Not long ago, private equity was considered one of the most promising growth sectors among banks. Financial institutions invested enormous resources in the complex asset class. But the shine is fading now.
Investments in companies that are not listed on the stock exchange and at the same time have not yet reached their zenith are at the core of the private equity industry. Numerous financial firms have channeled personnel and know-how into this business in recent years, as reported by finews.com.
That was hardly a coincidence, as investments on the stock market were increasingly regarded as overvalued in a period of rock-bottom or even negative interest rates, and facing an Icarus-like risk of crashing. During that time, interest in private market investments grew all the more because they had little or no correlation with traditional financial markets.
Global Downturn
The downturn risk has now turned into reality, triggered by higher-than-expected inflation and correspondingly resolute interest rate hikes by central banks in the first half of 2022. But even private equity was not spared as is now apparent. Although buyout funds still invested $512 billion in new investments worldwide in the first six months of this year, restraint is growing noticeably.
Bain & Company reached that conclusion in their «Private Equity Report Midyear 2022». Analysts write «But signs suggest that we are approaching the end of the business cycle, and at midyear, we’re already seeing a slowdown in private markets.» Moreover, «uncertainty around inflation and asset valuations has slowed deal pipelines, and first-half data already shows a sharp decrease in exit and fund-raising activity,» the report said.
In other words, the era of records is over for now.
Fear of Negative Surprises
Most funds have owed their high returns over the past 20 years in large part to higher valuations. This can no longer be the assumption in times of strong inflation and rising interest rates emphasizes Bain partner Alexander Schmitz, who heads the private equity practice for the DACH region. At the same time, such funds need to take a much more critical look at new investments to protect themselves from negative surprises in the event of a recession and sustained inflation.
Transactions in the current environment are also made more difficult by two additional factors. Firstly, financing costs are rising as a result of the interest rate turnaround. Second, banks are now taking a much more critical look at the extent to which a transaction will pay off under more difficult conditions.
Fewer IPOs
On the sales side, the private equity sector has not been spared the consequences of economic uncertainty. In the first half of 2022, the exit volume of buyout funds fell by 37 percent year on year to $338 billion, with the slump in the initial public offerings (IPO) business a particular contributor. The value of IPOs worldwide at mid-year was only $91 billion, down 73 percent from the first six months of 2021.
If sales into public markets become more difficult, holding periods for portfolio companies will also lengthen - in turn reducing distributions to investors, experts concluded in their study. In the face of such challenges, private equity funds are likely to focus even more on secondary buyouts in the future and thus on sales to competitors, says Bain partner Silvia Bergmann.
Difficult Times for New Funds
In addition, the launch of new funds is likely to become more costly and protracted. In the first half of 2022, buyout funds reached $138 billion in fundraising worldwide, compared with $284 billion in the same period a year earlier.
To be sure, the private equity scene can weather the low in new business for a while, Bergmann emphasizes. After all, at $3.6 trillion, it has more than twice as much uninvested capital as it did six years ago.
More Know-How Needed
In this respect, even more, know-how is now called for than in the past. Determining whether an investment in an unlisted company is worthwhile is a complex task in itself, and made even more so in today's difficult circumstances. But in the end, as Bain partner Schmitz notes, private equity funds were able to achieve above-average returns after an economic slump, especially with acquisitions.
