Fund performance will drop as portfolio company valuations experience markdowns.
Key takeaways
Value creation and exit strategies will become increasingly challenging to execute.
Stalling tactics are helping fund managers avoid having to sell in the current environment.
Private equity fund performance is set to drop as portfolio company valuations experience markdowns amid a rapidly changing economic landscape. Contributing factors include the fall in public market comparable companies, the rising discount rates in response to the Federal Reserve interest rate hikes and—as the market recalibrates portfolio company growth rates amid recessions fears—supply chain constraints, inflationary pressures and labor shortages.
As the economy slows, fund performance will also suffer from extended holding periods, with managers expected to delay exits in hopes that bids on their portfolio companies will return to levels closer to what the private markets became accustomed to in 2021.
By the numbers...
PitchBook data shows that $529.2 billion worth of private equity deals were completed in the first half of 2022, representing a drop of 28% compared to the $735.5 billion in the second half of last year. Deal count dropped by 17%, closing at 4,337 versus 5,255 in the second half of 2021. We expect the second half of this year to return even lower numbers.
The top challenge for private equity sponsors in a slowing economy is the drying up of exit options.
With volatility in the public markets at elevated levels and the stock market experiencing its worst first half since 1970, the ability to exit via the initial public offering (IPO) route is all but frozen. This position leaves the sale to other private equity sponsors or corporate strategic buyers as the available exit routes. Given the negative sentiment and the prevailing cautious mood, these participants are also not eager buyers. For private equity funds at or nearing the end of their term and have to sell in this market, giving back some of the unrealized gains built up over the past couple of years will be a tough pill to swallow.
Value creation presents another challenge for private equity managers.
Private equity managers create or unlock value from portfolio companies through the expansion of multiples, EBITDA growth or deleveraging. All three will be under pressure in the current environment. Multiples will be restricted by dropping valuations as outlined above. Deleveraging will be challenging as the rise in interest rates will make it difficult for portfolio companies to service or refinance debt. EBITDA growth is the one lever that private equity sponsors will have more room to maneuver. Beyond having to preserve or grow earnings in the midst of rising prices, a competitive labor market and supply chain disruptions will put the managers' skills and acumen to the ultimate test in turning around or advancing businesses.
Private equity sponsors are using stalling tactics to help mitigate these challenges.
Private equity sponsors are biding their time and putting off exit plans where possible. Some that have to exit are exploring general partner-led secondary transactions in the form of continuation funds in order to extend their holding period in anticipation of a more receptive selling market in the future. Where fund documents give leeway to extend the fund's life, private equity managers will likely take advantage of such provisions to allow them enough time to secure a more orderly liquidation of the remaining portfolio holdings. Should there be a need to continue financing these portfolio companies, some private equity managers are looking to private credit funds and NAV loans to bridge the gap.
Other top considerations to offset the impact of headwinds facing private equity
For funds that are still actively deploying capital, the current environment may present a golden buying opportunity at more compelling prices and more favorable terms.
For top-tier managers with stellar track records, fundraising in the current environment is still possible, albeit very competitive, with several managers in the market to replenish their war chests after expending dry powder in a year of quick deployments in 2021.
Though private equity managers are not quite in the triage or crisis mode they experienced during the height of the COVID-19 pandemic in the late first quarter and second quarter of 2020, it is clear that managers will have to be more attentive and work closely with portfolio companies to help them navigate the current headwinds. Assessing how each is uniquely affected will be crucial to prioritizing and strategizing accordingly.
RSM contributors
Industry inflation snapshots
Hampered by rising inflation, geopolitical uncertainty and supply chain disruptions tied to the COVID-19 pandemic, the U.S. economy contracted in each of the first two quarters of 2022.
RSM economists peg the chance of a full-blown recession over the next 12 months at about 65% (as of October 2022); an economic slowdown of any measure creates significant challenges for middle market companies. We took a look at the potential impact on several industries.
