Are LPs Rethinking the Role of Private Equity Amid a Higher-Rate Era?

Alison McNeely of Bloomberg news reports private equity's tough year is showing no signs of letting up:

Private equity titans including KKR & Co. and Thoma Bravo pursued unorthodox paths to dealmaking this year in response to a challenging environment likely to persist in 2023. 

Firms sold stakes in their portfolio companies, took on private debt, offered preferred equity and plunked down billions in cash to make deals happen as leverage became scarce. 

After a red-hot 2021, private equity funds raised $404.6 billion of capital during the first nine months of 2022, a decline of more than 20% from a year earlier, according to Preqin. Deal volume as of Sept. 30 was only a third the record $404.4 billion for all of last year.

Private equity boomed in 2020 and 2021 after Covid-spurred volatility in financial markets gave way to government stimulus that sent asset prices soaring. That rally reversed starting this year as inflation and higher interest rates thwarted dealmaking. The tough environment may persist until the Federal Reserve stops hiking rates and inflation cools further.

“There’s no question that it is currently, and will likely be, a more challenging time for private equity firms,” Jason Strife, head of private equity and junior capital at Churchill Asset Management, said in an interview.

Debt Alternatives

The Fed’s monetary tightening has made it more expensive to access debt financing that greases private transactions, with the benchmark rate increasing to around 4.75% in December from about 0.2% a year earlier. Investors’ reluctance to fund risky transactions has shelved about $40 billion of debt that banks would have otherwise sold in the public markets.

Some firms have resorted to doing all-cash deals rather than saddling themselves with costly debt. That’s highly unusual for an investment model that takes advantage of leverage to boost returns. KKR agreed to fund its entire €2.3 billion ($2.4 billion) purchase of insurer April Group, while Francisco Partners, Thoma Bravo and Stonepeak Partners have also funded deals entirely with equity in recent months.

But firms might not have enough liquidity to fund all-cash deals as falling valuations make it harder to sell assets. 

Private company valuations declined 5.3% in the first half of the year, compared to an increase of 25.5% for the same period in 2021, according to Cambridge Associates. The firm predicts a continued slide as inflation and labor shortages weigh on companies. 

Those dwindling valuations could also put pressure on portfolio companies bought during the heady days of late 2020 and 2021, according to Andrea Auerbach, head of global private investments at Cambridge Associates.

“I’m actually really worried about all the investments that were made in 2020 and 2021,” she said. “How are you going to earn the return that you told us about? You’ve got to work really, really hard, and that company’s probably going to have to do things that it didn’t think it had to do in order to earn that return for us.”

If portfolio companies don’t make those expected returns, private equity firms will have even less less cash on hand to make distributions to their investors or pursue new deals. That’s created an opportunity for providers of private credit, such as loans backed by the value of a fund’s portfolio, and preferred equity that pays a dividend and can offer protections similar to debt.

Churchill Asset Management has seen more interest from borrowers that want to structure payment-in-kind debt that doesn’t require interest to be paid in cash. Forgoing cash interest payments allows private equity firms to fund other obligations, such as distributions to their investors.

In this environment, private equity firms can also benefit from co-investment, which brings in limited partners to take a stake in a portfolio company rather than a fund. Firms might also pursue continuation funds, a secondary market option that has sponsors move an existing asset into a new fund — often bringing in new investors at the same time.

“The story of 2023 will be all of the continued evolution and growth within the secondary market,” said Drew Schardt, head of global investment strategy at Hamilton Lane.

Despite these creative funding strategies, the near-term outlook for private equity remains cloudy. Still, dealmaking could pick up in the second half of 2023 if the Federal Reserve halts its rate hikes and inflation decelerates.

If a recession does materialize next year, the downturn could yield better returns for funds that can scoop up potentially profitable companies at a discount.

“Great returns are made in recessionary periods,” Auerbach said.

Helen Thomas of the Financial Times also reports private equity’s debt tower is teetering:

Once upon a time, private equity was — relatively — simple. Buy a company, oversee a turnround tricky to do in the public markets, and then sell at a profit.

Even the cynical version of the above isn’t terribly complicated: buy a company, load up with debt, cut costs, shut off investment, hope for a fair wind on valuations and sell before the rot sets in.

Now that story of buy, fix, sell is more complicated, after years of cheap money and booming interest in private asset classes stoked experiments in structures and in financing. Even as inhospitable markets force buyout groups, or general partners (GP), to write bigger equity cheques to get deals done, the different slices of their own funding continue to proliferate.

