A Bend in the Road: What’s Next for Investors’ Private Equity Love Story?

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Earlier this month, I had the chance to spend time with John Beil. John is Partners Capital’s Global Head of Private Equity. John was reflecting on the past couple of years and setting the course for how we invest in Private Equity in the years ahead. This newsletter is a synthesis of the most interesting parts of our discussion. After reflecting on a number of structural issues with the model adopted by most Private Equity GPs, John expands on where he sees opportunities going forward – including the lower middle market, co-investments and a focus on operational value-add. His view is that today is a great time to be focused on making the right type of Private Equity investments and that this is a once in a market cycle opportunity for LPs to rebalance their portfolios, partner with previously access-constrained managers, and allocate to strategies with strong tailwinds, such as secondaries or energy transition.

?Emmanuel Pitsilis: We hear a lot of negative commentary about the Private Equity market and its future in the press. Reliance on leverage for returns is often mentioned in the context of higher interest rates; this is just one example. Do you agree with some of the issues that are mentioned?

John Beil: I do agree that parts of the industry are and will be facing issues. We are coming out of a decade-long period of low interest rates and ever-increasing purchase price multiples. These boosted the availability of capital and the performance of both buy-out and venture capital. As you’ve mentioned several times in previous newsletters, this Goldilocks’ era is over, and we are likely to enter a period of more elevated and more volatile inflation. In addition, we have seen material multiple expansion across Private Equity over the past 10 years with a peak during the Covid crisis. This was particularly acute in the large buy-out market (see Chart 1). This was also unsustainable.

Chart 1: Multiple expansion, especially in the large buy-out market

Entry price EBITDA multiples, 2013-2023

What is more structural is that many GPs (and LPs along with them) have been riding this cyclical boon and misconstrued this for sustainable Private Equity capabilities. In reality, many firms have not built the required value creation capabilities to justify their fees. Similarly, few LPs have been focused on identifying, evaluating and measuring their LPs performance in driving operational improvements at their portfolio companies. In a context where an unprecedented amount of dry powder is chasing fewer opportunities (USD2.6T as of July 2024[1]), this has put significant pressure on a large share of the industry.

EP: What about existing portfolios, how much pressure do you see with existing investments and how deep will be the impact on returns for investors? Where do you think we are today in the repricing cycle?

JB: Yes, we have seen material pressure on existing portfolios. On the positive side, managers continue to report strong revenue and EBIDTA growth from their investee companies in line with strong economic resilience, especially in the US. Sample surveys[2] report that PE firms generated positive earnings growth throughout most of 2022 and 2023. Specifically, throughout 2022 and 2023, companies in these surveys have shown broadly between 1.5 and 3% EBIDTA growth. Through conversation with managers, there is anecdotal evidence that, outside of areas of stress (e.g., parts of the ventures market), the performance of investee companies has not been affected materially.

The issue is that exit activity has declined substantially – in the US, exits have declined by 24% in 2023 vs. 2022 and by close to 75% vs. the 2021 peak. This represents a close to 40% decline vs. the pre-pandemic peak in 2017[3]. This lack of activity means that sponsors are holding assets for materially longer. In 2023, the median company exit in the US occurred after an all-time high 6.4 years according to Pitchbook. So, while cash multiples on exits are likely to hold, IRRs for recent vintages may continue to compress. Many sponsors, particularly those in the large and mega cap market, overpaid for assets in the 2019-2022 vintages and will likely experience multiple compression upon exit. This will further erode returns for deals done at the peak of the market cycle.

Today, we believe the market has largely reset. Managers are acquiring assets at lower purchase price multiples and incorporating both a higher cost and lower availability of debt into their underwriting models. While there is still significant macroeconomic and geopolitical uncertainty across the globe, we are cautiously optimistic that the current vintage of funds is poised for strong performance, similar to what the market experienced after both the dot-com crisis and global financial crisis.

EP: So, what does it mean concretely for IRRs on some of the current holdings in existing portfolios?

JB: This is really guess work at the market level but we can quantify the combined impact of multiple compression, higher cost of debt and longer holding periods. In some of our analysis, we have seen that portfolios that were expected to return gross IRRs slightly north of 20% now would return slightly higher than 10% based on an increase of cost of debt by roughly five percent, a holding period increasing from 5 to 7 years and a multiple compression between entry and exit of about 15%[4]. It does not mean that all portfolios and all vintages will be affected to the same extent of course; we still expect that best in class GPs, in particular those focused on operational value add and more inefficient segments of the market (e.g., lower middle market) have the potential to generate significant excess returns versus the broader PE market. ?It just illustrates though how a lot of LPs need to reset expectations about some of the most recent vintages they may be invested in already.

EP: This is backward looking. Looking forward, doesn’t this also create attractive opportunities for nimble investors?

