The State of Private Equity – Part II

The State of Private Equity – Part II

Part II: Inflation vs Private Equity

Inflation is going to eat into returns – scenario planning is going to be key. Read on to know more:

With private equity investment activity in the second half of the year expected to slow considerably owing to recessionary headwinds, ‘public market woes in 2022 have already had an impact on exits given that the market for initial public offerings (IPOs) has all but dried up,’ write consulting giants Bain & Co.

The global exit value of a buyout-backed investment for the first half of the year was at $338 billion – down 37% year-on-year. The higher percentage decline, although owing in part to base effects – i.e. a decrease from a higher base value for the unusually torrid 2021 investment period, is clearly indicative of the market reacting to global headwinds to the world economy and movement towards safe-haven assets.

Image source: Bain & Co. research

Overall global IPO value including buyout-backed and others, came in at about $91 billion, a sharp 73% decline year-on-year. Although base effects are again clearly at play, “the slowdown will likely extend to exits across the board. Notably, the first-half buyout number does not include exits in growth equity and venture capital investments, where the drop in technology valuations will have the largest impact,” writes Bain & Co.

Image source: Bain & Co. research

Fundraising through the storm

While a large number of funds will still be able to close during the first half of 2022, global fundraising has seen a rather sharp decline, especially over buyout funds. Global private capital came in at about $645 billion globally, down about 18% on a year-on-year basis. Buyout fundraising also dropped, substantially, down over 50% of the previous year’s value.

While turbulence over the short-term outlook is clearly apparent, historical precedence has taught investors to remain committed staunchly to the private equity cause – the rewards of waiting out the storm are often far outweighed by near-term risks. Bain research has found something rather interesting in this regard:

“If the economy tips toward recession, it will inevitably have an impact on the internal rate of return (IRR) from investments made coming into the downturn. Yet the IRR from investments made during recovery years has consistently outperformed the long-term averages, especially investments in top-quartile deals.”  

Image source: Bain & Co. research

While this is indeed an interesting statistic to consider, it would be prudent to be wary of the risks as well. The current environment seems to be posing two major threats for portfolio managers: rising costs owing to inflation and muted multiple expansion during ownership. This is probably why “top-tier funds are already deep into planning mode to gird portfolio companies against rising prices while modifying their approach to due diligence to account for the many risks associated with inflation,” opines Bain & Co.

In this regard, a prudent strategy to negotiate the high inflation environment is key. One needs to plan for scenarios and not certainties – developing a deep understanding of likely scenarios for industries and pressure-testing both portfolio and company performance against the risks.

An aspect to consider is also how much of an impact the rate of inflation is likely to have. A company growing at 5% would have been considered healthy in 2019 – but the same number at inflation rates of over 8% isn’t going to be considered the same. The major takeaway is that portfolio managers need to proactively engage in scenario analysis and get ahead of the period of turbulence to gain an adequate head-start in the recovery period. Bain & Co. writes:

“Data shows that the industry has relied disproportionally on multiple expansions to support returns over the past two decades, but that won’t work in a period of inflation. Top-tier performance moving forward will depend on nuts-and-bolts value creation and a clear understanding of how to manage effectively during a period of rising prices.”

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