Vive le Private Equity
In short:
- The private equity market has tripled to $6 trillion compared to the last decade.
- The industry persevered and showed its strength despite the pandemic.
- However, current inflation and high interest rates negatively impact the private equity sector, observing a 26% decline in volume compared to 2021.
- Due to ample dry powder, analysis of the past, and strong commitment towards the sector, it seems to be securing a promising future.
Record-high inflation, falling stock prices and rising interest rates. How does this affect the private equity industry now and in the future?
Recently, the private equity sector has demonstrated record-breaking performances. Compared to the last decade, the size of the private equity market has now tripled, from nearly $2 trillion in 2010 to over $6 trillion towards the end of 2021. Despite the pandemic, the sector has persevered and showed resilience. Now the question is how the private equity sector performed this year, and if this upward trajectory of the last decade will continue for the years to come.
Almost everything went in the right direction for the buyout industry’s billionaire executives so far. It usually does when stock prices are high and interest rates are low. Blackstone, the biggest private equity firm, increased their assets under management by 42% last year. However, as we have been noticing for a while now, the rates are rising. Thus now, the model of private equity firms is facing one the biggest challenges ever since the last financial crisis in 2008.
Understanding Private Equity
Before going deeper into the performance of the private equity industry, it might be useful to understand what private equity is and briefly go through its dynamics.
Private Equity (PE) refers to investment funds, usually organized as limited partnerships. PE firms acquire companies and overhaul them to obtain a profit when the business is sold again. The term ‘private’ in private equity typically entails capital provided outside the public markets and comes from outside investors normally supplemented by debt, meaning these firms are highly leveraged. PE funds might acquire either private or public companies, or invest in buyouts. PE firms, however, do not hold stakes in companies that are listed in the stock market.
The main objective of PE firms is to invest in mature companies, in lieu of start-ups. The reason for this is that they can sustain their portfolio companies so that their worth can be augmented before exiting the investment in a couple of years.
How PE creates value
Before pursuing a deal, a private equity firm has predetermined how it plans to increase the investment’s worth. Examples of this could be significant cost cuts or restructuring. There could be three particular ways to create value, namely, multiple expansion, leverage and operational improvements directed at augmenting revenues and/or margins. The most distinct and popular source in the 1980s was leverage – which now has been shifted away from as a source of value creation. As seen in figure 1, in the last decade, operational improvements have turned out to be preferable as many fund managers believe that the transformation of businesses has the ability to result in more sustainable ways to create value – which can then draw a higher exit premium.
Figure 1: PE has shifted away from leverage as share of value creation
Source: Goldman Sachs BCG-IESE estimate
Metrics for equity valuation must be collected, such as price-to-earnings, price-to-sales, price-to-book and price-to-free cash flow. In order to comprehend the target firm’s enterprise value (EV), the EBITDA multiple can be utilized. This is probably a much more precise valuation since it takes into account the debt in the value calculation.
PE firms’ performance and outlook
As mentioned before, in the last years, the PE industry has been booming and has seen a significant growth. However, the onset of new risks such as the infamous inflation of today, high interest rates or geopolitical turmoil have drastically contributed to the surge in volatility and decline in PE deals in 2022. Nearing the end of this year, we can observe the effects of these obstacles. The first half of this year already saw a 26% decline in volume compared to last year. The investing climate most likely is a test for current PE firms. Performance could begin to diverge since the cost of debt rises and the exits are harder.
In June of this year, the US Federal Reserve raised its benchmark interest rate by 0.75%. This macro-environment is unprecedented for an entire generation of investors in the PE industry. Fund managers have benefited from the absence of inflation so far, not having to ever deal with high inflation and interest rates. If we look at the trend of the last 20 years in figure 2, we see that while the 10-year treasury yield has decreased from 6% in 2000 to 1.5% today, the average leveraged buyout multiple has increased to nearly 12 times EBITDA, compared to the 6.8 times in 2000.
Figure 2: Average buyout multiple
Source: S&P Capital IQ
In turbulent times like these, it might not follow the same trend. And especially since the industry never had to cope with these situations before, it suddenly needs to learn how to. Companies around the world are already experiencing the cost pressures and current inflation are affecting pricing behaviour. In the short-term, it makes it necessary to comprehend and manage through the dynamic pricing conditions at every company.
The year started out pretty strong. PE gained over $510 billion in buyout deal value, putting it behind 2021’s all-time record. Yet, after entering the second half of 2022, we obviously notice a slowdown in activities. Deals are softening, debt is getting expensive, transactions are tougher to close; uncertainty being emphasized.
According to PwC, PE activity will recuperate considering the record-high levels of dry powder. Dry powder in PE entails the firm’s capital committed from its limited partners that are not yet deployed into active investments. As seen in figure 3, currently with $3.6 trillion in adequate dry powder generating fees, general partners are likely to emerge from the downtrend strongly and are ready for the recovery.
Figure 3: Global private capital dry powder
Source: Preqin
Moreover, the good part is that inflation-recession cycles normally are relatively short-lived. As we are noticing, things get a little choppy in the short run. Despite this, according to the midyear report by Bain, the long-term outlook for PE maintains its strength and looks optimistic.
Investors remain strongly committed to PE and lessons from the past, i.e. the global financial crisis, have taught them it is worth waiting out the storm. If the economy shifts into recession, it will certainly have an effect on the internal rate of return (IRR) from investments sealed. However, analysing the recent past shows us that the IRR from investments made during the healing years has constantly outperformed the long-term averages. In figure 4 it can be seen that investments of buyout deals that emerge out of a slump tend to generate superior returns.
Figure 4: Buyout deal internal RoR
Source: DealEdge
The bottom line
Of course, this does not necessarily mean that everything will be easy during these tough times. Deep planning, modifying approaches to due diligence to reckon the risks that come with inflation, and future-proofing the firm by, say, emphasizing ESG factors might help mitigate the effects.
The bottom line is, even though the private equity sector is facing challenges and obstacles right now, the outlook might look promising and in the long run seems to be going in a steady, positive direction. According to the global head of Blackstone, Verdun Perry, “when the markets stabilize, it will be a tremendous time for private equity”.
