold in 2022, exiting an era of exuberance and entering a new period of uncertainty. Record inflation, surging interest rates and a foggy economic forecast put the brakes on private equity dealmaking, which had accelerated to its fastest-ever pace by the end of 2021. Now, lengthening investment cycles pose new challenges to buyout fund managers.  

Longer hold times for private equity portfolio companies are placing a renewed emphasis on value creation. The power of multiple expansions to boost investment performance is fading as the outlook for growth dims. Skilled, active private equity fund managers stand to accelerate ahead of the pack.  

Economic uncertainty cuts both ways for private equity: Even as it undermines portfolios, it creates new opportunities for investment at lower entry points. The seeds of private equity's best vintages are often planted in trying times. Deep sector expertise will be crucial as firms scout for deals.  

The global private equity industry entered 2023 with its largest-ever stockpile of dry powder, a positive sign as it sails into a potential recession. But fundraising is getting harder, and lengthening investment cycles could make the problem worse by slowing distributions to investors.  

The Groundswell: Private Equity Rises Up

Over the past decade, the private equity market more than tripled in size and demonstrated itself to be a substantive and compelling alternative asset class as returns outperformed public markets by a considerable margin. During this time, general partners (GPs) raised ever-growing funds and returned to market for the next fund at a more rapid pace and larger size. At the same time, investors poured more money into the asset class.   

The appeal of private equity investing is that it is a medium- to long-term investment provided in return for a stake in companies that are not listed on a stock exchange. Typically, private equity investments are made by primary funds managed by a GP at a private equity firm and invested in by limited partners (LPs). Unlike a public equity investment, private equity capital is called from LPs over time as GPs find investment opportunities, while distributions are made as investments are exited.  

GPs generally invest their own money in a fund alongside their LPs. They make all the investment decisions and are responsible for raising capital from LPs or fundraising. With minimum investment amounts sitting at about $25 million, LPs tend to be large institutions such as pension funds. They have no influence over investment decisions despite the long commitment periods.  

A typical private equity fund has a 10-year life cycle with a fundraising period of 12-18 months, an investment period that tends to span the first five years, a hold period that takes it up to year eight and a harvest period in which the GP looks to exit the investment by way of an IPO or trade sale and distribute returns to LPs.   

Despite the long-term investment horizon, nimble and quick execution is the hallmark of private equity. Private equity funds generally have well-defined investment strategies, but their execution can easily flex and adapt to best take advantage of investment opportunities. Additionally, while private equity buyers have long been known as financial asset flippers, over the past decade firms have begun pursuing more complicated portfolio strategies that leverage their growing expertise and relationships to become sector consolidation powerhouses, a position traditionally dominated by corporate strategic buyers.  

Strategic flexibility combined with predictability of terms and readily available capital are among the factors giving private equity players the edge, as exemplified by the development of the technology and renewable energy sectors. 

Private equity buyers have been able to pursue these opportunities in technology partly because plummeting stock prices and heightened regulatory scrutiny are making M&A much harder for industry giants who have historically played the consolidator role. In fact, private equity buyers led seven of the 10 biggest information technology M&A deals in the US and Canada last year, the highest share recorded in the past 22 years, according to S&P Global Market Intelligence data. The biggest private equity purchase was a $17.18 billion deal by a company owned by Vista Equity and partners. Tibco Software Inc.'s acquisition of digital workspace provider Citrix Systems Inc. underscored private equity firms' buying power and showed how funds are expanding technology companies they already own via bolt-on acquisitions.  

In contrast, Microsoft Corp.'s $69.99 billion bid for games-maker Activision Blizzard Inc. has yet to clear antitrust hurdles about a year after the deal was announced. And depressed stock prices have made it harder to finance deals with equity. Meanwhile, specialists such as Thoma Bravo and Vista Equity— which focus on cybersecurity and enterprise software, respectively — took advantage of tech giants’ inability to do deals and emerged as effective consolidators.  

Since 2017, Thoma Bravo has spent at least $37 billion on cybersecurity companies — more than 10 times the amount invested by Palo Alto Networks Inc., the largest industry buyer in the period, according to 451 Research data. Vista Equity mirrored Thoma Bravo's strategy in key enterprise software segments. The US-based private equity fund has made more than 40 acquisitions in the enterprise resource management space over the past five years, according to 451's M&A Knowledgebase.  

Rising rates are affecting the financials of North American renewable energy and infrastructure developers and electric utilities. However, private equity firms have yet to see a material impact on deal activity. Private equity has been able to replace some deal leverage with equity, increasing power purchase agreement (PPA) prices, becoming more flexible regarding exit strategy and looking ahead to take advantage of additional production and investment tax credits in the US Inflation Reduction Act. 

Even if valuations decline, the energy transition's growth and value opportunities will continue to boost the amount of private capital chasing renewable energy and infrastructure deals. Rising prices for renewable energy PPAs are helping private equity firms protect returns in a high interest rate environment.  

Large private equity firms continued to strike deals in 2022 despite the deteriorating macroeconomic outlook. JP Morgan's investment management arm's leveraged buyout of South Jersey Industries Inc. for nearly $8 billion, announced in February 2022, was the year's biggest private acquisition in the sector, according to S&P Global Market Intelligence data.  

A growing number of US investor-owned utilities, including Dominion Energy Inc., Duke Energy Corp. and FirstEnergy Corp., are considering selling — or actively shopping for — renewable assets or minority stakes in regulated subsidiaries to minimize future external capital market needs, creating possible buying opportunities in 2023.  

Hurricane Swells Ahead

The majority of private equity growth has been in a long, low interest rate environment. Even the pandemic did not hold it back. After a brief pause in 2020 due to the onset of COVID-19, the industry roared back, setting new annual records for exits and entries. Fundraising for private equity and venture capital firms topped $1 trillion in 2021, another high-water mark for the year.  

The party ended just a few months into 2022 with the onset of the Russia–Ukraine war, which rattled supply chains and fed a global wave of inflation. In June, the US Federal Reserve unveiled a 75-basis-point rate hike, followed by other central banks, bringing the era of cheap money to a halt. Suddenly, debt became harder to come by and more expensive, and it was clear that the shift that undermined the economics of the traditional leveraged buyout was here to stay for the foreseeable future. 

By year-end, private equity activity was down across several key metrics including entries into new investments, fundraising and exits. Collectively, private equity firms posted almost 20% fewer technology deals in the second half of 2022 compared with the same period in 2021. The nature of acquisitions changed, with smaller bolt-on deals accounting for 71% of all private equity buys in the space in 2022.  

The difficulty in financing larger deals is a critical driver of the drop, as is the pressure to boost return profiles with smaller, more affordable transactions following the spate of large-scale, expensive deals that defined 2021 and early 2022.