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Private equity crossed a threshold in 2022, exiting an era of exuberance and entering a new period of uncertainty.
Published: April 18, 2023
Record inflation, surging interest rates and a foggy economic forecast put the brakes on private equity dealmaking, which had accelerated to its fastest-ever pace by the end of 2021. Now, lengthening investment cycles pose new challenges to buyout fund managers.
Private equity crossed a threshold in 2022, exiting an era of exuberance and entering a new period of uncertainty. Record inflation, surging interest rates and a foggy economic forecast put the brakes on private equity dealmaking, which had accelerated to its fastest-ever pace by the end of 2021. Now, lengthening investment cycles pose new challenges to buyout fund managers.
Longer hold times for private equity portfolio companies are placing a renewed emphasis on value creation. The power of multiple expansions to boost investment performance is fading as the outlook for growth dims. Skilled, active private equity fund managers stand to accelerate ahead of the pack.
Economic uncertainty cuts both ways for private equity: Even as it undermines portfolios, it creates new opportunities for investment at lower entry points. The seeds of private equity's best vintages are often planted in trying times. Deep sector expertise will be crucial as firms scout for deals.
The global private equity industry entered 2023 with its largest-ever stockpile of dry powder, a positive sign as it sails into a potential recession. But fundraising is getting harder, and lengthening investment cycles could make the problem worse by slowing distributions to investors.
Over the past decade, the private equity market more than tripled in size and demonstrated itself to be a substantive and compelling alternative asset class as returns outperformed public markets by a considerable margin. During this time, general partners (GPs) raised ever-growing funds and returned to market for the next fund at a more rapid pace and larger size. At the same time, investors poured more money into the asset class.
The appeal of private equity investing is that it is a medium- to long-term investment provided in return for a stake in companies that are not listed on a stock exchange. Typically, private equity investments are made by primary funds managed by a GP at a private equity firm and invested in by limited partners (LPs). Unlike a public equity investment, private equity capital is called from LPs over time as GPs find investment opportunities, while distributions are made as investments are exited.
GPs generally invest their own money in a fund alongside their LPs. They make all the investment decisions and are responsible for raising capital from LPs or fundraising. With minimum investment amounts sitting at about $25 million, LPs tend to be large institutions such as pension funds. They have no influence over investment decisions despite the long commitment periods.
A typical private equity fund has a 10-year life cycle with a fundraising period of 12-18 months, an investment period that tends to span the first five years, a hold period that takes it up to year eight and a harvest period in which the GP looks to exit the investment by way of an IPO or trade sale and distribute returns to LPs.
Despite the long-term investment horizon, nimble and quick execution is the hallmark of private equity. Private equity funds generally have well-defined investment strategies, but their execution can easily flex and adapt to best take advantage of investment opportunities. Additionally, while private equity buyers have long been known as financial asset flippers, over the past decade firms have begun pursuing more complicated portfolio strategies that leverage their growing expertise and relationships to become sector consolidation powerhouses, a position traditionally dominated by corporate strategic buyers.
Strategic flexibility combined with predictability of terms and readily available capital are among the factors giving private equity players the edge, as exemplified by the development of the technology and renewable energy sectors.
Private equity buyers have been able to pursue these opportunities in technology partly because plummeting stock prices and heightened regulatory scrutiny are making M&A much harder for industry giants who have historically played the consolidator role. In fact, private equity buyers led seven of the 10 biggest information technology M&A deals in the US and Canada last year, the highest share recorded in the past 22 years, according to S&P Global Market Intelligence data. The biggest private equity purchase was a $17.18 billion deal by a company owned by Vista Equity and partners. Tibco Software Inc.'s acquisition of digital workspace provider Citrix Systems Inc. underscored private equity firms' buying power and showed how funds are expanding technology companies they already own via bolt-on acquisitions.
In contrast, Microsoft Corp.'s $69.99 billion bid for games-maker Activision Blizzard Inc. has yet to clear antitrust hurdles about a year after the deal was announced. And depressed stock prices have made it harder to finance deals with equity. Meanwhile, specialists such as Thoma Bravo and Vista Equity— which focus on cybersecurity and enterprise software, respectively — took advantage of tech giants’ inability to do deals and emerged as effective consolidators.
Since 2017, Thoma Bravo has spent at least $37 billion on cybersecurity companies — more than 10 times the amount invested by Palo Alto Networks Inc., the largest industry buyer in the period, according to 451 Research data. Vista Equity mirrored Thoma Bravo's strategy in key enterprise software segments. The US-based private equity fund has made more than 40 acquisitions in the enterprise resource management space over the past five years, according to 451's M&A Knowledgebase.
Rising rates are affecting the financials of North American renewable energy and infrastructure developers and electric utilities. However, private equity firms have yet to see a material impact on deal activity. Private equity has been able to replace some deal leverage with equity, increasing power purchase agreement (PPA) prices, becoming more flexible regarding exit strategy and looking ahead to take advantage of additional production and investment tax credits in the US Inflation Reduction Act.
Even if valuations decline, the energy transition's growth and value opportunities will continue to boost the amount of private capital chasing renewable energy and infrastructure deals. Rising prices for renewable energy PPAs are helping private equity firms protect returns in a high interest rate environment.
Large private equity firms continued to strike deals in 2022 despite the deteriorating macroeconomic outlook. JP Morgan's investment management arm's leveraged buyout of South Jersey Industries Inc. for nearly $8 billion, announced in February 2022, was the year's biggest private acquisition in the sector, according to S&P Global Market Intelligence data.
