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Time for ‘storm management’ in private equity

The attractive returns that private equity (PE) has enjoyed for the last few years are set to collide with skyrocketing inflation as another business cycle draws to its close.

The current inflation spike could “precipitate a recession that starts in September, peaks in October, and then drops back to the long-term trend by September 2023″, according to Bain & Co.’s mid-year private capital outlook, authored by Hugh MacArthur and Brenda Rainey (photo at top).

“Deal pipelines in many sectors are softening, in technology especially, and debt is becoming more expensive,” the Bain & Co. report says. “Facing losses on loans committed before the slowdown, banks are asking a lot more questions about a company’s exposure to inflation and rising rates, making it harder to close transactions.”

“There’s always a lag in private mark-to-market reporting, but indications are that private multiples are heading lower, taking their cue from the recent slide on public valuations. That’s amplifying uncertainty (always a bad word when it comes to getting deals done), causing buyers and sellers to have increasing trouble aligning on price as buyers look for slack multiples and sellers wait for a better time to sell.”

Still, there’s reasons to be optimistic: deals done coming out of recessions tend to deliver strong returns, something general and limited partners (GPs/LPs) learned in the wake of the GFC, and top-tier funds are already “deep into planning mode to gird portfolio companies against rising prices” while modifying their approach to due diligence with an eye to inflation risks.

“If the economy tips toward recession, it will inevitably have an impact on the internal rate of return (IRR) from investments made coming into the downturn,” the report says. “Yet the IRR from investments made during recovery years has consistently outperformed the long-term averages, especially investments in top-quartile deals.”

Fund raising saw a sharp decline in the first half of 2022, particularly among buyout funds. Private capital raised globally came in at US$645 billion versus US$789 billion in the first half of 2021 – a “predictable” outcome given the “record-setting pace of fund raising in recent years.”

“GPs have been circling back for cash and ever larger funds at an accelerating pace in recent years (every two years vs. every four),” the report says. “Yet the recent squeeze on exists has reduced the amount of cash flowing back to LPs. And the prospect of a recession, which could force GPs to hold onto assets longer, is causing LPs to rethink commitments in the short term.”

“There’s also the “denominator effect”, stemming from the fact that declines in public valuations have yet to be fully matched by private marks. That magnifies the PE slice of an LP’s overall asset allocation pie (and therefore discourages new investments).”

Global IPO volume has slowed “dramatically” and will increase average portfolio hold periods, though the secondary market will see more growth as both GPs and LPs look for ways to increase liquidity.

“The growth in secondaries has not been without controversy, however,” the report says. “Critics have complained that various flavours of these deals have taken place too early in the hold period and disproportionately benefit GPs. Despite this, secondaries are poised to keep growing as GPs and LPs seek liquidity in a stagnant deal market.

“The question is whether market mechanisms will work to make the terms more equitable as scrutiny increases and GPs feel more pressure to get deals done.”

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