“The private equity reckoning has begun”, “private equity: higher rates start to pummel dealmakers”, “private equity industry ‘in retreat’” … these are but a few of the doom and gloom headlines seen in recent months relating to the private equity industry. Private equity firms undoubtedly surfed the low interest wave as well as possible, but tailwinds are clearly slowing. Nonetheless, do these justify the headlines we see?
Examining the fundraising side of the equation seems to highlight a poor state of affairs. Following a record high of US$579.4 billion in 2021, global fundraising fell by just under 20% in 2022 to reach US$464.2 billion according to Pitchbook, with the slowdown continuing into the first half of 2023.
Several reasons have contributed to this, with Johnny El Hachem, CEO of Edmond de Rothschild Private Equity emphasising the denominator effect for institutional investors, which has been further complicated by “the private equity industry, at large, showing a decrease in exits. Given they are therefore unable to provide investors with as much money as we saw in past years, investors themselves have less capital to allocate to the asset class.”
Multiple expansion has also been pared given current financing conditions. “Not all sponsors accept the new reality,” notes Luc Kicken, Benelux Client Solutions at Partners Group. “Sellers want last year’s valuations, buyers point to the cost of borrowing to demand lower multiples,” continues Kicken. All the while, volumes in private equity markets decrease.
Johnny El Hachem, CEO of Edmond de Rothschild Private Equity
This environment also fuels consolidation. “Smaller players or players with average or low performance, those who don’t have the capacity to sustain themselves either because of their size, performance, or lack of operational resilience, are clearly most at risk,” El Hachem notes. Quite clearly, the tide is going out and we are discovering who’s been swimming naked.
However, given the increasingly complex operating environment in which private equity firms find themselves, firms who weren’t prudent enough to invest in their operational readiness when times were good will likely rue their decision. Especially as operational challenges mount.
Private equity firms are increasingly looking for opportunities to drive EBITDA growth, focusing on operational excellence and cost optimisation.
“In the ‘80s this industry used to be a deal-making industry. Now, it’s heavily regulated and requires significant complexity and transparency,” states El Hachem. Firms who didn’t shore up their operations, from back office to middle office transaction support capacity, to cope with growing intricacy of regulations and rising pressure on fees will struggle to survive the coming decade.
Shoring up operations is not a once-off purchase and there is no lifetime guarantee. Technology has become a key enabler for not only private equity firms’ own operations, but also provides them with the tools to address the needs of their portfolio companies. “Value creation has become the key value driver,” according to Kicken. “Private equity firms are increasingly looking for opportunities to drive EBITDA growth, focusing on operational excellence and cost optimisation” Kicken continues.
It is also not only small players that are feeling the heat. In the wake of challenging market dynamics, larger firms such as EQT, Silver Lake, and others have resorted to buybacks following poor public market performance of companies they floated in recent years. After an era of abnormality, with businesses lacking fundamentals raising billions in cash and some going public we are getting back to the basics. “Public markets cannot, and analysts will not, understand how a loss-making company is constantly progressing in value. So, we have to admit that some of this is healthy, in the sense that we are returning to our fundamentals,” El Hachem emphasises.
Now, it’s more about creating value with your teams’ skills, your networks’ know-how, and with the intentionality to enter into a business, fix a problem and create value through that.
Returning to fundamentals has also been boosted by the exit from the negative interest rate environment. An environment in which many players resorted to increasing leverage to create value and increase prices. Leveraging deals with free money, while a product of the times, did little to separate the wheat from the chaff in terms of private equity firms. “Now, it’s more about creating value with your teams’ skills, your networks’ know-how, and with the intentionality to enter into a business, fix a problem and create value through that,” El Hachem highlights. The firms who are able to do this are likely to continue to enjoy good momentum both in terms of deployment and fundraising. Kicken concurs with this sentiment, noting that “driving value creation in businesses is what drives long-term return, focusing on strong and active boards, as well as ensuring investment professionals provide a good mix of financial and operational backgrounds.”
Private equity also continues to offer investors certain advantages over the turmoil we are currently experiencing. “This is due, in part, to the industry’s agility and ability to focus on long-term solutions rather than short-term gains,” Kicken states. “When multiples decrease but EBITDAs are growing at more than double the speed of public markets, private equity has the ability to continue thriving, even in more challenging markets.”
Additionally, private equity firms offer more of the driver’s eye view for investors as it were. Via their operational teams, firms play a more active role in shaping the strategy of their investments and creating long-term sustainable returns for investors. “We are acting, shaping, defining the strategy, creating jobs, scaling businesses, and solving problems. These are value creation tools that private equity firms bring to the table that reduce volatility” notes El Hachem.
While undoubtedly the current operating environment is not as beneficial as it was once for private equity firms the water is definitely getting chillier, is it truly as doom and gloom as headlines suggest?
The asset class offers diversification for investors, operational expertise for portfolio companies. It offers the ability to reduce volatility and preserve capital over the longer-term. Strong sector expertise and a seat at the table means that investors have the opportunity to drive capital into companies that are playing a critical role in the economy.