Pressure is building on private equity fund managers to act on a backlog of delayed portfolio company exits, particularly for those managers with near-term fundraising ambitions.
Private equity exit activity continued to rebound in the third quarter after falling dramatically in 2022 amid inflation, rising interest rates and recession fears that combined to drive a wedge between buyers and sellers. Still, even after three consecutive quarters of increasing private equity (PE) exits, the consequences of last year's slowdown can be seen in the lengthening holding periods for portfolio companies.
Holding periods this year through Nov. 15 were, on average, 7.1 years between buyout and exit of a US or Canadian portfolio company, according to Preqin. That is longer than any annual average buyout holding period since at least 2000, and compares to an average hold time ranging from 5.1 years to 5.9 years between 2010 and 2022.
"I'm alarmed. I haven't seen it this bad, period," said Greg Turk, who until July was director of investments for Teachers' Retirement System of the State of Illinois, a public pension fund managing close to $65 billion in assets.
Potential triggers
Private equity at midyear held a record $2.49 trillion in dry powder, or capital raised but not yet invested. However, the dry powder is not evenly distributed across the industry, said Golub Capital LLC President David Golub.
"There are many firms that are either at or near a point where they need to go back [to investors] to replenish their dry powder. Those firms are going to feel more pressure to sell some of their portfolio companies to realize some winners in order and be able to return capital [to investors]," he said.
Golub said a second potential catalyst for deal activity is a looming change in tax rates for capital gains. He noted a Trump-era tax cut that lowered the top capital gains rate is set to expire in 2025, and business owners aiming to beat the deadline and lock in a lower rate could prompt a wave of sales in late 2024.
A third factor is less uncertainty in the macroeconomic outlook. As the global wave of inflation and central bank rate hikes in 2022, which prompted fears of a recession, fades, the easier it becomes for buyers and sellers to see eye to eye on a deal.
"But it could very easily take another five months before we see really significant improvement in PE-backed activity," Golub said.
Growing urgency
Longer holding periods are also creating complications for private equity investors, also known as limited partners (LPs). While a PE fund's life cycle may play out over a decade or more, the investments in individual portfolio companies are expected to run between three and five years in most cases, Turk said. Exits return cash to LPs in the form of distributions.
“That's where the gears get a little bit messed up — when you're anticipating returns and you're not getting your capital back,” he said.
Turk said many large institutional LPs with mature PE portfolios expect them to be "self-sustaining," meaning new fund commitments are largely funded via distributions. As holding times extend to six years and beyond, it disrupts the pacing of distributions and commitments and "forces investors to really think about deploying less," he said.
"If we don't get a flood of transactional activity in the first half of [2024], I'd be a little surprised, and I think that's when my alarm bells would probably go off a little more," Turk said.