Private Equity in Volatile Times: 4 Trends to Keep an Eye on

In an environment of constantly rising asset prices and where money has been incredibly cheap, generating strong performance was comparatively easy all across the board. But with inflation hitting record highs in many countries and interest rates rising for the first time in years, uncertainty has returned with a vengeance to financial markets. There has been plenty of talk in the industry when and to what extend the recent drawdown in public markets could affect private markets.

A few thoughts on what the current environment means for private equity.

1.???Fundraising-Environment

Facing the current mix of geopolitical risks, supply chain issues, high inflation and rising interest rates, investors are anticipating a long-awaited recession and acting more cautious than in previous years. This somehow divides the private equity industry into two increasingly unequal parts: The majority of market participants are experiencing prolonged fundraising processes in order to reach target volumes. On the other side there is an ever-smaller group of top performers who continue to finish their fundraising heavily oversubscribed and in record time. Basically, demand for alternative investments remains high, but investors are becoming more selective and increasingly turning to funds that have already proven their operational expertise in past crises. As a result, competition for top-tier funds gets even fiercer.

2.???Dry Powder

Due to the strong fundraising in recent years, dry powder remains a hot topic. The very large amount of uninvested capital is a major contributor to the fact that entry prices for many private equity transactions remain high despite the recent volatility in public markets.

In search of attractive niches, it is worth taking a look at the details: The dry powder is distributed primarily among funds in the larger end of the market, where vast amount of capital faces few potential investments. Entry multiples are correspondingly higher there, which has a negative impact on the managers' return expectations. We continue to see a healthier relationship between capital and the number of possible investment targets in the small- and mid-cap segment, where entry multiples are correspondingly lower.

3.???Interest rate turnaround and inflation

The European Central Bank has announced its first interest rate step for the end of July, while the U.S. central bank Federal Reserve already reacted to soaring inflation with its biggest interest rate hike since 1994. This turning point in monetary policy will of course affect all asset classes. For private equity, rising financing costs are particularly relevant as well as the growing pressure on company valuations due to the higher discounting of future cash flows. Rising financing costs could become a problem especially for fund managers who have made particularly intensive use of the favorable credit conditions in recent years and have increasingly worked with leverage.

Persistently high inflation is putting the focus on companies with strong unique selling propositions that can more easily pass on price increases to their customers. The experience and expertise of fund managers with regard to pricing strategies is thus becoming increasingly important. ?

Demand is therefore shifting towards funds that generate returns primarily through operational enhancements and top line growth. They typically have teams with deep sector expertise and many years of experience in the operational and strategic development of companies.

4.???Sustainability

Ten years ago, sustainability played at best a marginal role for the masses at industry meetings. That has changed fundamentally: Now ESG topics are omnipresent - and nearly all investors agree that not only sustainability risks but also corresponding value creation opportunities are an essential part of any due diligence process.

The biggest challenge for private equity investors is the variety and quality of available data. While legislators are increasingly raising pressure on market participants, there is still a lack of standards. As for now, there exists a wide range of different ESG approaches, questionnaires and performance metrics. We are most likely to see consolidation in the near future. While it is not yet foreseeable which ESG standards will prevail in the long term, it is certain that the trend towards responsible investment is irrevocable. Thus, all market participants must take this into account and further evolve in this regard.