In this edition of the Private Market Report, we review developments from the first half of 2022 relating to private equity, venture capital, private debt, and real estate.
Our Research Spotlight examines how private equity firms drive returns for investors by creating value in their portfolio companies, both organically and inorganically. We also analyze how private equity performs during periods of economic turbulence and potential advantages over the public equity markets during such times.
Executive Summary
- Private Equity remained well-capitalized and willing to make new investments under the right circumstances. However, exit activity (the selling of current investments) has slowed down as managers focused their efforts on portfolio company operations to protect profitability and valuations amid market volatility.
- Venture Capital activity remained strong despite headwinds including inflation and rising interest rates. Still, managers are taking a more cautious approach to unprofitable companies with unproven business models and longer runways to exit.
- Private Debt continued to attract yield-driven investors who desire portfolio diversification, but increased competition has made it more important to select the best managers with appropriate risk-adjusted returns. Performance has generally held up well, contrary to public bond markets, as these investments tend to be floating rate loans which benefit from higher interest rates.
- Real Estate markets have experienced rapid price appreciation in recent years as a result of supply shortages and ultra-low interest rates. While interest rates have risen this year, demand remains strong and supply remains low, partially insulating prices from the full effects of today’s economic challenges.
Private Equity Playbook
A common misconception is that private equity (“PE”) firms generate returns by aggressively leveraging companies with significant debt, stripping assets from the business, and slashing its workforce. While these strategies have been employed in the past, and well-publicized in some cases (such as RJR Nabisco in 1988), the days of creating returns solely via financial engineering are no longer the norm. In reality, these strategies often diminish the value of the company and ultimately the owners’ equity (including the PE firm and its investors).
So how do PE firms drive returns today? At its core, private equity creates value by investing in businesses and then improving them in every fashion imaginable – nearly all can be improved in some way, no matter the size. The end goal is to sell the upgraded portfolio companies for a justified premium, thus realizing the value created.
The best PE firms offer far more than just capital. This often includes invaluable capabilities that leverage resources, experience, and relationships the business may not have access to on their own. In fact, many companies are more inclined to select a PE partner for their proven ability to grow a business, rather than simply accept the highest initial dollar offer.
Company growth, organic and inorganic, can often be independent of market conditions, though economic factors certainly impact decisions PE firms make along the way. For example, PE firms have recently navigated a global pandemic, rising labor and input costs, and supply chain constraints. While there are always bumps in the road, long-term growth initiatives remain intact. Since PE funds typically have long time horizons, the focus is entirely on the long-term value creation playbook, rather than responding to short-term targets as is often the case with publicly traded stocks. In many cases, this long-term lens results in the best outcome for all stakeholders, including employees and customers.
“If everyone is moving forward together, then success takes care of itself.“
This quote from Henry Ford illustrates how CEOs of PE-backed companies generally view their relationship with PE firms’ operations teams.
So how do PE firms grow businesses to create value? There are many methods PE firms use to drive growth, and the best firms are highly focused on every detail. From bolstering sales teams, to optimizing operations, to acquiring competitors, to rightsizing the capital structure, the private equity playbook is extensive and dynamic.
Put simply, growth can be classified into two categories – organic and inorganic.
Organic Growth
Organic growth uses a blend of resources, expertise, marketing, relationships, and capabilities to internally grow revenue and profit margins. Before making an investment, PE firms create a playbook to implement enhancements, which often includes bringing on additional professionals, expanding product lines and distribution, refining manufacturing and supply chains, and introducing new technology. PE firms with a proven track record are well-equipped to create value organically based on past experiences and implementation of best practices. In addition, PE firms often employ experienced industry specialists (“operating partners”) who work directly with company management teams to execute the playbook from start to finish.
Inorganic Growth
Inorganic growth is achieved primarily through mergers and acquisitions. PE firms will invest in a high quality “platform” business and then acquire a number of smaller companies to the platform in order to quickly grow revenue and market share, as well as expand the business into new geographies and product lines. The PE firm provides capital for acquisitions and a depth of knowledge on effective integration, allowing the platform company to benefit from multiple areas of specialization and revenue growth while also increasing profit margins for the consolidated business. In addition, these smaller companies are typically bought for relatively cheaper valuations, which effectively reduces the all-in entry price of the consolidated business and ultimately results in higher returns on the investment when the company is sold.
Which Growth Strategy is Superior?
The answer is – it depends.
The playbook for one company will never be identical to another, and often involves aspects of both organic and inorganic growth. The most important factor to success is having the right PE partner with the resources, experience, and network to execute on the vision and try to create long-term meaningful value.
How Does Private Equity Hold Up in Times of Economic Uncertainty?
During periods of economic uncertainty, private equity’s focus on long-term value creation, whether through organic and/or inorganic growth initiatives, can be a major advantage to investors. PE firms are not as beholden to the short-term stock market and can take a more patient approach.
In addition to outperforming stocks during periods of economic decline, private equity has historically proven to be more resilient to catastrophic loss. The relative illiquidity of private markets can actually be protective in times of economic downturn. “Panic” selling is less common as investors are typically more committed to the long-term success of the investment. 1
Moreover, PE firms are typically well-capitalized, with dry powder (purposefully reserved capital waiting for deployment) that can be used to alleviate companies’ financial stress.
