Private markets health check: rebounding with strength

An unusually high level of activity in 2021 was followed by an economic slowdown with high interest rates and inflationary pressures. Rates appear to have peaked, and recession is settling into a soft-landing scenario returning the markets to a more normal private investment environment. While we're starting to see some investment activity in Europe, it's still muted. Planning the year ahead we look at private market investments headwinds and tailwinds impacting the fundraising, deal activity, investment performance

Fundraising remains contracted

Full-year fundraising continued to decline from the 2021 peak. Fundraising periods have notably lengthened, with the average cycle now stretching with cycles now approaching two years compared to the previous 8–12 months. This adds to the overall competition in the market for investor commitments. Recent data points indicate that there are around 40,000 funds globally aiming to raise $3.3 trillion. It’s certainly much more favorable time to be an LP. Last year, nearly every large-cap European fund was raising capital, offering a wide range of options.

The headwinds have not affected all managers equally. While some LPs have increasingly backed emerging managers in the past due to the more favorable terms they offer, the current market environment also presents opportunities to partner with more established GPs while still securing favorable terms. The potential shift from small fund and emerging managers towards larger funds could reduce the innovations and diversity of investment strategies available in the market.

Distribution drought

The economic downturn has disrupted the cash flow cycle, leading to a slowdown in returns to LPs. Typically, capital begins to flow back to investors within the first 1.5 to 4 years, with larger distributions being made once fund managers realize their investments in companies. Industry analysts report that private equity managers are now sitting on 28,000 unsold portfolio companies, collectively worth $3.2tn trillion of investment (1). With managers delaying exits and limited cash circulating through the system, LPs are struggling to reinvest in the new generation of funds or even fulfill existing commitments. GPs are now under significant pressure to deliver returns and restore distribution yields to more typical patterns, in order to satisfy LPs and maintain a healthy investment ecosystem.

Low asset valuations

Higher interest rates have made financing more expensive and lowered company valuations. Private market valuations remain significantly below 2021 levels, down by about 25% on average (2). While the situation is improving with falling interest rates, there is still a need for realistic adjustments in asset expectations. Many GPs are apprehensive about the future performance of these assets. The pressure to return capital to investors is expected to drive GPs to sell investments, even at reduced valuations.

Moreover, concerns about growth prospects are shaping valuation theses. Higher interest rates have significantly eroded earnings, forcing companies to prioritize debt servicing over reinvestment and growth. In recent years, GPs have primarily focused on transacting in the most pristine assets with clear revenue visibility. However, the landscape is shifting, and the scope of transactions is expanding to include a broader range of assets. These deals, however, are likely to proceed only if there is a significant recalibration of price expectations to align with the evolving dynamics of private markets.

Funded primaries and single asset transactions gained popularity

Amid market uncertainty, investors are seeking diversification through less traditional investment approaches, such as funded primaries and single-asset transactions, to mitigate market risk and enhance liquidity. As fundraising takes longer, funded primaries enable GPs to raise capital and simultaneously deploy it while the fund is still in its fundraising phase. This structure creates an opportunity to capitalize on specific investment opportunities and realize returns more quickly than with conventional fund structures. Instead of relying on a blind pool analysis of speculative real assets, funded primaries allow investors to directly engage with real assets and observe GP performance in real time. This approach contrasts with traditional approach, where investors commit without knowing which companies will be acquired and GPs invest based on a predetermined strategy.

Single-asset transactions have been also gaining traction. Historically, PE is typically characterized by a broader portfolio approach, longer investment cycles, and less emphasis on single-asset transactions or GP-led dealmaking. However, with limited deal flow in core buyout portfolios, LPs exploring opportunities in single-asset transaction route to access liquidity. The scale and expertise of resources are critical when conducting due diligence and structuring these deals, as they require deep industry knowledge to thoroughly analyze the underlying companies.

Value creation and growing pressure on GPs

The primary drivers of private equity returns have shifted from financial engineering to value creation within the assets themselves. Today, the focus is on growing the business and improving profitability, rather than relying on financial maneuvers. In the 1990s, the strategy was based on multiple arbitrage, or simply buy low, sell high approach. In a recent analysis of the last 40 deals made in the past 12-18 months, we found that 55% of returns in the base case were driven by revenue growth, while 30% came from margin expansion (3). Mergers and acquisitions accounted for 22% of the returns. Notably, multiple expansion and leverage were negative contributors to return.

There is little doubt that the pressure on GPs to create value has intensified, requiring a deeper level of operational expertise and a more hands-on approach with portfolio companies. GPs must have a thorough understanding of the industries they invest in and drive transformation within the assets during ownership. Over the past 10-15 years, as private equity has matured, GPs have developed a greater sector-specific focus. This evolving expertise will undoubtedly benefit them moving forward. As we approach 2025, GPs are expected to face mounting pressure to identify exit opportunities for many of their investments.

In the past, private equity focused on selecting investments and providing capital. However, in recent years, sourcing opportunities has shifted to a competitive process. Simply offering cash is no longer enough. With less money available, companies now have more time to carefully assess their options and potential financial partnerships. GPs must demonstrate their ability to add value and be true partners, investing energy into building trust. As founders often are rolling over their investments alongside PE, its co-creation of value and identification of opportunities that will help the company grow to the next level. The conversation extends beyond a single price point, requiring empathy, sector expertise, and a deep understanding of the value creation tools relevant to a company's development cycle. Sophisticated GPs, who start sourcing years in advance and communicate their value over a sustained period, can differentiate themselves and create a competitive advantage.

Over the past 20 years, global PE has delivered an annualized return of 10.5%, surpassing the 7.0% return of global public equity portfolios (4). In recent years, it has been challenging for both LPs and GPs to wait for private markets to recover. While public markets often outperform private markets in the short term, both PE and VC typically yield much higher returns over longer periods. Private markets remain inefficient, offering significant opportunities to capture value and drive assets with specialized skills and creating a positive outlook for the industry

Analysis prepared by Tetiana Kosten. Image courtesy of Pietro Mattia

Endnotes:

(1) Bain & Company's Global Private Equity Report 2024, Calculations of global buyout of unrealized value is based on Bain & Company assumptions and analysis and of Preqin and PitchBook data

(2) Atain Investment Strategy Calculations, Cambridge Associates as of 29/09/2024

(3) Neuberger Berman, as of 9/30/2024, keynote panel analytics presented at the Women Private Equity Forum 2024 in London

(4) Preqin Private Equity Peer Universe as of 12/31/2023