“The irony is that it is called private equity when you look at the multiple layers of debt now in the system,” said Eamon Devlin, a former lawyer now at Saïd Business School. “And many of these are new finance products since the [global financial crisis].”

Leave aside the debt that can be loaded on to the investments themselves, or operating company debt. Above that sits a growing number of financing facilities, or “solutions” as everyone in the sector insists on calling them.

These can be pretty functional. Subscription lines are essentially credit facilities at the fund level, which enable buyout groups to do deals more quickly than relying on calling up investors’ capital. Happily for GPs, this also delays when client, or limited partner (LP), money enters the fund, artificially boosting returns. But the facilities are short term and at least pretend to solve an actual problem.

At the other extreme, there are collateralised fund obligations, a product that everyone in private equity swears is rare — probably because the echo of the slicing and dicing of debt that preceded the 2008 crash is too embarrassingly obvious. These package together stakes in different private equity funds, before issuing bonds to investors. “It’s financial engineering,” said one buyout chief. “It doesn’t seem sustainable at all.”

Elsewhere, private equity has had to look harder for its “solutions” as lending from banks dried up and the ability to sell or list existing investments evaporated. An increasingly popular option this year has been preferred equity, an old product that has found renewed demand.

This feels like a bit of an end-of-cycle hail mary: a slug of covenant-lite, more expensive financing issued through a special-purpose vehicle at the fund level. According to advisers, this can take the place of a so-called NAV financing, portfolio-level debt that has become scarcer as banks have pulled back from the market. Or it can also substitute for a continuation deal, where assets left in a fund approaching its end or a particular investment are in effect sold into a new vehicle of the same buyout group.

Private equity’s sell-to-yourself trend, itself a function of dwindling exit options, has prompted mutterings about pyramid schemes. Preferred equity, largely provided by specialist investors like 17 Capital or Whitehorse, is another way of getting liquidity to LPs who want out. But it doesn’t require agreeing valuation for the underlying assets, as the new investors get downside protection. Convenient, given that private market valuations have defied gravity as listed stocks have sunk.

When it comes to the rights of those new investors relative to original LPs, whether the latter need to give their approval, whether preferred even counts within the fund’s stated leverage limits, or how much money raised can go straight out as returns, it is all subject to negotiation. However, fund documentation was often written and signed before such structures were even contemplated. The onus, say advisers, is on the GP to do the right thing by its original investors but “we will see much more robust language around this” in new agreements, said one.

Everyone maintains that such “solutions” have their place. What isn’t clear is to what extent they are being used to stave off the inevitable, or to take money off the table in poorly performing funds. Either way, heavyweights are betting that the fallout will involve faster consolidation in a sector that has mushroomed to 18,000 funds, up 60 per cent in the past five years. “A lot of the industry is finance and financing,” said one boss. “We’ll see how that ends."

I'll tell you exactly how private equity's debt towers ends, very badly.

At the end of October, I posted a comment on how big trouble is brewing in private equity.

I can quickly sum up what the big problems are going to be over the next couple of years:

  • The huge decline in stocks markets (it's far from over, the worst lies ahead) means exits for GPs are closing.
  • The rise in interest rates means the cost of debt has risen and returns will necessarily come down. Also, the days of financial engineering are over, you really need to roll up your sleeves and adopt a longer term perspective right now to make decent returns in PE.
  • GPs have been slow to lower the net asset values (NAVs) to reflect the tough environment in public equities but they will eventually reset them lower.
  • Activity in the secondaries market has picked up significantly as LPs look to cut their allocation to PE.
  • LPs are stuck because as GPs fail to lower their NAVs, the allocation to private equity rises as a percentage of total assets as stocks and bonds get hit and they can't allocate more to private equity (need to follow their investment guidelines and not exceed their allocation target) but they need to keep up with their capital calls and fund re-ups (listen to podcast below).

On that last point, Rae Wee of Reuters reports that turnover surges as funds rush to exit private equity stakes:

Private equity holdings are being sold at a record clip in an opaque secondary market, investors say, as asset managers cash out to cover losses elsewhere and rebalance portfolios.

The wave of selling is the latest of several signs of stress in private markets and is another signal of investors starting to fall out of love with "alternative assets" that only recently were drawing in cash.

Conceived as an illiquid but lucrative method of accessing unlisted companies, private investments are typically structured into funds run by buyout firms. As they have become popular, they have expanded to encompass property and infrastructure projects.

Yet since such funds are difficult to exit before maturity - usually at least three years - money managers needing to cash out use a secondary market that has lit up in the last few months.