A growing number of US investor-owned utilities, including Dominion Energy Inc., Duke Energy Corp. and FirstEnergy Corp., are considering selling — or actively shopping for — renewable assets or minority stakes in regulated subsidiaries to minimize future external capital market needs, creating possible buying opportunities in 2023.
The majority of private equity growth has been in a long, low interest rate environment. Even the pandemic did not hold it back. After a brief pause in 2020 due to the onset of COVID-19, the industry roared back, setting new annual records for exits and entries. Fundraising for private equity and venture capital firms topped $1 trillion in 2021, another high-water mark for the year.
The party ended just a few months into 2022 with the onset of the Russia–Ukraine war, which rattled supply chains and fed a global wave of inflation. In June, the US Federal Reserve unveiled a 75-basis-point rate hike, followed by other central banks, bringing the era of cheap money to a halt. Suddenly, debt became harder to come by and more expensive, and it was clear that the shift that undermined the economics of the traditional leveraged buyout was here to stay for the foreseeable future.
By year-end, private equity activity was down across several key metrics including entries into new investments, fundraising and exits. Collectively, private equity firms posted almost 20% fewer technology deals in the second half of 2022 compared with the same period in 2021. The nature of acquisitions changed, with smaller bolt-on deals accounting for 71% of all private equity buys in the space in 2022.
The difficulty in financing larger deals is a critical driver of the drop, as is the pressure to boost return profiles with smaller, more affordable transactions following the spate of large-scale, expensive deals that defined 2021 and early 2022.
It was a swift end to a roughly decadelong run for private equity when broad-based economic expansion lifted fund performance. Cheap debt and steadily rising corporate valuations permitted private equity firms to use large amounts of leverage to go after expensive targets and financially engineer a good exit.
Those firms that surfed a rising economic tide may be in trouble now that slower growth and rising interest rates have changed the calculus for private equity. Portfolio companies carrying heavy debt loads are less able to pivot in the face of changing macroeconomic conditions. They may lose out as competitors gobble up market share.
Private equity firms that were more disciplined in applying leverage stand to be rewarded for their restraint. Portfolio companies with the capacity to add more leverage can act aggressively, scooping up add-ons as large corporates shed noncore assets.
The challenge for the private equity industry in the coming years will be how to exit these enlarged platforms at a profit. Overall exit activity slumped by nearly one-third from a record $576.37 billion in 2021, totaling $391.44 billion for the year, according to Preqin. Larger companies are inherently more difficult to sell, and industry buyers are unlikely to escape regulatory scrutiny any time soon. The IPO market may also take a while to rebound, given rampant inflation and volatile markets.
As credit headwinds continue, private equity is preparing investment strategies for an even longer investment cycle as continuation funds are on the rise. Longer investment cycles mean that private equity firms have more time to play out their value-creation strategies with portfolio companies.
While the outlook on interest rates remains uncertain, the possibility that they could remain higher for longer is already prompting changes within the private equity ecosystem. Investment strategies must adapt as the tolerance for cash flow-negative business models rapidly wanes, and this shift will impact sectors such as technology that have long focused on total return. The growing position of private equity as a consolidator to create a better, more nimble industry may change.
Digital transformation remains a key value-creation theme across sectors. Bolstering supply chains is a rising priority amid geopolitical tumult. And as portfolio company hold times lengthen, fund managers are placing a renewed emphasis on fostering a strong corporate culture. They are acting on perceived links between investment performance and lower rates of employee turnover and attrition at a portfolio company.
But private equity's challenge does not boil down to management acumen alone. In addition to guiding portfolio companies through this uncertain period, fund managers are tasked with finding new deals — a growing challenge amid a broader slowdown in M&A activity. That is where sector expertise comes into play.
Downturns are expected to produce a crop of spinoffs and divestments as large corporates refocus on their core strategies. Fund managers with an inside-out understanding of their sector will be among the first to spot those buying opportunities. But just as important is their understanding of long-term, sector-specific trends and the ability to visualize a path to growth. That means looking beyond near-term uncertainty to the end of private equity's typical three- to five-year investment cycle.
Sector experts can also use their unique insights to break through the M&A logjam.
Inflation, geopolitical turmoil, labor and supply challenges, and a cloudy economic forecast are pulling down corporate valuations and driving a wedge between buyers and sellers. Sellers have been slow to accept lower valuations, and buyers generally are not willing to pay 2021 prices in an economic landscape that now looks very different. Combined with tighter lending standards from banks, that bid-ask spread slowed M&A activity in 2022.
In this slower dealmaking environment, fund managers with deep sector insights are at an advantage. They can leverage those insights to find a price that brings reluctant sellers to the table.
Conventional wisdom in private equity is that economic downturns produce some of the industry's best vintages. Corporate valuations dip, allowing private equity to enter new investments at a discount. With any luck, the economic cycle will have shifted when it comes time to exit after private equity's typical three- to five-year hold period for portfolio companies. Faster growth boosts valuation multiples and returns on investment.
This article was authored by a cross-section of representatives from S&P Global and in certain circumstances external guest authors. The views expressed are those of the authors and do not necessarily reflect the views or positions of any entities they represent and are not necessarily reflected in the products and services those entities offer. This research is a publication of S&P Global and does not comment on current or future credit ratings or credit rating methodologies.