The end of the era of quantitative easing, low inflation and ultra-loose monetary policy was always going to prove a challenge to financial systems, but on many measures the transition to a new normal is, in fact, running relatively smoothly. The US and Europe have so far managed to avoid recession, many fundamentals such as job numbers look positive, and inflation is being tamed. The Armageddon some predicted when the Fed started hiking rates has not come to pass.
In the world of private equity there are also challenges, and from some quarters concerns, about the new rates environment. The UK's Financial Conduct Authority (FCA) is starting a review of private equity with a focus on valuations, and in September the International Organisation of Securities Commissions (Iosco) published a paper examining 'potential vulnerabilities' in private markets, which also looked at valuations concerns, among other issues, including potential systemic risk.
Iosco noted that private finance is experiencing rapid growth, with annualised growth at nearly 18% since 2017 and private market assets under management reaching USD 12.8 trillion by June 2022, so it is only natural that regulators and watchdog organisations should take a closer look at the industry. In conducting these reviews however, it is important that these organisations that as private markets transition to a new normal, they too are likely to do so along a relatively smooth glide path, even if there will be bumps along the way.
Reasons for optimism start by recognising that the private markets industry is sitting on record amounts of dry powder – raised but yet to be spent capital. Global private equity dry powder reached record levels last December, at $2.59 trillion, according to S&P Global Market Intelligence and Preqin data.¹ This war chest can help managers to shepherd existing portfolio companies through market turmoil, either through the provision of additional capital support or by backing 'buy-and-build' acquisition strategies that expand earnings and market positioning.
With valuations tracking lower this year, managers can deploy their dry powder at much more attractive entry multiples. Target companies, on the other hand, have to accept lower prices on the back of inflationary pressures and pricing in the risk of a future slowdown. As of April 2023, purchase price multiples paid by private equity buyers were in 'full correction mode', according to Pitchbook.²
Also, in response to rising prices and interest rates that constrain the expansion of multiples, private equity firms are able to create value by switching their focus to operational improvements. They can apply their deep industry expertise to uplift revenue, improve operational efficiency, retain talent, or increase the bottom line before selling upgraded companies for a higher multiple than they were acquired for.
And many buyout fund managers actively target companies that are market leaders or provide critical goods and services without having to sacrifice order volumes. This makes these businesses more resistant to inflationary pressures as they can pass on higher input, labour or supply costs to consumers.
Recessionary periods have historically been some of the strongest vintages for private equity returns. This is driven in part because fund managers continue to deploy capital through cycles and can therefore selectively acquire businesses at lower valuations in more challenging times. Indeed, private equity generated some of its best performing vintages during the dot-com crash of 2001 and the 2008-2009 global financial crisis.³
There are, therefore, many reasons to be optimistic about private markets performance in the 2020s. Concerns about systemic risks remain theoretical. This does not mean the potential for such risk to materialise should not be explored, but it does mean any such analysis should be engaged in free from the assumption that the risk is there and it is material.
Similarly, on valuations, a principal feature of private markets is lower liquidity and therefore, by necessity, less opportunity to test valuations in the market. This is not in-and-of-itself a negative, and indeed it could be argued that the smoothing of 'animal spirits' plays some positive contribution to help keep markets stable. It is, however, imperative for investors in private markets to fully understand the liquidity and transparency differences with public markets.
Just as the catastrophe some predicted for the world's biggest economies has so far not materialised in the new era of higher rates, it seems the most likely scenario for private markets will be a similar adaption to the new reality. Regulators and others should examine private markets, especially as they become more important to more market participants. But the resilience of private markets must also be considered alongside theoretical risks.
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* Past performance is no guarantee of future returns.
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