Performance trouble spot: Private equity
The machinery of private equity has been sputtering ever since zero and negative interest-rate policies came to an end. While fund managers are increasingly coming under pressure to deliver their promised performance not just on paper but also in the form of capital distributions to investors, institutional investors are asking themselves whether they need to tweak their portfolio allocations. The private equity industry, as always, is very creative in its efforts to live up to its reputation of consistently churning out high returns, with attendant risks and side effects – as well as opportunities for private investors.
Are the good times over?
The job of a private equity manager used to be easier than it is these days. The last two years have proven to be extremely difficult for the industry. The combination of a precarious macroeconomic climate, heightened geopolitical risks, temporarily overshooting inflation, and massively increased market interest rates has thrown a lot of sand in the gears of the deal machinery of the private equity industry. The number of transactions in 2023 was around one-third lower, and the transaction volume 60% lower, than in the peak year 2021. Exits – i.e. sales of portfolio companies that produce a profitable ka-ching for investors (by allowing capital to flow back to them) – actually even decreased by 70% compared to 2021 in volume terms and were the lowest on record since 2013. The steep plunge was caused by a veritable blockage of traditional private equity exit routes. In prospective sales to other private equity managers, bid and ask prices were often (too) far apart – while sellers were still gunning for valuations that prevailed in the era of ultralow interest rates, valuations of that kind often were no longer thinkable for buyers in the face of increased interest rates and the resulting altered financial arithmetic. Only the very best assets were sellable. Strategic buyers wishing to strengthen themselves by taking over a small competitor also tended to exercise restraint last year. And the third option – the classic initial public offering (IPO) – likewise was hardly practicable up until a few months ago due to insufficient investor appetite. The IPO volume in 2023 was 90% lower than in 2021.
Stabilization… | …at a lower level
Volume of buyout transactions worldwide (in USD billion)*
Sources: Dealogic, Kaiser Partner Privatbank
*2024 estimated based on data January to June
The deal carousel spins on…
At the start of 2024, the private equity industry was looking ahead to the year with calculated optimism. After all, inflation by now is indeed no longer an issue. Moreover, (US) economic activity has stayed robust to date, and the mergers-and-acquisitions (M&A) market has recently picked up. However, hopes for a series of interest-rate cuts by the tone-setting US Federal Reserve have not been fulfilled thus far. So, buyout activity has normalized at a lower level than before. If one extrapolates the transaction data from the first half of 2024 to the full year, the volume of new deals and exits is likely to turn out only slightly higher than last year on the bottom line. The IPO space illustrates just how challenging the climate remains. Alongside successful exits via the stock market such as in the case of Swiss skincare specialist Galderma in March, in which private equity manager EQT was one of the players on board, there have also been recurring mishaps. The managers at Permira, for example, pulled the emergency brake on their planned initial public offering of shares in Italian luxury sneaker manufacturer Golden Goose at the proverbial last minute in mid-June (after a 10-month preparation) to avert a debacle like the last Permira IPO, which resulted in shoemaker Dr. Martens now trading at just one-fifth of its original value three years after having gone public.
The fundraising scene also provides evidence that the auspices for the private equity industry have changed. Many a manager these days is finding it hard to reach the planned target sizes for new fund vehicles and oftentimes has to postpone the final closing date. The more than 14,500 private equity managers worldwide by now make competition in the sector extremely fierce. Moreover, in a (monetary) climate that has become more difficult, investors are differentiating between them more and more critically, seeking mainly managers with proven expertise and a long track record of success. As a result of this, a few megafunds are splitting the largest slice of the pie of newly raised money among themselves. Although the number of new funds decreased again year-on-year in 2023 by 38%, the average fund size actually increased by a good 80%, resulting in the raising of a record total of almost USD 500 billion of fresh capital. The 20 largest funds alone took in more than half of all new capital commitments, with European private equity titan CVC setting a new record for the biggest buyout fund (EUR 26 billion). The indications from the first half of 2024 thus far bespeak a continuation of the trend toward an ever narrower concentration of assets between the largest private equity managers. In the first six months of this year, the 10 largest funds scooped up 64% of all the new money.
