Private markets have outperformed public markets over recent decades, and these investments are going mainstream. But with the macroeconomic stress of likely recession, double-digit inflation, substantial interest rate hikes and – most importantly – reduced customer spending, the coming few quarters are likely to be challenging. And several PE strategies are likely to suffer more than others.
Tougher Environment
At the end of September 2022, fundraising in Europe was at its lowest in the past 10 years with €37.4 billion across 66 vehicles, compared to a total of €92.4 billion across 182 funds in 2021 [1]. “I expect the European deal-making environment will continue to be under pressure through Q4, and at least for the first half of 2023,” said Mr Zorzetto. Fundraising will continue to be challenging with lower distributions to investors, leaving less to be reinvested in the next vintages. Compounding these are concerns that company valuations are decreasing just as interest rates are rising, not least because portfolio companies will have their own inflation and liquidity challenges. “As a consequence, the amount that the investor and the fund manager are willing to pay now for future cash flow is lower,” he said.
Private equity must tie up with expertise in the field in which the fund manager is investing.
“It is a concern that many fund managers have never experienced the current market environment,” Mr Zorzetto commented. He sees that many have come to rely on expectations of near-automatic multiple expansion, with only a need to invest and wait before reaping the rewards. “It will be the funds that are able to adjust their investment selection process over the next couple of years and implement a strong-value creation framework that will perform best,” he said.
Fresh Value Approach
Creating value in this environment requires a fresh approach. “Private equity must tie up with expertise in the field in which the fund manager is investing. This means more specialisation, coupled with a strong entrepreneurial approach to managing each portfolio company,” he said. This also means a more hands-on approach with helping companies to grow. This can come in many forms, including improving operational efficiency, helping with recruitment and retention, boosting external financing, helping to diversify the product offering, working on the pricing approach, and much more.
As for specialisation, Mr Zorzetto believes that funds will move away from acquiring multiple different companies for their portfolios, towards a “bolt-on” approach. “This strategy involves buying a strong platform company and building value through well-executed add-ons,” he said. This should improve value creation as synergies are built.
Sustainability Transparency
Sustainability, inevitably, is also part of this overall maturing approach. “There is a premium on active ESG value creation in private equity, not least because it is important for assuring effective fundraising,” he said. Many pension funds and insurance companies now formally require fund managers put effective ESG strategies in place. Here too, PE managers and investors have choices of how they can contribute, including energy efficiency improvements, supply chain management upgrades, strengthening occupational health and safety, improving company decision-making, gender diversity and more. This ESG strategy should be embedded in the entire value chain, from pipeline build-up down to post-execution ongoing monitoring. Delivering on what has been committed will be essential.
Strong communication with investors is also key to a successful ESG strategy. The data needs to be not only available but high quality. “You really need to sit down with a portfolio company to tell them that investors require this feedback,” Mr Zorzetto said. This will generate a cost, but it can be outweighed by the benefits that will accrue. This and other aspects of operational activity can be supported by successful digitalisation.
There is a premium on active ESG value creation in private equity, not least because it is important for assuring effective fundraising.
Liquidity Flexibility
Managers will also need to offer their investors greater flexibility in terms of exposure management. “During these more challenging market conditions, it is important to stay patient to allow value creation strategies to develop,” Mr Zorzetto said. Nevertheless, not every investor will be able or willing to stay the course. This is particularly true as the private markets open up to a broader range of investors, such as family offices; a trend that we at IQ-EQ have been observing for some time now [2]. As interest rates rise, many may look again towards more traditional capital markets, so to ensure PE investing remains attractive, creative liquidity options should be deployed.
“Private equity funds can put together hybrid solutions to allow reallocation through liquidity windows before the end of the official lock-up period,” he said. This isn’t about providing full, permanent liquidity, but about giving the investor a reasonable amount of flexibility. Secondary and “evergreen” funds may increase liquidity in the market.
“As an industry and as an ecosystem we will need to have the tools to enable these options for institutional investors,” he said. “Structuring flexibility, value creation, ESG, and so on will trigger a need – in my opinion – for even higher levels of transparency, which requires quality reporting and a lean and agile regulatory framework to allow fund managers to remain compliant.
[1] Source: Pitchbook – European PE Breakdown
[2]More infos