Global Private Equity Review and Outlook for 2024
The small and middle market buyout space continues to see steady deal flow. Attractive supply demand dynamics coupled with slowing fundraising is resulting in attractive entry prices, and opportunities for active co-investments are increasing.
Private equity has drawn its fair share of criticism this year as financial conditions have continued to tighten. The prophets of doom have been loud and united:
“Hordes of investors ‘stuck’ in painfully over-valued assets”
“Screws tighten on super funds over valuing unlisted assets”
“Private equity heads for a ‘slow motion train wreck”.
While such assertions make for juicy headlines, they haven’t been borne out by reality; at least as it relates to Schroders Capital and the way we invest. Below, I explain some of the structural trends shaping today’s investment landscape, respond to some of the criticism [mis]directed at private equity, and identify some of the key trends emerging from the asset class as we move into 2024.
Today’s market conditions are far removed from those of just a few years ago. Back then, zero rates, quantitative easing and yield curve control collided with fiscal stimulus to create a perfect storm of excess liquidity and multiple expansion.
Most of these trends reversed with the onset of inflation. The response by the US Federal Reserve was swift and deliberate – 11 rate hikes in 17 months took the federal funds rate to between 5.25% and 5.50%, its highest point since 2007.
We now look to be at or near the end of this tightening cycle.
But inflation is a hard genie to put back in the bottle. While a pause looks imminent, rate cuts appear less so with inflation remaining uncomfortably above target. Fed Chair Jerome Powell has repeatedly flagged the danger of inflation expectations becoming entrenched. But this horse may have already bolted, with yields at the long end of the Treasury yield curve breaching 5% in October.
We believe that inflation and rates will indeed remain higher for longer, and that this regime shift, what we call the “3D Reset”, is more structural than transitory - owing in large part to three key underlying structural drivers.
- Decarbonization, however important, will be expensive. Not only does it require the development of new technologies, but also the formation of new supply chains and the recalibration of existing ones. According to Schroders modelling, decarbonization will put upward pressure on prices over the long-term and growth will be slower in all but the net zero with innovation scenario. That additional innovation helps boost growth through the period, but it's still a very challenging outlook and innovation is not a given. It's certainly not our base case scenario.
- Demographic changes should also put upward pressure on prices. The retirements of Baby Boomers will impose a funding liability, while a smaller labor pool could contribute to wage inflation and a possible wage-price spiral.
- Rounding out the structural trifecta is geopolitics and deglobalization. Great power competition between China and the United States continues to intensify, marked by the implementation of protectionist trade policies. And the war in Ukraine, together with worsening conflict in the Middle East, headline what has become an increasingly fraught geopolitical landscape. At the same time, the world is moving away from bipolarity (dominated by the United States and Europe) towards multipolarity, where growth should be more dispersed.
Private equity has been resilient
Private equity has been in the firing line this year for being too illiquid, overly levered, and overvalued. We believe these concerns are misguided. So let’s take them in turn.
First – liquidity.
Yes, the IPO market dried up in 2023; but we don’t generally rely on IPOs to exit our positions. We were also coming off a high base. 2021 was a euphoric year with market activity including liquidity far above the normal, and a degree of slowdown from those highs was to be expected. We typically target small and mid-cap businesses, and we’re usually out of them before they get to IPO stage. We tend to sell our businesses to other funds or corporates, and while exits here are down, they’re not at levels that make us uncomfortable.
To this point, recent exits include Electrical Supply Inc, PSS, Lenskart, and Olink. So the liquidity is there, albeit down from previous levels.
Next – debt.
Some pundits criticize private equity for being overly levered – up to 80%. It is true that geared takeovers at the upper end of town can involve this kind of leverage. However, Schroders’ assets currently sit at the opposite ratio of 70:30 equity to debt – a function of our filters as well as the debt levels typically found in the small and middle markets.
Finally – valuations.
While pricing events are far less frequent than in liquid markets, we mark our assets in our semi-liquid funds on a monthly basis and don’t believe our own assets are overvalued. Across the portfolio, twelve month sales have grown while sustaining our EBITDA margin, which is indicative of our investments’ ability to pass through inflation.
This resilience is in large part due to the types of businesses in which we invest. That is to say, businesses in the small and middle markets which we think are generally less exposed to the business cycle. And we favor non-cyclical industries such as healthcare and mission critical technology.
Investing in secondaries during volatile markets can also be a driver of return in and of itself. As the adage goes – buy when others are selling. The same goes for private equity.
Bring on 2024!
A few key themes have emerged which set to shape private equity in 2024.
Fundraising has returned to pre-pandemic levels. However the number of buyouts remains low and larger funds have taken the lion’s share (79%).
The opportunity set among private large cap businesses is limited, so all eyes had been on these firms to deploy their large pools of capital in the form of take privates. But the equity market strength we saw earlier in the year presumably gave them some pause for thought. It follows that with equity valuations now moderating, privates will likely be back on the radar.
Higher cost of debt courtesy of higher yields is also necessitating a quality bias, since positive cashflow will be needed to offset interest costs.
The small and middle market buyout space – the part of the market we choose to target – continues to see steady deal flow. Attractive supply demand dynamics coupled with slowing fundraising is resulting in attractive entry prices, and opportunities for active co-investments are increasing.
Finally, Asia’s share of global fundraising has decreased from 47% in 2018 to 9% in 2023 while Europe’s share has significantly increased. This dynamic is significantly driven by large US investors moving their international allocation away from China and allocating it to Europe. Still, through 2022 and 2023, private equity investments in India and Southeast Asia grew by 11% and more than 30% respectively, while China saw a decline of 9%. In the first half of 2023, India and Southeast Asia became the largest recipient region in emerging markets. So the opportunities are there. And funding them should be rewarded.