Private Equity’s End-of-the-Party Strategy

Flush with cash, private markets managers are trying to be cautious, even as they are confidently putting new money to work in the late stages of a ten-year-old bull market.

Almost three-quarters of private equity firms and 56 percent of venture capital managers think a downturn is coming within two years, according to BDO’s U.S. private capital outlook survey of 100 private equity and 100 venture capital managers. Nearly all of them think a downturn will come within the next four years, which BDO points out is shorter than the holding period for most of their investments.

Asset managers are taking concrete steps to be defensive. Twenty-eight percent of private equity respondents said they will put the most capital toward funding the working capital needs (read: cash) of the companies in their portfolios over the next 12 months. This is up from a year ago, when the vast majority directed the most capital toward new deals, according to the report. 

VC fund managers are even more cautious. Forty-one percent will be dedicating the bulk of capital to their portfolio companies’ working capital requirements. 

“For the last several years, there has been this focus on companies that are growing at all costs,” said Kevin Bianchi, who co-leads BDO’s VC practice, in an interview. “As people have been thinking about when this market comes to an end, they’ve been focusing on whether companies are able to sustain themselves through a downturn. Now firms are looking at margins as well as growth.”

With markets still booming, respondents said it’s a good time to cash in. BDO’S survey found that 30 percent of private equity firms and 20 percent of VC managers want to exit current investments. That percentage rises to 36 percent of private equity respondents and 21 percent of VC respondents among those also expecting a market downturn to happen within two years.

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Still, technology, one of the most expensive sectors, is the most popular area for private equity and VC funds going into 2020. Fifty-four percent of private equity and 51 percent of VC firms say it is the most likely area of the markets to experience increased deal activity. Managers also are vying for opportunities in energy and natural resources and financial services, according to the report. 

About 40 percent of both private equity and VC managers reported that distressed businesses will be a key source of investment opportunities in the next 12 months. Only 1 percent of private equity firms said distressed assets were a key driver of deal flow last year. Forty-seven percent of private equity respondents said public-to-private transactions would be an investment opportunity (39 percent for VC firms). 

“While the number of distressed opportunities in the market is currently quite low, fund managers appear to be anticipating increased investor appetite for capitalizing on distressed assets,” according to the report. “During the great recession, LPs flocked to distressed debt funds, as such funds typically outperform other PE fund strategies during a downturn.” 

BDO pointed out that special situations and direct lending, fledgling strategies in 2008, may actually outshine distressed when the markets next correct. 

Asset managers say the biggest challenge to closing deals is increased competition from strategic buyers, rival private equity firms, hedge funds, and mutual funds. Private equity firms are also facing off with a growing number of family offices and other institutions that are directly investing in deals. Many of these new competitors are also continuing to invest through funds. 

Even though fundraising has been at highs for years, the end of the bull market — whenever it comes — is prompting private equity and venture firms to raise even more cash before the door closes. 

“In a sign that fund managers may be rushing to close their vehicles before a market correction hits, fundraising activity is also picking up,” according to the report. BDO cites November PitchBook data showing that U.S. private equity funds raised the largest amount of capital on record this year. 

“Based on recent conversations, asset managers are looking at the first quarter of 2020 as another time to fundraise,” said Bianchi. “People will want funds to be locked and signed and raised before the election season kicks off. I’m surprised at how quickly funds are turning right around and raising their next flagship fund.”