Increasing concentration | Brand-name managers are attracting more and more money
Number of new private equity funds and amount of capital raised (in USD billion)*
Sources: Preqin, Kaiser Partner Privatbank
*2024 estimated based on data January to June
…because it must
The amount of dry powder accumulated in the industry as a result of the continual raising of capital has swelled to more than USD 1.2 trillion at last look for classic buyouts alone (excluding growth and venture capital). A good quarter of that capital has been sitting idle for more than four years now because private equity funds have not called it from their investors yet. In cases of this kind, managers slowly run out of time to find suitable investment candidates because private equity funds typically have an investment holding period of five to six years. The same can be seen on the sell side. Around half of all companies currently owned by private equity firms have been in their hands for more than four years already (median age: 6.1 years). Meanwhile, the intended holding period upon acquisition usually is four to six years. The invested private equity universe (buyouts) currently consists of a total of 28,000 companies with a combined market value amounting to a good USD 3.2 trillion. The pressure on private equity managers is slowly but steadily mounting. The “traffic jam” that has arisen must be unsnarled, and the performance machinery must be put back into motion, not least also because investors are increasingly growing impatient. Since most private equity funds in recent years have called more capital than they have returned in distributions, investors increasingly lack the financial means to make capital commitments to new funds and to keep their private equity portfolios rotating. As a result of the muted exit activity, around three-quarters of all investor portfolios were cash-flow negative last year. The last time the disparity between capital calls and distributions to investors was as wide as it is today was back in 2008 (in the midst of the Great Financial Crisis). The cash-flow problem is being exacerbated more and more by “zombie funds,” which have extended far beyond their standard 10- to 12-year lifespan and are sitting on (evidently) unsellable assets. Many (new) investors in private equity have likely received a rude awakening over the last two years because the hidden liquidity risks of classic private equity funds are now becoming visible in tough times.
Cash crunch | Paper gains alone don’t make investors happy
Cash-flow profile of global buyout funds (in USD billion)
Sources: Bain & Company, Kaiser Partner Privatbank
Creativity is called for…
Private equity managers have no shortage of creative ways to keep the deal carousel spinning. They employ a variety of sometimes questionable strategies to maintain an ability to return capital to investors:
- GP-led secondaries: General partner (GP)-led secondaries are one increasingly popular exit option. Under this strategy, a private equity manager retains ownership of one or multiple companies instead of selling them to an external buyer. The portfolio companies are simply shifted from one fund wrapper to another, enabling old investors to be paid off this way. Normally, however, managers can only execute transactions of this kind with their star companies. So, in this sense, this type of “creativity” is the one least worthy of criticism. On the contrary, in fact, GP-led secondaries frequently present good opportunities for new investors and enable them to participate in the future growth potential of a manager’s best assets.
- Dividend recapitalizations: Dividend recapitalizations are another way of returning capital to investors. Under this strategy, a private equity manager encumbers its portfolio company with additional debt for the sole purpose of using the money raised to pay out a dividend. This maneuver, of course, further increases the leverage ratio of companies that are often already loaded with debt as is. Dividend recapitalizations nonetheless are very much in vogue right now, in large part because investors have a big appetite for debt at the moment and credit conditions have become a bit cheaper lately. In the first half of this year alone, USD 36 billion worth of leveraged loans were raised worldwide to fund dividends. This strategy was carried to an extreme by private equity manager 3i with its portfolio company Action. After investing (just) EUR 130 million in the Netherlands-based discount store chain in 2011, 3i has since paid out several billion euros to investors via a total of eight dividend recapitalizations.
- NAV loans: A related variant is net asset value (NAV) credit facilities under which private equity managers take out loans that are secured by an entire portfolio of companies. This, too, enables managers to return capital to their cash-hungry investors without having to sell assets at a potentially bad price. But NAV loans are not necessarily inexpensive, and they diminish investors’ end return in any event because they indirectly have to pay the interest expenses themselves.
