Private equity firms say they will have to get creative to cope with ongoing market challenges, from inflation to rising interest rates.
After years of high-flying returns, fundraises, and deal valuations, private equity firms are coming back down to earth.
“It’s not an easy environment right now with interest rates being high and valuations dropping, but it’s not a doomsday scenario,” said Markus Bolsinger, co-head of private equity at Dechert.
Year-over-year, the number of deals has dropped by 18 percent in 2022, while valuations have fallen more steeply: the total value of deals transacted in the first three quarters of 2022 was $685 billion, compared to $1.2 trillion during the same time frame in 2021, according to a new Dechert report.
The law firm expected to release new research Monday on the state of the private equity market, polling 100 senior-level executives at PE firms managing more than $1 billion. The survey showed how investors are tapping into earn-outs, club deals, and improved fundraising terms to attract investors and win out in acquisitions.
These moves are in response to pressures in the private equity markets. For survey respondents in North America, the issue is financing. Forty two percent said availability and cost of leverage due to monetary tightening — and valuation uncertainties making buyers and sellers hesitant to ink deals — are the industry’s biggest challenges. Investors, meanwhile, in Europe, the Middle East, and Africa, called competition for limited deals their top challenge, while those in the Asia-Pacific region are worried about existing investments at valuations high enough to exceed the hurdle rate. The hurdle is the minimum that managers need to achieve for investors before they can take a cut of profits.
Fundraising is also facing headwinds. North American firms say they are competing against rivals for limited partners’ capital, particularly with the largest or most well-diversified funds. The challenge is different for EMEA and APAC firms, who say large LPs are narrowing their focus to only a few managers, concentrating capital in the process.
“What we have seen is fundraising is taking longer and the largest private equity houses have an easier time raising funds,” Bolsinger said. “One of the statistics is that the top 25 private equity houses held 50 percent of the total allocated capital. That’s a pretty dramatic statistic if you think about what that means in terms of concentration.”
General partners have started to offer LPs more in the deal-making process to encourage them to invest. The majority of survey respondents say that there has been an increase in LPs asking for larger GP commitments to funds, and for higher hurdle rates in light of rising interest rates.
Some general partners have decided to sell a stake to an outside investor, freeing up capital for improved terms, according to Bolsinger.
Private equity investors are also tapping into creative solutions to acquire — and keep — the assets they want in their portfolios.
Club deals, when private equity firms partner with competitors to do a transaction, may be coming back. Seventy-two percent of survey respondents said they are either very likely or somewhat likely to engage in club deals, which can help access assets that may otherwise be out of range. In 2021, just 32 percent of general partners said they would be very likely to engage in a club deal. In 2022, that number jumped to 57 percent.
“From a GP perspective, if you do one huge deal and have one egg in your basket, that’s not really good,” Bolsinger said. “Club deals to me are a way to derisk your equity deals and have more, but smaller eggs.”
GPs are also using earn-outs more frequently to sweeten deals. These transactions provide additional payments from the buyer of a company to the sellers’ shareholders if they meet certain milestones. In 2022, 57 percent of GPs said they used them, compared to 27 percent in 2021.
Meanwhile, 65 percent said GP-led secondaries and continuation funds, which allow private equity firms to hold assets in their portfolios for longer than promised, have become more popular.
“Finding good assets is always hard,” Bolsinger said. “If there’s room to grow, why not do a continuation fund? If LPs need liquidity, provide it to them, but otherwise have that portfolio company harvest those returns under your ownership, rather than someone else’s.”