Is the best yet to come?
Are LPs in line for some great returns over the coming period? Or are things different this time?
There is no doubt that the benign economic conditions over the past 10 to 15 years, characterised by the low interest environment, have helped boost private markets returns. Cheap leverage, high multiple expansion potential and strong exit markets all created DPI momentum. That has come to an abrupt halt over the past 18 months, so what will happen to recent investments made in more exuberant markets? And what’s the outlook for the next couple of vintages? Are investors expecting a return to historical patterns of private markets showing greater outperformance versus other asset classes in what is undoubtedly a more challenging environment? Here, GPs and LPs offer their perspectives.
Periods of economic difficulty have historically been some of private markets’ best vintages. So are LPs in line for some great returns over the coming period? Or are things different this time?
Private markets numbers are down, but far from out
Last year saw new investment, fundraising and – in particular – exit pace decline from 2021 and 2022 numbers. Yet it’s worth taking a longer term perspective, says Britta Lindhorst, Managing Director and Head of European Investments at HQ Capital. “The numbers are down, but that is against record years in 2021 and 2022,” she says. “Most of the numbers are actually slightly above those of 2019 so I don’t see it as a decline, it’s a normalisation.”
“Today, we’re seeing some normalisation and much better opportunities than in the recent past,” agrees Steffen Meister, Executive Chairman at Partners Group. “People have tended to focus on lower market volumes through 2023, but we've seen more private markets fundraising than we’ve seen public markets equity issues and the buyout values have closed out the year close to historical, pre-2020 levels.”
Concerns remain about investments from recent vintages...
“There is no doubt that private equity has a resilient business model, especially in more difficult times,” says Ralf Gleisberg, Partner, Private Equity at Unigestion. “But higher interest rates mean there may be trouble still ahead of us, especially in those parts of private equity that are more sensitive to these. Some portfolio companies have high leverage and there is a wall of refinancing coming down the line.”
“The last five years were relatively easy for investors,” adds Meister. “Debt was easily available, transactions were getting done, and there were plenty of opportunities. But that doesn’t necessarily create the best conditions for investors, and we may see some vintages over the past five years come out at the lower end of the past 20 years.”
However, some LPs are more sanguine about recent portfolios, given the shift of focus among GPs since the last crisis. “There will be some issues in current portfolios,” says Lindhorst. “But there is a major difference since the GFC. Before that, GPs relied much more on financial engineering. Today, they have more capability to improve operations and dig more deeply into portfolio companies. They are better equipped to deal with a difficult environment.”
…but there is confidence that private markets has some great vintages ahead
Some of this is based on looking back at previous times of liquidity crunch. “Our 30 years of fund investments tells us that funds raised in more difficult markets are the best vintages,” says Anne Fossemalle, Director of the European Bank for Reconstruction and Development. “Raising less capital sharpens everyone’s spirit and tools. And the fundamental alignment of interest and value creation private markets are based on are powerful tools that can address a range of issues, including climate change. Some players will disappear as LPs can vote with their feet, but that has always been the case and that’s healthy.”
And some is based on what LPs are observing in the market today. “We will see better returns in this environment,” says Imogen Richards, Partner at Pantheon. “We are seeing GPs underwriting more conservative investment cases that include potential downside macro risks and increased costs. GPs are being much more disciplined today – and the good news is that we have started seeing more activity – there are signs of recovery. If we reflect back to the last downturn in 2008 and 2009, we wish we had invested more at that point, even though it felt uncomfortable, because that period generated great private equity returns.”
Yet LPs could boost their returns further if they were to look at emerging managers, according to some LPs. “It’s the really tough vintages where we see emerging managers outperform most,” says Kim Pochon, Senior Vice President at Unigestion. “That’s partly because they have the time and resources to dedicate to new deals – they don’t have legacy portfolios to deal with.” Owen Khonje, Director at Time Partners, agrees. “There is a flight to quality among LPs today, and that’s tending to mean larger funds,” he says. “But emerging managers tend to outperform most in difficult market – they have leaner teams and really focus on transforming companies.”
Co-investments may take centre stage
Relatively rare in previous times of capital constraint, co-investments have the potential to play a big role in LP returns in today’s more difficult environment – provided they select well. Many LPs say they are now seeing some of the best quality co-investments they have ever assessed. “Co-investment deal flow has increased significantly in the past six months,” says Andrew Brown, Head of Private Equity Res
earch at WTW. “And it is tending to be very much in the managers’ sweet spot, the right size and with all the boxes ticked. Co-investment has tended to be pro-cyclical but managers this time want to stretch their funds as far as possible and so they are offering LPs some great deals.”
He adds: “You can’t time the market, but it does feel like an attractive market: pricing is down – by more than two turns even for strong assets – leverage is down, and managers are looking at great assets.”
Yet the caveat is that there is a fundamental difference in today’s market compared with the last crisis. Where lower interest rates in the GFC improved the economics of dealmaking, higher interest rates (even if they do shift down a little over 2024) could well dampen down transaction levels. As Uwe Fleischhauer, Founding Partner and Member of the Executive Board at YIELCO, points out: “Private equity funds that have just raised capital are in a good position; the issue is that they may find it very difficult to finance deals.”
