The distance between top-performing private equity funds and the also-rans is likely to grow as firms avoid exiting investments in an unsettled market and hold onto portfolio companies longer.
These longer hold periods will test private equity firms' value-creation strategies, potentially rewarding skilled operators and revealing the fund managers who relied too heavily on financial engineering to goose returns. The rising global economic tide that lifted corporate valuations and buoyed private equity performance went out in 2022.
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"The more leverage you put on, the better you did. And it was never tested," said Bob Belke, a managing partner at Lovell Minnick Partners LLC and chair of the firm's investment committee.
Now private equity owners must contend with slower growth, spiking inflation and rising interest rates.
"This is an environment where there will be haves and have-nots," Belke said, adding that over-levered investments can quickly turn distressed in a downturn.
Private equity portfolio companies burdened with a heavy debt load are also less nimble and less able to take advantage of the growth opportunities that appear during times of disruption, said Ben Russell, a senior vice president at global investment firm Partners Group Holding AG.
"Managers that have historically been very successful in just a rising tide and cheap and available leverage, I think, are really going to suffer," Russell said.
A correction or something more?
While trade sales remained relatively strong, other exit routes slumped, and private equity-backed IPOs all but disappeared compared with a year earlier. Overall exit activity fell by nearly one-third from the record $576.37 in 2021, totaling $391.44 billion for the year, according to Preqin. The private markets data source is projecting depressed exit activity over the next few years as slower global economic growth hinders private equity performance.
That's not an entirely bad thing, said Cameron Joyce, deputy head of research insights for Preqin, describing the industry's 2021 surge as "unsustainable."
"To a large extent, the corrections that we've seen in 2022 are quite healthy because we've taken a lot of the excess out of the market," Joyce said.
Instead, if you ignore 2021, the record-setting outlier in terms of private equity dealmaking, the trajectory for secondary and trade sales looks more like a return to trends seen before then, Joyce said.
Global private equity exit value in 2022 finished well ahead of 2019 and 2020 and just behind the mark set in 2018, according to Preqin.
Recent shifts in private equity markets may be more than a correction, Joyce said. They could signal the end of one long-term cycle and the transition to another, one marked by downward pressure on valuation multiples and tightened financing conditions. Either way, unsettled markets and an uncertain economic outlook have widened the bid-ask spread and slowed private equity dealmaking.
"Getting a price point where a transaction can be done is becoming more difficult, and that's why people are more likely to sit on the sidelines in this environment," he said.
Active ownership
Lovell Minnick Partners' Belke said longer hold times have a potential benefit for private equity firms, in so far as it gives them more time to grow the value of their portfolio companies. But tough economic conditions also require a higher level of commitment from firms.
"You're steering companies through what is likely to be a more challenging time, so you get much more actively involved when you're working through those periods of change," he said.
Russell said longer ownership periods reward those firms with their finger on the pulse of the work culture in their portfolio companies, adding that lower levels of employee attrition and turnover tend to boost investment performance.
"We've put a tremendous amount of emphasis on how we get that employee engagement. Is that through larger management incentive pools or equity incentive pools? Is that through a flexible work arrangement? Sometimes it's just small things," he said. "Providing access for employees, even if you're a large company, to the CEO — that can go a long way."
How firms enter this period of longer portfolio company hold times is critical. Firms that used high levels of debt to win prized assets at inflated valuations will not be able to react as quickly as those that "remained disciplined around leverage and pricing," Belke said.
"You may still have capacity for leverage — to be able to do an add-on acquisition, for instance. You might still be able to draw on the financing markets in many of your companies when others can't," he said. "Be aggressive and do the things that your competitors are not doing. You come out on the other end much, much stronger, and you emerge the winner."
A dilemma for investors
Extended portfolio company hold times are not without their consequences, however, and can impact the entire investment cycle, including a firm's ability to raise new capital. For one, they delay the return of capital to investors via distributions.
That delay in distributions is one of several factors gumming up private equity's fundraising cycle, which Preqin, in its recently released five-year outlook report for private markets, predicts will "slow considerably" before returning to a modest pace of year-over-year growth in 2024. When fundraising slows, so does the creation of new funds and the deployment of capital into new investments.
That poses a dilemma for the institutional investors — mainly public pension funds, endowment, sovereign wealth funds — who are private equity's primary source of capital, said Mark Perry, head of alternative manager research at Wilshire Advisors LLC.
"We all know that periods of market dislocation are great vintage years to be putting out capital," Perry said.
Market dislocations create an opportunity for private equity to enter investments at a low point in the economic cycle. They can acquire businesses at a discount, hold them for a few years and, if all goes well, exit when the economic cycle has turned up again.
In between entry and exit, Perry added, expert managers can go "on offense," taking advantage of weakened competitors to grow market share.
"Times of dislocation can be fantastic times to deploy capital with the right managers with the right skill sets with the right strategies that can embrace this complexity and try to capitalize on it," he said.