By Shanu Sherwani. DELANO (Luxembourg) June 2022
At last week’s SuperReturn International conference in Berlin, billed as the largest gathering in global private equity, it was clear that the industry is facing challenges due to years of rising prices fuelled by ultra-low borrowing rates. Since 2022 began, inflation, Covid-19, and environmental concerns have grown. Inflation in the US, UK, Europe, and the rest of the world has reached record highs in recent decades, and to prevent hyperinflation; central banks are raising interest rates.
Many industry insiders I spoke to, stated that several deals were mispriced due to a prolonged period of low-interest rates. Overall, everyone at SuperReturn was concerned about the economic environment: the likelihood of a recession, which may be longer and more profound than the previous two years, and what inflation implies for private equity. While this can be bad news, it also creates opportunities.
One of the best things for the industry over the past 12 years is that rates have been at very low levels, giving it a considerable boost. Many businesses have found it easier to make money because of this. Declining interest rates increase the capital available to private equity businesses as investors shift their focus away from fixed income and credit instruments. This presents a buying opportunity for private equity firms, as they can access readily available funds and increase activity. Second, private equity firms can enter into a transaction, lock in lower interest rates, reduce their periodic outflow, enhance their internal rate of return (IRR) and, ultimately, their return on investment.
However, the current global economic climate, in which many nations have historically had low-interest rates, has resulted in a capital glut. The combination of readily available finance and intense rivalry to acquire assets drives up prices. Some private equity executives will be worried that they struck deals at top-of-the-market prices.
On the other hand, sellers benefit from the availability of capital. When interest rates are low, the number of initial public offerings (IPOs) rises. When interest rates are low or dropping, it is advantageous for private equity firms seeking an exit, as they can attain greater valuations and substantially higher profits than anticipated.
The current rise in interest rates could cause investors to flock to fixed income and credit assets. Therefore, fundraising becomes difficult. In addition, investors and the general public have a diminished desire for IPOs, and asset valuations decline, which is troublesome for private equity firms that had planned their departures around the same time. However, it is advantageous for private equity firms seeking undervalued firms and assets. These companies can invest the wealth they have accumulated throughout the low-interest period.
To be honest, private equity has been one of the most renowned financial winners over the last decade, with investors pouring hundreds of billions of dollars into the asset class in search of yield. The infusion of capital, along with readily available debt, fueled a deal-making frenzy that drove asset prices to all-time highs.
With rising interest rates and the greater possibility of a recession, high asset prices paid in the past will undoubtedly begin to eat into returns. I think private valuations will fall as the private equity industry has to return capital to investors. The present valuation reset also provides attractive opportunities for recently and newly established funds, as these will evolve in a more favourable valuation environment. It’s also worth noting that the year 2021 was an exception. Not reaching those levels again does not imply that PE in 2022 has failed; rather, it indicates that the market is correcting to a normal level. However, the tougher economy will also make it more difficult for private-equity firms to sell their assets or list them on public stock exchanges in the near term as investors adjust pricing expectations.
Despite a potentially advantageous valuation reset, investment managers must also negotiate inflationary pressures, increasing interest rates, and geopolitical shocks, casting a cloud over the longer-term picture.
I sincerely believe private equity firms are generally more prepared to address these issues than in the past. Managers are far better positioned to face the rising cost of capital than they were a decade ago. For current investments, fixed-rate borrowing will allow some leeway to examine the capital structure before refinancing. Rate hikes will be factored into entry prices for new assets, implying lower leverage.
The industry’s overall change aids this perspective from being predominantly debt-focused to one that now prioritises operational improvements to add value. The private equity industry has evolved tremendously since its inception, with most managers generating returns through financial engineering in the form of leverage in the past. Today, the value creation approach has gradually shifted to operational improvements.
This change has aided the sector in surviving many historical market occurrences, including one as recently as two years ago. A greater emphasis on hands-on value creation combined with more careful use of leverage proved to be a good combination. PE managers could weather the storm and service a modest pile of debt when the pandemic arrived. This has paved the way for private equity firms to outperform even during times of crisis. In particular, private market funds tend to deploy capital over three to five years, reducing exposure to a single entry point and valuation environment. We saw this before during the Great Financial Crisis, with private equity’s 2008 and 2009 vintages providing solid returns in a highly unpredictable and uncertain market.
It is important to note that an unprecedented amount of money to deploy through record dry powder raised in 2021 gives added comfort. A similar event occurred early in the pandemic when lockdowns and supply chain disruption caused a wave of panic in public markets. At the time, a large amount of dry powder was critical since managers benefited from substantial money to sustain existing portfolio companies and avoid any liquidity crisis. The significant amount of dry powder raised should result in beneficial outcomes for fund managers, as they can deploy capital at a more favourable valuation situation.
Private equity can not only assist businesses in withstanding downturns, but they may also have the skills, tools, and ability to navigate and capitalise on volatility. Active ownership implies that private equity managers may be able to identify methods to boost earnings, pivot strategy as needed, and step in to aid portfolio firms. The pandemic is a prime illustration of this; private equity managers were very imaginative and quick in grabbing new opportunities in the early days of the crisis, leading to an accelerated transition to digital and significant prospects in the technology industry. Something similar is already taking place as General Partners begin to capitalise on solutions to today’s issues. As global supply networks continue to be disrupted, investment is pouring into logistics firms.
Away from the party atmosphere on the edges of the conference, many speakers at SuperReturn warned of challenges ahead and the likelihood of a recession. But most executives thought that since their industry wasn’t very liquid, it would help them weather the storm. They could keep their investments until the economy improved and valuations, hopefully, went back up.