Empirical research using data since 1980 suggests that the risk of “catastrophic loss” (defined as a 70% decline from peak value) is drastically lower for PE-backed companies, and particularly PE funds, compared to publicly traded companies. 1
While CEOs of public companies generally report to their board of directors quarterly and independent operators must rely on their own resources, PE firms actively support their portfolio companies’ management on a daily basis, allowing them to better anticipate and respond to crises.
While economic uncertainty has an impact across all segments of the market, it also reminds us of the importance of picking quality investments that have shown an ability to weather periods of turbulence.
Venture Capital
Managers adopted a more conservative and selective approach in the first half of 2022. Taking a cue from public markets, technology companies with unproven business models were hit the hardest as rising discount rates (affected by interest rates) and lower growth rates impacted valuations. Macroeconomic factors including inflation, rising interest rates, and geopolitical uncertainties, created strong headwinds thus far and will likely continue to create challenges, particularly for those companies with high cash burn rates and longer runways to profitability and / or exit. Even with the decline in activity, 2022 is still on pace to rank as the second biggest investment year in history following a record-setting year in 2021 2.
Private Debt
The industry continues to attract investors for its reputation as being a high-yield asset class with favorable risk-adjusted returns, particularly compared to today’s public bond market with still relatively low yields and rising rates. Alongside its growing popularity, Private Debt markets have become more competitive, putting pressure on returns and separating the best managers from the pack 4. Going forward, optimism remains in the space given the strong demand from Private Equity sponsors with capital to invest as well as the appealing credit terms offered by Private Debt managers in a difficult economy.
Private Real Estate
Deal activity remained strong in the first half, despite rising interest rates. While the industrial space cooled some from its torrid pace in recent years, demand for these assets, particularly in niche areas (for example cold storage), is still strong and driving growth. The residential market continues to run hot, with a severe supply shortage, favorable demographics, and rent growth driving price growth in certain markets. However, the surge in interest rates certainly raises some concerns about pricing going forward, particularly if supply normalizes. Transaction volume showed signs of recovery in the retail, hospitality, and office sectors, driven by the consumer’s appetite for experiences and a “return to work” trend 3.
Private Equity
Private Equity’s record-setting performance over the past 18 months could return to more normal levels in the coming year. Data from the first half of 2022 shows a slowdown in exit activity due to uncertainty surrounding inflation, public market volatility, rising interest rates, and geopolitical tensions. The IPO market all but dried up earlier this year, further contributing to a slowdown in Private Equity exits.
While the pace and volume of new dealmaking continues to be strong, there seems to be more scrutiny from managers and a hesitancy to overpay or undersell. Rather, the best managers have been highly focused on the nuts-and-bolts of their portfolio companies, improving operations and preparing them for a variety of economic outcomes. In the current inflationary environment, it is essential to help companies boost revenue growth, maintain or expand profit margins, and keep a healthy balance sheet.
The long-term outlook for Private Equity remains strong as quality managers are well-positioned for the future4. With capital to invest and healthy fundraising, managers are prepared to react opportunistically if valuations continue to become more attractive. As such, it is worth remembering that companies bought coming out of recessions have historically performed quite well.
Sources of Information Cited for “Research Spotlight: Private Equity Playbook”:
1. J.P Morgan Eye on the Market Special Edition. “The Agony & Ecstasy. The Risks and Rewards of a Concentrated Stock Position.” 2014, https://privatebank.jpmorgan.com/content/dam/jpm-wm-aem/global/pb/en/insights/eye-on-the-market/eotm-the-agony-and-the-ecstasy.pdf
Sources of Information Cited for “Market Update: Mid-Year 2022”:
2. Grabow, Jeffrey. “The Venture Capital Bull Market Has Run Its Course, but Reports of Its Demise are Premature.” EY.com, 28 July 2022, https://www.ey.com/en_us/growth/the-venture-capital-bull-market-has-run-its-course-but-reports-of-demise-are-premature.
3. 2022 Global Real Estate Outlook. “2022 Global Real Estate Outlook Late-Cycle Investing Philosophy Comes Early.” Morgan Stanley, 14 January 2022, https://www.morganstanley.com/im/en-us/individual-investor/insights/articles/2022-global-real-estate-outlook-late-cycle-investing-philosophy-comes-early.html.
4. McKinsey Global Private Markets Review 2022. “Private Markets Rally to New Heights.” McKinsey.com, March 2022, https://www.mckinsey.com/~/media/mckinsey/industries/private%20equity%20and%20principal%20investors/our%20insights/mckinseys%20private%20markets%20annual%20review/2022/mckinseys-private-markets-annual-review-private-markets-rally-to-new-heights-vf.pdf.
© 2022 Moneta Group Investment Advisors, LLC. All rights reserved. These materials were prepared for informational purposes only based on materials deemed reliable, but the accuracy of which has not been verified. This is not an offer to sell or buy securities, nor does it represent any specific recommendation. An index is an unmanaged portfolio of specified securities and does not reflect any initial or ongoing expenses nor can it be invested in directly. Exposure to an asset class represented by an index may be available through investable instruments based on that index. You should consult with an appropriately credentialed professional before making any financial, investment, tax or legal decision. Past performance is not indicative of future returns. These materials do not take into consideration your personal circumstances, financial or otherwise.
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