The challenges facing the Private Equity industry in 2022

As I look forward to returning to ESSEC Business School in September 2022 to teach my own course to students, and ahead of the summer break, I would like to share with you some of my thoughts on the Private Equity market and the challenges it will face from September 2022 onwards.

I was lucky enough to start my professional career working in investment funds involved in Private Equity:

• Private equity growth capital,
• Private debt,
• Fund of funds (secondary investments and co-investments)

The importance of the Private Equity industry is no longer in doubt. This industry is fertile with development and jobs and investment funds have become indispensable in the structuring of several sectors.

Moreover, Private Equity as an asset class has been transformed to meet the growing demand of investors (both private and institutional investors), and it is now difficult not to find a niche (sectoral or strategic) that is not covered by a dedicated investment fund. I refer readers of this article to the publications produced by the official private equity associations (such as France Invest in France).

The turmoil in the public equity markets has not yet reached the private equity industry. Fundraising rounds continue to be announced (to a more limited extent in the venture capital ecosystem) and large deals continue to be closed.

However, there are several endogenous and exogenous factors, which are already identifiable, that lead me to write this article. The aim is not to make an alarming observation but to present the challenges that the industry will have to overcome.

It should be remembered that the value creation promised to shareholders (or "Limited Partners", "LPs") is based on three main levers commonly accepted by the financial community:

1. Growth (of EBITDA), whether organic or external;
2. Leverage (or deleveraging) i.e. the ability of a portfolio company to repay its LBO debt;
3. The "market" effect (or multiple expansion lever), which consists of selling at a higher multiple than that of the initial acquisition.

Economists agree that our economic world has not experienced a boom and bust cycle like the one we are currently experiencing.

Yet the levers of growth, deleveraging and market effect are directly targeted by the slow growth and high inflation that lies ahead. This poses several challenges to the private equity industry: will they be overcome? It is up to the industry professionals to answer this in their own way. What is certain is that it will be all the more differentiating for these players to be able to provide LPs with a clear response to these dangers.

I.????????Expansion cycle (or "Bull Market" see photo)

I am part of a very lucky generation in France that has experienced the exponential expansion of assets under management in the Private Equity industry. The Economist in its latest article states that the Private Equity industry has grown from $1.3 trillion in 2009 to $4.6 trillion today.

This increase is evidence of the (growing) interest of the private and institutional investment community in a proven alternative asset class. This appetite for private equity is also a direct consequence of the monetary policies pursued by the FED and the ECB with historically low interest rate policies following the financial crisis of 2007-2009.

Recent analyses of value creation agree on one thing: value creation has been driven mainly by inflation in multiples (and therefore in assets) rather than by growth or the ability of companies to deleverage.

Low interest rates are bringing more and more liquidity to the private equity market, which is driving up asset prices significantly in competitive acquisition processes (auctions).

The value of an asset thus deviates from its intrinsic value due to a windfall effect. This windfall effect is even more pronounced when private capital is directed towards industries with the most wind in their sails: technology, health, education, etc. Company acquisition multiples are at record highs (exceeding the multiples recorded in 2007).

II.???????Waiting for the slowdown

The private equity market, unlike the directly listed markets (listed securities), benefits from a time lag. Indeed, the illiquidity of private equity assets (although reduced by the development of the secondary market) leads to a time lag between the actual performance of the assets under management and that communicated by the funds.

Mechanically, the net asset value (or NAV) of private equity funds can present a significant risk of deviation from the real value of these assets. Without going into detail about the methods of determining the NAV, most depend on a mix of valuations including multiples of comparable transactions or multiples of comparable companies whose information is available (therefore public).

In terms of valuation, how can we rely on what is comparable when the period ahead is unprecedented in economic history?

How will fund managers who have positioned themselves on very expensive transactions (at very high transaction multiples) manage to achieve their value creation thesis?

It is a safe bet that only managers who have maintained investment discipline outside of inflationary sectors will survive the impairment tests that await their portfolio holdings.

III.??????Why should we not despair?

The major private equity houses in France (note that this is not a criterion of size but of competence) cannot be reduced to traders of unlisted companies who rely solely on buying at a low price and selling at a high price to achieve their value creation thesis.

However, the bosses of these Houses will have to arm themselves to accompany these companies under management, which will be navigating (are already navigating?) in a period of stagflation: pressure on margins and weak growth.

How do you defend the profitability of a portfolio company?

How to preserve existing growth channels?

How do you restructure a company that is no longer growing, especially since these companies are most often overleveraged?

How to achieve the value creation thesis promised to investors (or "LPs") in a context where leverage is no longer as easy as it used to be with lower cash generation and increasingly expensive LBO debt?

So many questions that we hope only the most talented managers (students, young professionals, advisors or investors) will be able to answer! Private equity, with its agility, can be a real solution in times of economic downturn.

Alexis Fontana Mu?oz - Certified Accountant and soon-to-be lecturer in Corporate Finance