Four perils for private equity now, and what they mean for new investments

Most of 2020 and 2021 were record years for private equity. Buoyant asset markets, cheap borrowing costs, supportive fiscal and monetary policy, a booming IPO market, and insatiable demand from investors for anything with a good story behind it all played a role. It wasn’t only private equity that benefitted. The Covid era has sometimes been described as the “everything boom”.

But every single one of these drivers has gone into a hard reverse.

Inflation is heading towards double digits in many developed economies, levels not seen for several decades. Interest rates are rising, the IPO market has all but jammed shut, and growth and technology stocks are being hammered.

The private equity industry is facing risks on several fronts. But from adversity may come opportunity, at least in some areas.

Risk 1: recession risk is rising

Central banks are trying to engineer a “soft landing” by raising interest rates enough to fight inflation but not so much as to cause a recession. As our economists argue in their recent Economic and strategy viewpoint, this will be difficult to achieve. Not least because some of the drivers of inflation are being driven by commodity price shocks as a result of the war in Ukraine.

But recessions have been better times for private equity than might be expected. Funds benefit from “time-diversification”, where capital is deployed over several years, rather than all in one go. This allows funds raised in recession years to pick up assets at depressed values as the recession plays out. And then to exit later on in the recovery phase when valuations are rising.

The average internal rate of return of private equity funds raised in a recession year has been over 14% a year, based on data since 1980. This is higher than for funds raised in the years in the run up to a recession – which, at the time, probably felt like much happier times.

Figure 1: Private equity funds raised during recessions have performed well
Private equity vintage performance (average of median net IRRs)

Past performance is not a guide to future performance and may not be repeated.
Source: Preqin, Schroders Capital, 2022 Based on analysis of vintage years from 1980 to 2009; recessions determined based on NBER methodology (1980–1982, 1990–91, 2001, 2007–2009).

Risk 2: stagflation

Worse than a regular recession is the risk of stagflation – weakening growth at the same time as high inflation. For the public equity market this has been the worst possible environment for returns.

But not all sectors are affected equally. Historically, among public markets, the IT sector suffered most, followed by communication services and industrials. In contrast, it has been a very good time to invest in consumer staples and healthcare companies. Parallels can be drawn to private equity.

Figure 2: Sector performance during stagflation varies a lot
 Annualised average sector return vs. MSCI World Index (since 1995), %

Past performance is not a guide to future performance and may not be repeated.

Source: Refinitiv, Schroders Capital, Schroders Strategic Research Unit. Analysis from January 1995 to December 2021. Stagflation is calculated as the months where US CPI inflation is above its 10-year average and our Global business cycle indicator is in the slowdown phase; above table excludes utilities, energy, real estate, materials and financials as these are less relevant for private equity

As an industry, technology features heavily with private equity. If historical public market experience is a guide, then many strategies could find the going tough if stagflation becomes an issue – albeit shielded to some extent by time diversification.

And, rather than struggling, investors with exposure to consumer and healthcare-focused strategies may even be pleasantly surprised by how their funds perform.

Risk 3: the IPO market is closed

The $10 billion of US IPOs in the first quarter of 2022 was 92% below what was raised in the same period last year – when the recent IPO boom was at its peak. As of 9 June, the figure for the second quarter has collapsed further, to next to nothing. A paltry $3 billion has been raised quarter to date. 2022 is shaping up to be the worst year for IPO volumes for a long time.

Figure 3: A weak IPO market shuts one door for private equity exits

US IPO Value, $bn

*Data as at 9 June 2022. Based on IPOs which raised more than $100m. Source:  Morgan Stanley/Dealogic, Schroders Capital.

The IPO market is a key exit route for venture capital investments, so this presents a problem. And heightened risk aversion is also likely to impact many companies’ appetite to pursue mergers & acquisitions. But the closing of these exit opportunities will also create opportunities for some general partners (GPS) and limited partners (LPs).

GP-led transactions, where one private equity general partner/fund manager sells one or several portfolio companies to another vehicle set up by the same GP, are likely to come more into vogue. This was already happening, but the closure of the IPO market and a reduction in M&A exits could accelerate the trend.

Figure 4: GP-led secondary transactions have soared in recent years

Secondaries transaction volume (bn USD)

 Past performance is not a guide to future performance and may not be repeated.

Source: Jefferies, Greenhill, Credit Suisse, Evercore, Lazard, Schroders Capital, 2022.

GP-leds secondaries have two main benefits. One, the sale allows investors in a given private equity vehicle (LPs) to achieve an exit, with an associated cash distribution. But, second, they also allow GPs to maintain exposure to those companies that they feel have further upside – rather than, for example, being forced to exit completely when a fund nears the end of its life.

Risk 4: fundraising excesses will come home to roost

While all private assets have been attracting increasing interest from investors in recent years, some parts of the private equity industry have gone stratospheric.

Excessive amounts of capital leads to more competition for deals, higher prices being paid and, ultimately as we are likely to see, worse returns.

A prime example is the late stage venture/growth segment. For years, our Schroders Capital Fund Raising Indicator (FRI) has been flagging the fundraising excesses in this area. And all of this money had to find a home somewhere. 

Figure 5: Venture/growth capital fundraising has been running hot for several years, driven by late stage strategies

Venture/growth capital fund raising (US, Europe) and its long term trend

Source: Pitchbook, Schroders Capital, 2022.

This wall of money contributed to a nine-time rise in median valuation of companies at the pre-IPO fundraising stage over the last five years. And a soaring number of unicorns. But, as with all assets whose valuations have been pumped up by easy liquidity in recent years, the future now looks a lot more stark for many of these companies. The private equity funds which backed them are likely to go through a much more challenging period for performance.

Figure 6: Unicorn creation went into overdrive and is now declining

VC backed monthly unicorn creation

Figure 7: Exuberance was concentrated on unicorn / pre-IPO financings

Increase in median pre-money valuations 2016–2021*

* Early-stage defined as Seed to Series A rounds, early-growth defined as Series B-E rounds, and late-stage pre-IPO rounds defined as Series F and beyond rounds.  Increase is for the period 2021 vs 2016. Source: Pitchbook, Schroders Capital 2022.

However, fundraising has not been so wild everywhere in private equity. Early stage venture capital has been much more contained. One way to see this is in the relative change in valuations of early stage venture capital investments compared with later stage ones. The median valuation of venture-backed companies at the early stage (seed/series A round) “only” doubled between 2016 and 2021. This is a long way short of the liquidity-fuelled nine-times rise in late-stage (Series F+) rounds. That should feed through into more resilient performance on the early stage side.

And, within the buyout space, valuations on small buyouts have been more stable than large buyouts, in part due to less capital flowing into their area. The risk of a valuation-driven fall in prices is lower in small buyouts than large.

Figure 8: Smaller buyouts with more stable pricing than larger buyouts over past several years

Pro forma trailing EBITDA multiples US and Europe

Past performance is not a guide to future performance and may not be repeated.

Chart shows equally weighted average of US and European deal multiple. Source: Baird 2021, S&P 2020, Schroders Capital, 2022.

Opportunities amid adversity

Private equity is not immune to the forces which are buffeting all financial assets right now. However, while some parts of the industry are likely going to face more difficult times, others are likely to be more resilient, even with opportunities to thrive.

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