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Writer's pictureCorley Randolph

Private Equity's Record-Setting Performance is About to End: What You Need to Know


Private equity is having a tough time right now. A recent report from Preqin says that the "current bull market for private equity is set to come to an end in the next two years." This is because of inflation and asset values, which have caused deal pipelines to slow down and led to a decrease in exit and fund-raising activity. If you're someone who's been thinking about getting into private equity, now is the time to do it!

The private equity industry has enjoyed 18 months of record-breaking performance, but the next 18 are shaping up to be considerably more challenging. Inflation is topping 9% and stock markets are skidding. Interest rates are sharply rising. The challenges facing the industry are numerous and daunting, but there are also opportunities to be seized. Private equity firms that are able to adapt to the new environment will be well positioned to take advantage of the opportunities that exist.


We can't predict the future, but it looks like we might be coming to the end of the business cycle. Private markets are already slowing down.

Some smart investors are paying attention to how long inflation has been going up. They are looking at the pattern since 1956. A sharp rise in prices makes people buy less and sometimes the Federal Reserve does this by raising interest rates. But this is not a forecast and it is not sure that the pattern will happen again now. If we take the average time it takes for these events to happen and apply it to today, then the current inflation could cause a recession that starts in September, reaches its peak in October, and goes back down to the long-term trend by September 2023.


If companies are not already running inflation and recession scenarios against the companies they own or are looking to buy, they may have trouble. This is because an industry that has never had to cope with surging inflation before is suddenly getting a crash course in how to manage through it.

Inflation-recession cycles can be short. The long-term outlook for private equity is good. (LPs) have signaled they want to keep giving money to PE firms. This is because PE returns are better than other asset classes. With $3.6 trillion, GPs can wait out a downturn and be ready for the recovery. This could mean opportunity for deals done during a recession which tend to have good returns.


There are likely to be some bumps in the short-term. Let's take a look at what we can expect in the first half of the data.


Investments

Globally, private equity has generated $512 billion worth of buyout deals in the first half of 2022. This puts it on track to produce the second-highest annual total ever (behind 2021's all-time record). The 18-month total of $1.7 trillion is by far the strongest year and a half in the industry's history. Average deal size remained close to $1 billion in the first half, and deal count was robust.


The market is slowing down and it is harder to get deals done. Banks are asking more questions about a company's exposure to inflation and rising rates. This makes it harder for buyers and sellers to agree on a price. Buyers are looking for lower prices and sellers are waiting for a better time to sell.

The market's recent surge has been led by US and tech investors. However, they are the most sensitive to uncertainty around inflation and technology valuations. Europe is less sensitive to tech trends, but it faces its own problems like inflation concerns and disruption associated with the war in Ukraine, particularly in energy markets. Asia is a mixed bag. Covid-19–related shutdowns in China, the largest PE market in the region, have roiled deal markets. Yet other markets, such as South Korea and Japan, are holding up well so far.


Getting Out

Public market woes have already impacted exits. This is because the market for initial public offerings (IPOs) has almost dried up. Global buyout-backed exit value was $338 billion in the first six months of the year. This is a decline of 37% from the same period a year ago. Global IPO value including buyout-backed and other, came in at $91 billion. This is a 73% decline vs. the first half of 2021. As this period of turbulence wears on, the slowdown will likely extend to exits across the board. Notably, the first-half buyout number does not include exits in growth equity and venture capital investments, where the drop in technology valuations will have the largest impact.

There has been some controversy around the growth of secondaries. Critics say that these deals are happening too early in the hold period and disproportionately benefit GPs. Despite this, secondaries are expected to keep growing as GPs and LPs seek liquidity in a stagnant deal market. The question is whether market mechanisms will work to make the terms more equitable as scrutiny increases and GPs feel more pressure to get deals done.


Fund-raising

A number of large funds were still able to close during the first half of 2022. However, global fund-raising showed a sharp decline, especially among buyout funds. Private capital raised globally came in at $645 billion vs. $789 billion during the first half of 2021. Buyout fund-raising dropped from $284 billion to $138 billion for the same time period

The decline was predictable given the record-setting pace of fund-raising in recent years. GPs have been circling back for cash and ever larger funds at an accelerating pace in recent years (every two years vs. every four). Yet the recent squeeze on exits has reduced the amount of cash flowing back to LPs. And the prospect of a recession, which could force GPs to hold onto assets longer, is causing LPs to rethink commitments in the short term. There’s also the “denominator effect,” stemming from the fact that declines in public valuations have yet to be fully matched by private marks. That magnifies PE's slice of an LP's overall asset allocation pie (and therefore discourages new investments).


Storm Management

What does this turbulent short-term outlook mean for fund managers? Investors remain strongly committed to private equity, and they have learned from past experiences that it is best to wait out the storm. If the economy tips toward recession, it will have an impact on the internal rate of return from investments made during the downturn. However, the IRR from investments made during recovery years has consistently outperformed long-term averages, especially investments in top-quartile deals.


This doesn't mean that it will be easy to manage through this period of inflation. As we discussed in Bain's Global Private Equity Report 2022, when interest rates go up, asset prices usually go down. This means that the current environment is a double threat for fund managers. They have to worry about two things- the cost of things going up for their portfolio companies and the fact that investors are not going to be willing to pay as much for companies during this time period. Because of this, top-tier funds are already preparing by getting their portfolio companies ready for rising prices and changing how they do due diligence to account for all the risks associated with inflation.


In order to be successful in today's market, you will need to control what you can. This means making sure that the company makes more money, keeps the same (or more) profit, and manages cash well. You will also need to help the company prepare for the future. This includes making sure that they focus on things like the environment, social responsibility, and good corporate governance. In a time of inflation, businesses will have to do a lot more research before they make any decisions.


Proactive management will be key to weathering the turbulence and taking advantage of the recovery. PE firms need to focus on creating value through nuts-and-bolts operations, not rely on unsustainable multiple expansion. Those that can do this effectively will be best positioned to succeed in the coming years. Have you seen any examples of top-tier performance in your industry? Let us know in the comments below!

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