Down but not out
The role of Private Equity in the coming cycle
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It’s been a tough year for private equity firms. As an indication of how far deal activity is down this year, one of the largest service providers told us that they had onboarded just 15 new European loans so far this year, compared to 55 last year, and one well known private equity firm told us they haven’t closed one deal yet this year.
The deterioration of asset values coupled with a lack of activity and an arduous capital raising environment has posed an existential question for private equity companies. Singapore’s GIC, one of the world’s largest institutional investors and a major supporter of buyout funds, went as far as to say that the golden age for private equity firms is over. Jeffrey Jaensubhakij, the Chief Investment Officer put it “Many of the things that were tailwinds for the private equity industry have come to an end…and I don’t think they are coming back any time soon.” He identified both a supply and a demand problem: not enough assets available at good prices, and a lot of investors keen on investing in this kind of asset. Industry stalwarts agree. Industry veteran and CEO of Apollo Global Management, Marc Rowan, claimed that the phase has come to an end for the $4tn industry and that it could no longer rely on asset values consistently going up to drive returns anymore.
The next era for private equity will be a massive wave of consolidation thinks David Layton, chief executive of Partners Group which oversees assets of $142bn, shrinking the number of private market fund managers to as few as 100 next-generation platforms that matter over the next decade. Private markets are evolving into a more mature and consolidated phase, according to Layton. Economic challenges are pushing managers to seek growth through wealthy individual clients; this shift is expected to trigger a surge in mergers and acquisitions and only the big players can weather these changes. At the end of December, illiquid private market strategies held about $12tn in assets. However, total private markets fundraising saw an 8.5% dip to $1.5tn last year, with net inflows into private equity managers down 7.9% to $677bn in 2022. Smaller private equity managers are finding it increasingly challenging to attract new business. The top 25 largest competitors have captured over a third of the $506bn new capital allocated to private equity so far this year. Layton added: “There is a real bifurcation between the managers that can raise money and those that cannot.”
Supra-regulatory bodies are wading in and activating the brake-pads. The chair of the International Organization of Securities Commissions (Iosco) Jean-Paul Servais warned that executives in private equity and private debt may be too relaxed about the growing risks in their industry. Their research suggested that the $12tn market, covering private equity, venture capital, and real estate, could be tested in ways that “uncover hidden risks” over the coming years. Higher interest rates, it said, threatened defaults that could put pressure on opaque valuations in a corner of the market subject to far less regulatory scrutiny than the banking sector. “There is a degree of nervousness out there but also, frankly speaking, a little too much confidence that all will be fine,” Jean-Paul told the FT.
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More regulation in private equity may also be on the way. The US Securities and Exchange Commission is preparing to impose tough rules. The far-reaching rules require detailed quarterly reporting on performance, prohibit secret side deals that give better terms to some investors and limit what expenses private managers can pass on to their clients. “For the first time, really, the SEC, especially in the institutional space, [would be] effectively dictating what terms you can and can’t give in the context of institutional arrangements between private fund managers and their investors,” said Christine Lombardo, an attorney at Morgan Lewis.
In this more humble era, private-equity managers might have to ditch their habit of chasing the same targets. Over the past decade, around 40% of sales of portfolio firms were to another private-equity fund. Some private equity firms are even handing over struggling companies to their rivals' lending arms. This trend also points to the rising influence of credit offered by lending branches of these major private equity firms. In recent years, providing credit has been a faster-growing business than buyouts for many big names in the industry like Apollo, Carlyle, and KKR. To reinforce this point, Goldman Sachs just announced the accumulation of a $15bn private equity fund, not to buy companies, but to buy limited partner interests in other funds, a transaction known as a secondaries which we touched upon in a previous note.
Fundraising is tough, in the first half of this year, the total private capital raised globally fell sharply to $517 billion, marking a 35% decrease compared to the same period last year. For the full year, there's a projected decline of 28% in value and 43% in the number of funds closed when compared to 2022. It’s worth noting that these fundraising numbers are a lagging indicator that might make the current environment seem better than what GPs are actually experiencing on the road. Many funds closing now were planned and committed to during more favourable times in 2021 or 2022. A more forward-looking indicator is the current level of supply and demand. On numbers provided by Preqin, Bain & Company’s Private Equity Midyear Report 2023 demonstrated that there are 13,931 funds globally seeking approximately $3.3trn in new capital. Yet based on first-half results, only around $1trn in LP allocations will be available. Put more simply, every $3 of current demand in the market is chasing just $1 of supply. This imbalance is the worst it’s been since the global financial crisis, and it may not improve in 2024 since many LPs may be pulling forward next year’s allocations to fund things that they find attractive today.
In the face of such a tough fund-raising environment, firms are increasingly offering sweeteners such as fee discounts to secure backing from deep-pocketed investors. Blue-chip firms including CVC Capital Partners, Ardian, TPG and Cinven have all in recent months offered investors either a discount on management fees or other incentives such as larger amounts of so-called co-investment, which enables investors to get a bigger slice of individual deals without paying a fee, according to people familiar with the matter and fund marketing documents.
Distress does bring its own opportunities though. “We think there’s a real opportunity to deploy more capital,” said Blackstone President and COO Jonathan Gray, “I think the private credit area is really at a golden moment because we do see tightening out there.” In real estate, capital is being raised, if not on the same scale as in previous vintages. KKR launched its third European real estate opportunity fund, KKR Real Estate Partners Europe III. While the equity target wasn't specified, the previous European fund raised $2.2bn (￡1.7bn) during its 2021 close. That fund had invested $1.4bn as of March this year while producing a gross internal rate of return of 6% on assets it sold. Likewise, Carlyle is actively fundraising for its European real estate fund, receiving a $75m commitment from the Indiana Public Retirement System for Carlyle Europe Realty II. While Blackstone is eyeing a substantial €10bn for its seventh European real estate fund, Blackstone Real Estate Partners Europe VII, it raised the same amount for its sixth European fund in late 2019. As of March, it had spent about €5bn of that equity on deals totalling €9bn, including debt. That fund has a net IRR of 20% so far.
Norges Bank Investment Management in a discussion note empirically quantified the alpha private equity firms generate. Comparing private equity fund cash flows with identically timed investments in public stocks, they found that buyouts have consistently performed better than public equities, with an annual outperformance of 3-4pp on average. On the flip side, they found that venture capital and growth equity have lagged behind, with an average underperformance of 1-2pp. They also find that performance in private equity isn't consistent and greatly relies on strategy, timing, and manager choice, suggesting that investors must carefully assess and choose their private equity approach and funds.
One steely private equity boss likes to remind his investors that a buyer of Microsoft shares in the months before the dotcom bubble burst in 2000 would have had to wait until 2015 to break even. Timing is everything, particularly in real estate, and the scorecard in the form of quarterly valuations is an unreliable barometer of long term performance. A new study entitled Should You Launch Products During a Recession by Harvard Business School, found that products launched during recessions outperform those launched in non-recessionary times and even survive longer (14% longer on average in the UK), predominantly because “there is less noise in the marketplace, making it easier to differentiate products and draw consumers’ attention.” For those funds with access to capital, this will be an excellent vintage.