However, when faced with private equity’s performance problem, institutional investors like pension funds, sovereign wealth funds, and foundations do not have to depend solely on managers’ hacks and tricks. They can practically obtain liquidity on their own by selling part of their respective private equity portfolios on the secondary market. The market for LP-led secondaries of this kind has grown rapidly in recent years. The motives of the sellers vary here. Many an investor just would like to reduce the number of managers in its portfolio while others would like to tactically shift portfolio weightings or bring their portfolios back in line with their strategic asset allocation. Unlike in the early days of secondaries, financial difficulties in servicing capital calls are no longer the most frequent motive for selling. Nevertheless, sellers tend to have scant bargaining power, which is why private equity portfolios usually come onto the secondary market at a discount price. In most cases, buyers not only get an attractive price, but frequently can also cherry-pick from the portfolio put up for sale.
Only with a discount | Buyers are at an advantage in an illiquid market
Secondary market prices for buyout and venture capital portfolios
Sources: Jefferies, Kaiser Partner Privatbank
…and so is handcraft
Strategies for dealing with the cash-flow problem are just one aspect. Another matter at least equally as important for investors is performance. Private equity managers have had to do some rethinking here as well ever since, if not before, central banks’ zero and negative interest-rate policies came to an end. After a decade in which the high returns in the industry were driven primarily by revenue growth and valuation expansion, the focus in the future must be concentrated much more on operational improvements and profit-margin growth. The days of financial engineering and valuation arbitrage are likely over for a long time because a return to the monetary policy environment that prevailed prior to the pandemic is not in sight anytime soon. Industry spokesmen see it the same way, or at least most of them do. The CEO of private equity firm New Mountain Capital aptly put it this way: “I preach against the old private equity model of 40 years ago where people think you borrow as much as you can, go play golf, and see if it all worked out in five years.” Private equity managers focused on a specific sector are particularly likely to be at an advantage in the future. They seem to be the ones most capable of using a proven playbook to guide their portfolio companies on a path to success.
Easy was yesterday | Margin growth looks set to gain importance
Value drivers in global buyout transactions (2013–2023)
Sources: Bain & Company, Kaiser Partner Privatbank
Performance prospects for private investors
Whereas the current environment is challenging for managers and institutional investors in equal measure, private equity presents great opportunities for private investors. Innovative products enable them to tap this asset class these days with smaller investment amounts and low administrative expenses without having to put up with typical pitfalls. The liquidity problem particularly can be bypassed with evergreen funds. These semi-liquid vehicles enable not just a full investment of capital in a timely manner through monthly or quarterly subscriptions, but also enable divestments if so desired within a reasonable time frame (usually three to 18 months).
The number of evergreen funds on the market has increased considerably over the last three years, in large part because big private equity managers like Blackstone, KKR, EQT, and their peers by now have discovered the retail wealth channel as a new source of money for themselves. For private investors, simply having access to private equity is no longer all that’s important; so is having a selection of (the best) products within the ever-expanding universe of semi-liquid private equity funds. Fee structure, portfolio composition, underlying substrategies, and the toolboxes employed by managers are examples of key criteria that make the difference between mediocre and good investment products. Kaiser Partner Privatbank offers a discretionary mandate – the Kaiser Partner Private Markets Solution – that provides exclusive access to the best private-market managers and funds.
Private equity underperformed the booming (US) stock market last year. Despite the challenges, though, the industry nonetheless continued to generate solid double-digit percent returns in 2023. Private equity remains out in front in a long-term return comparison over five and ten years. We are operating on the assumption that investors can continue to earn a return pickup of 200 to 300 basis points per annum with private equity in the years ahead, provided that comprehensive due diligence is performed and good selection choices are made.
A short-term laggard… |…but private equity remains in the lead in the long run
Annualized returns
Sources: Cambridge Associates, Kaiser Partner Privatbank