JB: Yes. We have found not one but many silver linings in the current market environment. Some of these opportunities are cyclical. Some are more structural. I will mention four cyclical examples. To start with, parts of the secondaries market, especially LP driven deals[5], are more attractive than in previous years. This is especially true for the smaller end that is less competed by large firms operating in the secondaries market. We still see discounts of 10-15% for lower middle market funds compared to 5-10% for large cap funds. Second, there is also an immediate opportunity for LPs with flexibility to access some of the best GPs that were previously closed to new LPs but whose current investor base is grappling with over-exposure to Private Equity and lack of liquidity. Third, there is a compelling opportunity in the primary market to 'buy complexity’,?investing in buy-out funds that can take advantage of business or process complexity to acquire fundamentally sound assets at discounted prices – often from other Private Equity firms. Finally, there is an opportunity to increase allocations to co-investments to reduce the j-curve, minimise fees, and create opportunities for deal selection alpha. This is actually not only a cyclical opportunity: we believe that co-investments are a very important part of any Private Equity portfolio and I know that you talked about it in one of our previous newsletters .

?EP: These are attractive cyclical opportunities. Is there structurally a new model that’s required for Private Equity?

JB: The “new” model exists already but not all LPs have been paying attention. Over the past decade, the Private Equity market returned an attractive beta. We believe and we have believed for a long time that real outperformance in Private Equity requires a different approach and different capabilities from what most firms deliver today.

Most importantly, we believe that earnings growth – whether from revenue growth or margin improvement – is the only sustainable source of value creation for Private Equity buyouts. We believe it will become the largest share of value creation in the years to come (see Chart 2).

Chart 2: Value creation

Median Percent of PE Equity Value Creation, by Year of Exit

Second, we believe that the lower middle market will offer greater alpha generation potential, partly because it taps opportunities from professionalising often under-managed assets and partly because it is a less competed segment. This is true in the US, but it is also true in Europe or Japan where we have followed with attention the development of this previously underdeveloped segment of the market.

Thirdly, we believe that sector specialists have an outsized potential to achieve top quartile returns, particularly those sectors where we believe competitive edge is strongest including software, healthcare, industrials, consumer, and energy transition.? In our experience, sector specialists benefit from several enduring advantages. Superior industry coverage and networks bring better and often proprietary sourcing capabilities. In-depth subject matter understanding makes for better underwriting and pricing capabilities, critical in areas such as technology or healthcare for example. Finally, familiarity with the industry brings “muscle memory” – in-depth operating playbooks accumulated by executing repeatable business plans.??

Putting all this together means that the winning firms of tomorrow will be different from those of the past. Most important, and we mentioned this before in passing, they will possess real and differentiated value creation capabilities. This means different types of talent internally, this means leveraging outsiders differently to transform companies, this also means different underwriting processes and involving the team that will take over the business much earlier on during the deal process. This is what we look for when underwriting new GPs and what we have been looking for for a long time. As a result, we already know that the share of value creation in our own portfolio coming from operational value creation is materially higher than that in the rest of the market. We deal with this in much more depth in a recent white paper on the topic.

EP: Now the question on everybody’s mind is what it means for new deals in 2024 and 2025 vintages?

JB: I unfortunately do not have a crystal ball… We can however look at the recent evolution and extrapolate where we may end up with these vintages. Entry multiples have declined substantially from more than 13 times to slightly lower than 11 times[6] in 2021. Let’s assume that this leads to more sustainable entry valuations but that exit valuations show no multiple expansion going forward. If you assume also that the cost of debt remains elevated but that holding periods revert to the previous mean of around 5 years, you get to gross returns of 16 to 18% in the middle and lower middle market segments, which should translate into 12.5 to 15% post fees[7]. We think that these are sustainable and attractive long-term returns for investors.

EP: Final question, what would be your advice to long-term investors about how to build their Private Equity portfolio?

JB: Beyond everything above? I guess we always have to go back to the most fundamental best practice first. This means building a diversified Private Equity portfolio by consistently investing and committing across vintages. Unless you access an evergreen vehicle to accelerate deployment, you need to factor in 5 to 8 years to build a mature Private Equity portfolio. Trying to do it faster is tantamount to timing markets and can lead to issues as you outlined in a previous newsletter . Diversifying also means accessing more than a handful of managers – think 10 to 20 managers and not 3 to 4. These are the fundamentals. In addition, we think that a well-executed co-investment programme should play an important structural role in a long-term Private Equity portfolio; that there is a cyclical opportunity around secondaries, especially LP-driven secondaries; and that focusing on the middle market broadly defined should generate higher returns over time. Finally, we think that investors should not give up on venture capital despite the difficulties in the current vintages – maybe that’s a topic for a future discussion!

[1] S&P Global Market Intelligence

[2] Lincoln International, Q3 2023 Private Market Index

[3] Pitchbook 2023 Annual US PE Breakdown

[4] Partners Capital analysis

[5] The secondaries market, now a significant part of the industry, includes both GP-led and LP-led transactions offering alternative liquidity solutions. GP-led deals allow General Partners to raise additional capital or to rotate capital through structures like continuation vehicles. LP-led deals provide Limited Partners with opportunities to exit early by selling to other LPs, often at a discount.

[6] 13.0x multiple represents the post-GFC peak multiple. 11.0x multiple represents the current multiple in the DealEdge sample.

[7] Hypothetical return expectations are based on simulations with forward looking assumptions, which have inherent limitations. Such forecasts are not a reliable indicator of future performance.

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