Private equity fundamentals resilient in headwinds

The economy and markets are beset with headwinds, and private equity assets are unlikely to be impervious. The concerns with the asset class are wide-ranging, from difficult financing conditions to rising interest rates, squeezed corporate margins and closed exit routes. 

Given this uncertainty, understandably there are worries around the potential impact on the four key stages of the private equity investment cycle, namely, sourcing opportunities, financing the purchase, managing and adding value to the business, and selling. However, in-depth analysis indicates that these fears could be obscuring the underlying resilience of the asset class. 

Dealflow due bounce

Global private equity deal activity slowed in 2022, and continued market volatility could curtail it further. However, while mergers and acquisitions (M&A) activity has dropped due to the worsening economic climate, deals are still being done, and some of them are sizeable. 

A meaningful uptick in opportunities should also arise as companies sell off divisions to slim down, cut costs and focus activities. Indeed, this year’s slowdown has already brought public equity valuations down to attractive levels for private-equity buyers sitting on substantial dry powder. 

Market weakness may also force more sales from distressed business sellers. It could accelerate the trend of ageing owners selling their family businesses, as younger potential inheritors resist managing a company through tougher times. 

Financing options intact

As for private equity’s financing outlook, data from PitchBook confirms that the sector is sitting on more than $1trn (€930bn) of uninvested capital commitments – close to an all-time high. 

This suggests there is enough dry powder to balance out any upcoming slowdown in fundraising. As such, the key question becomes: given the potentially lower availability and higher costs of debt financing, will investors need to deploy significantly more dry powder for each transaction? Analysis suggests not.  

Firstly, private equity leverage has not been excessive since the global financial crisis. According to S&P data, the average deal was geared at 5.7x earnings in 2014 and 6.8x in the third quarter of 2022, while the average equity cushion was 37% of enterprise value in 2014 and 45% in the third quarter of 2022. 

Secondly, while banks have pulled away from the syndicated loan market, the impact on the broad private equity ecosystem is limited. Private debt funds are still prepared to provide long-term capital if they can get a double-digit yield from a high-quality private company, posing an attractive source of opportunity. In short, while the cost of debt is likely to remain elevated over the coming years, the availability of debt financing should not be a significant issue.

Flexibility permits long-term focus

Regarding the management of private equity investments, current conditions are making it difficult for many businesses to keep costs low, maintain pricing power and sustain margins. For the first time in a long while, management has to contend with the cost of inputs and labour increasing simultaneously with the cost of debt-interest repayments.

However, the industry has changed considerably since it experienced these conditions in the 1980s and 90s. Back then, the leveraged buyout (LBO) strategy was focused on buying companies cheap, leveraging them with debt financing (with interest taxed at a favourable rate), and waiting for the valuation multiple to rise with the market. 

The target companies also tended to be more asset-intensive, cyclical businesses in the industrial sectors. Today, target companies tend to be less asset-intensive and more technology and knowledge-intensive. There is also much less reliance on debt and a greater focus on improving business fundamentals. 

The private equity industry has invested heavily in building what are effectively outsourced management teams. These consist of professionals with skills and experience drawn from the industries in which they invest, who can move into companies with strategic initiatives that quickly add value to the bottom line. 

“Given the potentially lower availability and higher costs of debt financing, will investors need to deploy significantly more dry powder for each transaction? Analysis suggests not”

This hands-on approach aligns well with some of the natural advantages of the private equity business model, where majority or sole ownership makes it easier to share ideas between portfolio companies and change management strategy or personnel. Furthermore, real-time transparency into cash flows is paired with the flexibility to ignore short-term volatility and focus on the long-term plan.

Willing buyers are present

As for exiting investments, there were few IPO exits for private equity deals last year. However, where portfolio businesses still need to be sold to return cash to investors, corporate strategic buyers and other private equity funds remain open to new acquisitions. 

Many of the remaining mature assets are high-quality companies that investors deliberately wish to hold on to through tougher times. Some are being carried over into ‘continuation funds’, where current and new investors can maintain or gain exposure. 

Along with credit and capital solutions, these continuation funds and other general partner-led secondary transactions could present attractive opportunities over the coming year. Indeed, while valuations are likely to decline from the peaks they reached at the beginning of 2022, there are willing buyers for mature assets, and many will have the means to complete deals.

There is a longstanding case for including private equity in a diversified portfolio throughout a cycle. Portfolio companies tend to be faster-growing than their public-listed peers and available at more attractive valuation multiples. Their governance model tends to give them flexibility and make them more responsive to the direction of skilled and engaged owners, and less subject to short-term market sentiment. Unlike many public equity portfolio managers, who must pay attention to the broad market benchmarks, private equity managers can focus on sectors where they have expertise and ignore those where they have no advantage or believe there are headwinds.

Does private equity face difficulties now, as the economic cycle turns? Yes, but the same is true for most asset classes.

All in all, while private equity faces difficulties, these are likely to be overstated. In previous downturns, valuations for existing private equity investments have tended to fall by about half as much as those for public equity. Moreover, new vintages will be putting freshly raised capital to work over the next four or five years, potentially taking advantage of lower acquisition valuations as we go through tougher economic times.

If one is already a private equity investor, it may be risky to turn away now and potentially miss out on future fundraising by the industry’s best firms. At the same time, new investors into the asset class may be investing just as the industry is deploying its skills to the fullest, in a buyers’ market of declining valuations.

Manuel Kalbreier is head of alternative specialists, EMEA, at Neuberger Berman