Private markets pivot
Suzi Gillespie, BVCA Head of Research, looks at the changes in economic conditions seen in 2022, how this is impacting private markets, what this means for BVCA members and how they are responding to the challenges ahead.
With the benefit of a bit of hindsight, we can see that there was an economic paradigm shift in Summer 2022. Inflation was driven up by supply chain disruptions, increased energy costs and households spending savings accrued during the pandemic. The central banks of developed economies started to raise interest rates to combat increasing inflation — raising the cost of financing for businesses and households at a time when everything was starting to feel expensive. This in turn impacted confidence levels throughout the economy.
Unsurprisingly, given the macroeconomic context, the second half of 2022 saw a significant drop in private equity deal making and fundraising that impacted the total investment for 2022. According to Bain & Co, global buyout deal value fell 35% to $654bn in 2022 from the prior year, while fundraising was down 10% from 2021’s record levels.
The cost of capital is a key factor for private equity and venture capital investors, in particular the cost of debt where transactions are partly debt funded. In Summer 2022, debt financing not only became more expensive but, in some cases, it was no longer available. Banks withdrew almost entirely from financing larger deals. Credit funds stepped in but became more selective about which businesses they backed.
For investors in early-stage businesses that are not yet cash flow generative, the increase in the cost of debt from close to zero to a more substantive level has focused investors’ minds on ensuring that investee firms have a robust business plan and strategy to getting to profitability as opposed to seeking top line growth only. Taking the UK as an example, on 23rd March 2023, the Bank of England increased it’s base rate to 4.25%. The last time it was at this level was before the Global Financial Crisis of 2008/09–15 years ago. We have a whole generation of investors and entrepreneurs for whom higher interest rates will be a new challenge to grapple with.
On a more positive note, many of our VC members are of the view that a higher cost of capital will be a long run benefit to professional investors who are able to help founders grow businesses. The apprenticeship style culture within investment firms will ensure that young(er) colleagues are mentored through this period of change.
Tenacity in turbulent times
We see our members asking themselves four key questions:
- How are we going to generate good returns?
- What do our LPs need?
- Where will future fundraising come from?
- How resilient are our investments?
Good returns come firstly from good investment selection, and then from making changes to allow the business to thrive. We know from the EY ‘Report on the Performance of Portfolio Companies’ that leverage does play a part in generating good equity returns. The long-term dataset shows that, on an aggregate basis, the 97 companies exited since the study began generated a gross return of c.3x the public equity market, with around 60% of the outperformance being due to additional leverage and 40% strategic return. This is encouraging and bodes well for the future. The higher interest rate environment we are now in means private equity sponsors are leaning in more to operational improvements and ensuring that their investments are more resilient, particularly in the face of higher inflation.
Just as the economic shifts have created challenges for GPs, likewise for LPs. Since 2011 private equity and venture capital funds have collectively paid out more in distributions than they had taken in via capital calls. LPs have been in the advantageous position of being able to fund drawdowns and new commitments via ‘recycling’ cash from distributions. This changed in the second half of 2022 when exit activity slowed significantly. For the first time in a decade, LPs are grappling with the need to fund capital commitments from other sources. Many are also overallocated to private equity as a result of the relative drop in public market valuations.
All of this is leading LPs to be more cautious with future commitments, and we are already seeing an increased investor preference for established managers. In 2022, 57% of funds raised went to mega funds (>$5 bn), up from 43% in 2021.
Maintaining an open dialogue with investors and potentially exploring liquidity options is important. I hosted the Secondaries Forum at the BVCA Alternative Fund Strategies Conference on 28th March, and continuation funds and secondary transactions are increasingly being considered as ways to generate liquidity for some investors. As ever, relationships and alignment of interests are key.
With some existing LPs potentially restricted in their investment capability, where will we fund future fundraising? The Bain & Co analysis suggests that around 50% of global wealth is held by individual investors, but only a very small proportion of this is allocated to alternatives. Increasing allocations from this segment of the market, even if only by a small proportion, could unlock a significant amount of capital for investment.
It is no surprise therefore that private capital firms are deepening their relationships with private banks and wealth management platforms. Fundraising from private wealth brings new challenges, including from a regulatory angle (as the participation of individual investors in private capital is more likely to trigger rules designed to protect retail investors).
The BVCA policy team is conducting extensive work in this area, in relation to new retail-friendly vehicles like the Long Term Asset Fund, the UK Government’s proposals to replace the legacy EU disclosure requirements with a new retail marketing framework, and the FCA’s new Consumer Duty.
Looking at the aggregate mix of companies invested in by private equity, the view from Bain & Co is that the portfolios are more resilient than one might expect. More than two thirds of decline in US public equities in 2022 was attributable to tech-related stocks, mainly large tech businesses (Microsoft, Meta, Alphabet, Amazon and Apple) whose share prices had shot up during the pandemic and are now coming back to earth. Private equity is also heavily invested in technology — but it’s a different type of tech. Rather than being mass consumer facing tech, private equity (and venture capital) has built strength and expertise in less cyclical segments such as payment facilitation software and health tech.
We will explore some of the themes around portfolio resilience in a future article.
Investing in ‘interesting times’
In conclusion: times have changed. What worked in the past decade probably won’t continue to work in the next. There will be a greater focus on business profitability and in particular cash flow generation. Relationships will also be ever more important.
Tapping into relevant experience and expertise will be key to navigating the turbulence — whether that’s drawing on the experience of colleagues working in Latin America who are used to operating in a high inflation environment, or listening to the wisdom of the people who were working in private equity when it all began 40 years ago and have navigated many economic cycles.
There is a quote, origin disputed, which says ‘May you live in interesting times’. 2023 is certainly an interesting time to be working in private equity and venture capital. But we know that when times change, the industry changes and adapts. We are confident that the private capital industry will successfully navigate the current choppy waters.
As Emilio Domingo, Head of UK Private equity at Bain & Company put it:
“H2 2022 was the first time in a decade when the tide really shifted and many macro factors all colluded to increase uncertainty — deal volumes, exits and fundraising significantly declined. The current environment presents multiple challenges for PE firms to navigate but the industry fundamentals long term are more solid than ever.”
Head of Research, BVCA
- Bain & Company Global Private Equity Report 2023
- McKinsey Global Private Markets Review 2023
- EY Report on the Performance of Portfolio Companies
This article was originally published on 30 March 2023 on the BVCA website.