Turbulence and Opportunity in Private Equity

It’s been a staggering boom for private equity funds over the past few years. Assets under management (AUM) have more than tripled since 2009, rising from $1.3trn to $4.6trn today. In 2021, Preqin estimated that private equity funds have struck deals worth more than $800bn.

Now however, times are turbulent, with investors in equities and debt markets experiencing a generational sell-off in the first half of 2022. This turmoil in the public markets has yet to fully permeate into the private markets, but a reckoning is on the horizon. The flood of deals struck at high valuations during the boom of the past two years puts pressure on performance. Pension funds and other investors are anticipating making lower returns than they hoped when they committed cash to buyout groups’ funds.

Due to the nature of private equity, illiquidity creates a delay between real and reported fund valuations. Funds determine the current fair value of their portfolios based on the price an investment would realise in an orderly transaction, in the absence of a liquid market to price investments. This price should be comparable to the valuations of comparable companies in public markets. But, these orderly exits are rapidly disappearing. Trades between private-equity funds are unlikely to sustain an alternative reality of high valuations. For some fund managers, adjusting valuations will be painful. Funds which bought companies at a premium to stock market prices will suffer mark-downs. Longer term, this will also create buying opportunities for those with capital.

Interest rates will prove to be a more enduring challenge to the buy-out playbook. Lower cost debt is alluring as it increases return by funding half of a typical buyout with debt. However, this debt has greatly increased in cost. American junk-bond rates have risen above 9%, as investors who are staying put seek larger returns. Leveraged loan availability, has stalled in June 2022, loan issuance was down 41% from the same month last year. Investment bankers, who underwrite these loans, are preparing for losses as they face significant headwinds in their attempts to sell the debt to investors.

Private equity investors have enjoyed growth and exceptional returns over the past few years. Now, it’s time for the asset class to prepare for uncertainty as well as opportunity.

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