The discounts on offer suggest there is a hurry to get out, and, while total turnover is hard to gauge, because deals are negotiated privately, it is at or near record levels.

Investment firm Hamilton Lane says an unprecedented $224 billion in private equity stakes have been offered in the secondary market this year to mid-November.

Not all have been sold, but analysis firm Preqin estimates the value of secondary transactions up until the third quarter was about $65 billion. This is not far off 2021's total of just over $70 billion and is far higher than previous years.

Market participants say several factors are driving selling.

Some investors need cash. Market participants pointed to the example of the meltdown in Britain's debt markets in September, when investors needed to cover losses and turned to their private equity holdings to do it.

Others want to deploy their capital elsewhere - a sign that private equity funds are no longer so highly regarded.

Then there are pension funds that are forced out by the need to comply with their caps on allocations to such investments. They are among the biggest sellers.

"If your allocation target is 5% and suddenly you have the kind of fair market value sitting at 10% ... what do you do?" said Alistair Watson, head of strategy innovation for private equity at fund manager abrdn.

The need to sell to rebalance can occur when, as this year, private equity funds have outperformed public markets.

"The challenge is that when you're trying to sell assets relatively quickly to fix target allocation, you're generally doing that sale in a period of volatility and therefore secondary pricing may not be the best," said Watson.


In steadier times, buyers usually extract modest discounts against book value, but these have lately widened dramatically.

"Usually, you would have a portfolio trading close to book value ... maybe a 1 to 2% discount. Today we're seeing these top-quality portfolios trading at double digit discounts," said Jan Philipp Schmitz, head of Germany and Asia at Ardian, one of the biggest players in the private-equity secondary market.

"As a buyer, you can be very, very picky," he said.

On paper, plenty of private investments, which are typically valued quarterly, appear to have done very well this year. But there are signs sentiment is turning.

U.S. buyout firm Carlyle Group is struggling to hit fund-raising targets, the Financial Times has reported.

Also, widely held unlisted Blackstone real estate trust, which has gained in value this year, is facing withdrawal pressure. It has restricted withdrawals after redemptions hit limits.

Still, there are plenty who are satisfied holding private investments.

Thailand's government pension fund, for example, has allowed the proportion of its portfolio invested in private assets to grow from about 5% eight years ago to about 18% to 20%, Man Juttijudata, deputy secretary general of the fund's investment strategy and external fund management group, told Reuters.

"It gives good returns in the long term, with acceptable risk levels and less volatility than the main assets," he said.

Yet, analysis from U.S. investment bank Jefferies found that 58% of secondary-market deals by value in the first half of 2022 were sales by other funds acting as investors in private-equity funds. Participants see more selling pressure building.

"There are still many companies that I feel are marked too highly, and I think that will change in the first half of 2023," said Vikas Pershad, portfolio manager for Asian equities at British fund manager M&G Investments in Singapore.

"I think people just have to get more realistic."

People will get a lot more realistic and by this time next year, you'll see significant markdowns in private equity to reflect what is going on in the economy.

The rise in interest rates is impacting all assets, public and private.

Earlier this week, I had a Q&A with Nathalie Palladitcheff, CEO of Ivanhoé Cambridge, CDPQ's large real estate subsidiary and explained why there's trouble ahead there too:

In the podcast below, Jim Pittman, BCI’s executive vice president & global head of private equity, and Craig Ferguson, Managing Director, Private Equity at IMCO recently sat down with Chris Witkowsky for an episode of Buyouts Insider new podcast miniseries “Private Markets and the End of Cheap Money” to discuss how the rising cost of debt is affecting institutional investors and portfolios. 

Listen carefully to their views but Jim is right, in an era of higher rates, pensions don't need to allocate as much to private markets (fully funded ones at least, underfunded ones will keep chasing yield).

Also, take the time to once again watch OMERS CEO Blake Hutcheson and Jim Pittman, Executive Vice President and Global Head, Private Equity at BCI discuss the long and short of patient capital at the Milken Institute's Asia summit (fast forward to minute 27 to hear Jim's comments on the amazing pause they're seeing in PE).

Lastly, BC Partners Europe Chairman Nikos Stathopoulos says the private equity firm is preparing for a recession in the region, leading to some difficult conversations with the companies it owns. “We are bracing ourselves, especially on the European side,” he says on "Bloomberg Surveillance: Early Edition."

Listen to him very carefully especially how "private credit has been the savior of the day". He's optimistic about 2023 but inflation will not come down to the target 2% level in 2023 and capital markets will be more chaotic next year so there I disagree with him (we might see a double-dip recession like the 1970s).