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Private equity risk breeds new potential

Although the private equity industry is facing multiple challenges, Schroders sees new pockets of opportunity emerging.
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After record years for private equity during Covid-19, the drivers of this activity seem to have gone into reverse.

While this has led to the industry facing risks on several fronts, Schroders believes that from adversity may come opportunity in certain areas.

“Private equity is not immune to the forces which are buffeting all financial assets right now. However, while some parts of the industry are likely going to face more difficult times, others are likely to be more resilient, even with opportunities to thrive,” said Dr Nils Rode, chief investment officer at Schroders Capital.

Perils – and potential – for private equity

One of the big issues for private equity comes from recession risk. Central banks face a tough task in trying to engineer a soft landing by raising rates enough to fight inflation, but not so much as to cause a recession.

Yet recessions have typically proven to be better times for private equity than might be expected, with the average internal rate of return of private equity funds raised in a recession year over 14% a year, based on data since 1980.

“Funds benefit from ‘time-diversification’, where capital is deployed over several years, rather than all in one go,” said Duncan Lamont, head of strategic research at Schroders.

“This allows funds raised in recession years to pick up assets at depressed values as the recession plays out. And then to exit later on in the recovery phase when valuations are rising,” he added.

Even worse than a regular recession, meanwhile, is the risk of stagflation, which for the public equity market has been the worst possible environment for returns.

However, not all sectors are affected equally. Historically, among public markets, the IT sector suffered most, followed by communication services and industrials, according to Schroders. In contrast, it has been a very good time to invest in consumer staples and healthcare companies.

Parallels can be drawn with private equity. “As an industry, technology features heavily with private equity. If historical public market experience is a guide, then many strategies could find the going tough if stagflation becomes an issue – albeit shielded to some extent by time diversification,” said Rode.

Further, investors with exposure to consumer and healthcare-focused strategies may even be pleasantly surprised by how their funds perform, he added.

Another headwind for private equity stems from a slowing IPO market. For example, the $10bn of US IPOs in the first quarter of 2022 was 92% below what was raised in the same period last year. And, as of 9 June, the figure for the second quarter has collapsed further, with just $3bn raised quarter to date.

“2022 is shaping up to be the worst year for IPO volumes for a long time,” said Lamont. “The IPO market is a key exit route for venture capital investments, so this presents a problem.”

At the same time, the closing of these exit opportunities will also create opportunities for some general partners (GPs) and limited partners (LPs).

Rode believes GP-led transactions, where one private equity general partner/fund manager sells one or several portfolio companies to another vehicle set up by the same GP, are likely to accelerate.

A fourth private equity-related risk relates to fundraising excesses, which lead to more competition for deals, higher prices being paid and, ultimately, worse returns.

A prime example is the late stage venture/growth segment, said Rode.

“For years, our Schroders Capital Fund Raising Indicator (FRI) has been flagging the fundraising excesses in this area. And all of this money had to find a home somewhere.”

The future now looks starker for many of these companies.

“The private equity funds which backed them are likely to go through a much more challenging period for performance,” added Rode.

Yet fundraising has not been so wild everywhere in private equity. Early stage venture capital has been much more contained.

Also, valuations on small buyouts have been more stable than large buyouts, in part due to less capital flowing into their area.

“The risk of a valuation-driven fall in prices is lower in small buyouts than large,” explained Lamont.

Part of the Mark Allen Group.