Private equity: strategies for success in a shifting landscape

Assessing risks and rewards for long-term investors amongst the evolving private equity landscape. 

Amy Taylor, Senior Research Analyst, significantly contributed to this article. 

There have been few periods this century where private equity markets didn’t outperform public market indices over the long-term (as measured by ten-year rolling returns). Whilst this trend may continue, there are several challenges currently facing the asset class which could reduce the margin of outperformance going forwards. For investors such as family offices and endowments, who typically have significant private equity exposures, is this risk being managed appropriately?

We expect to see a rise in the dispersion of private equity manager returns, driven by the heightened expertise required to navigate the challenges and reduced expectation of strong market beta returns seen in the past. 

Investors should remain mindful of the prevailing headwinds within the asset class and seek assurance that their chosen manager possesses the capability to generate returns that justify the illiquidity and governance complexities.

Below, we set out how to overcome current challenges and leverage potential opportunities in a complex, changing landscape.

Navigating challenges

Too much dry powder?

With 2021 being a year of record fundraising within the private equity market, and the typical investment horizon of a private equity fund spanning three to four years, much of this influx of capital continues to be on a countdown to deployment. 

This has created significant competition (and hence rising prices) for high quality assets, alongside increasing pressure for private equity managers to invest in lower-quality assets in the face of looming investment period deadlines.

^{Source: Preqin, J.P. Morgan Asset Management. Dry powder refers to committed but uninvested capital. Fundraising categories are provided by Preqin. *Natural resources includes energy, timberland, agriculture and farmland, metals and mining, water, and diversified business. **Data updated through May 31, 2024. Percentages may not sum to 100 due to rounding.}

Subdued market exit

Exit volumes in 2023 remained subdued, further accentuating the trend of private equity managers retaining assets for extended periods. The reduced transaction volume is a result of an uncertain market environment and managers not willing to sell assets due to falling valuations. 

Market uncertainty over the recent past effectively closed the Initial Public Offer (IPO) market and higher interest rates from central banks meant Merger & Acquisition (M&A) activity would be costly and was put on pause.  

Indications suggest that the market is beginning to ease its congestion. This is due to a combination of managers being more open to accepting lower prices and a reduction in spreads within the private credit market, thereby opening financing options. Whether this represents a temporary unclogging remains to be seen. In any case, the trend for a greater proportion of companies remaining privately-owned seems set to continue. 

^{Source: Preqin,  J.P. Morgan Asset Management. Exits include Bankruptcy/Write-off, IPO, Private placement/follow on, sale to management, secondary buyout, secondary stock purchase, trade sale, unspecified exit. *Data for the year 2024 is as of May 31, 2024.}

Merry-go-round

One potential exit route for private equity managers is to sell an asset to another manager, with some assets undergoing multiple transfers between managers. Whilst this route may become necessary when balancing demands for investor liquidity and a constrained exit environment, it can be hard to imagine what value can be squeezed out of such deals on an ongoing basis.

Increased financing costs 

The era defined by cheap financing resulting from a low interest rate environment appears to have ended. Although spreads in private credit have narrowed, offering some relief to the private equity exit market, financing expenses remain higher than in previous periods. 

While certain private equity managers have weathered periods of elevated rates before, such as those in the 1990s, this current environment may still erode returns in the private equity sector. It begs the question of whether the premium above private credit justifies assuming the additional risk.

Additional lending facilities 

An already complex and opaque asset class seems to be getting more complicated. The introduction of additional lending facilities available for private equity managers is gaining momentum. Examples include Net Asset Value (NAV) loans, which are gaining popularity and media attention, and involve a manager raising money at the end of an investment period against existing assets in the portfolio.

Although these facilities can help from a capital-raising, liquidity or expected return perspective, they may also introduce additional leverage to a private equity fund in a somewhat opaque manner and sometimes without investors’ knowledge.

Leveraging opportunities

How can investors leverage opportunities within the current environment?

Go long

The trend for companies to remain privately-owned for longer has benefits around privacy, retaining control over the business and reduced regulatory burden. As a private equity investor, this trend means that if you are able to remain invested in high quality companies for the long-term, decent returns may still be very much achievable.

Choose your vintage wisely

The subdued exit market and trend in managers extending fund lives means that many investors will not have received distributions in line with expectations. As a result, managers may struggle to raise funds for new vintages going forward, given investors are unable to recycle their capital and liquidity remains at the forefront of investors' minds. 

As a result, investors may wish to think carefully before automatically redeploying capital into their managers’ latest fund vintage, and instead focus on those managers which they feel are best suited to weathering the current market challenges.

Use secondary market

The prevalence of motivated sellers of private equity funds means that the secondary market could provide attractive buying opportunities for those investors wishing to increase or obtain an allocation to private equity.

Although secondary market discounts may be expected to reduce slightly from their current (close to historic high) levels, the market continues to develop and it remains a buyer’s market. Indeed, this is also the case in a wide range of private markets, not just private equity.

We believe that the challenges outlined above are in no way insurmountable, and private equity continues to offer the potential for good returns going forward.

What’s next?

Overall, private equity may face some challenges ahead, such as:

• Managers holding onto assets for longer;
• Fewer opportunities to sell investments;
• Investments moving between similar funds; and
• Lots of money chasing a limited number of deals.

But despite these issues, we still expect the asset class to provide good returns in future, albeit likely being harder to find and taking longer to achieve.

Good opportunities remain for investors able to deploy capital for the long-term with high quality managers. Currently, secondary markets may create better entry opportunities, enabling investors to maximise their risk-adjusted return potential.