Impact of market uncertainties on private equity

The first half of 2022 saw heightened market volatility that was led by inflationary pressures, geopolitical concerns in Ukraine, and global supply chain disruptions including the impact of ongoing lockdowns in China and tightening of labour markets. As shown in the chart and table below, all major equity indices have generated negative calendar year-to-date returns after a strong run since post COVID lockdowns.

So, what does this mean for private equity investments? How will the current macro headwinds impact private equity investments, given private equity is ultimately investing a businesses which are privately held?

Inflationary pressures, supply chain disruptions and tight labour markets

The impact of higher inflation, supply chain disruptions and tight labour markets experienced in listed markets are flowing through to private markets. To date most of the portfolio companies JANA covers have been resilient, being able to pass through the higher costs to end customers but there will be a point where increasing prices will eventually impact demands and ultimately earnings. The bigger challenge private equity companies have been facing over the past couple of years was tight labour markets, where companies had a challenging time hiring people to implement their growth plans.

Interest Rates

Higher interest rates will have the greatest impact on highly levered private companies, especially in the mega/large buyouts segments – this is a sector JANA has avoided. Higher interest rates will lead to higher debt repayments for floating rate debts and will make recapitalisation (an early distribution option for investors via refinancing of the company) more difficult. We will mostly likely see debt providers pulling back covenant-light deals and reduce the amount of leverage offered to new transactions. Given the abundant capital raised in private equity over the past five years, PE companies are less levered (~60% equity) and therefore better positioned (particularly compared to pre-GFC) to weather a rising rate environment.

Valuation

We expect private equity valuations to fall as private markets take into account listed market comparables and also macro headwinds will impact company fundamentals sooner or later depending on the length and extent of the market uncertainties. Fortunately, many of JANA’s preferred PE managers have positioned their portfolios defensively, either focusing on market leaders with pricing power, non-cyclical companies, or companies with resilient earnings characteristics (recurring revenues, low leverage, etc) in the anticipation of eventual market downturns.

Venture capital valuations are in-directly linked to the above macro headwinds, but one of the key drivers is capital flow into the segment as VC valuations are generally measured based on the valuation of the most recently raised round. In the current uncertain market environment, investors will generally move away from risk assets and into more defensive assets; hence capital will most likely be diverted away from the venture capital space, making it harder for VC companies to raise follow-on rounds at a premium. To date, JANA has seen some VC investors shy away from riskier/lower quality VC companies, but we are still seeing solid capital flow for quality VC investments, though this may change in the future.

Realisations

After strong exit activity over the past few years, we have seen private equity exits moderate in 2022. The IPO market is more subdued in the current volatile environment, but we are still seeing investors support high quality private companies. However, we are seeing more PE and VC managers choosing to delay IPO exits until market conditions recover as the look to extract maximum value.
A large portion of PE exits have been sale to strategic/corporate buyers and to larger PE funds. We believe these exit routes will still be robust given significant dry powder and the need for PE managers to deploy capital.

Quality Matters

The quality of both portfolio companies and managers will matter more in the current market as we believe there will be greater divergence between PE companies and also PE managers based on quality. There are no longer the tailwinds that private markets have enjoyed over the past decade and it will become more challenging for PE managers to generate alpha going forward.

Eventually PE/VC performance will normalise from recent historical highs, with shorter term return to be driven primarily by the extent of market volatility and depth listed market falls. It is important to keep in mind that private equity investments, although unlisted, are ultimately an investment into a business and hence these macro headwinds will have an impact on private markets, albeit a lagged impact compared to listed markets.

However, has history has shown, during market uncertainties, attractive opportunities will present whether it’s public to private, direct secondaries or small to mid-market buyouts opportunities.

The key success factors will be to continue to stay in the private equity market and to partner with quality managers who are disciplined, cycle tested with strong operational capabilities, who can weather the current market headwinds and take advantage of opportunities as they arise.

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