September 22, 2022

Private Equity, the Hot Asset Class for Allocators, Faces Headwinds

Deals are expected to fall far short of 2021’s record-breaking level.

Reported by Larry Light

Art by Caroline Barlow

Private equity has enjoyed a good, steady run for institutional investors. Can it keep going? Certainly not at such heady levels as 2021’s record performance, but strategists believe PE will soldier through any economic rough patches this year in good shape.

Last year was extraordinary for private equity, with global deal value reaching $1.2 trillion. Partly, that was fueled by enormous government and central bank stimulus aimed at combating the pandemic. This boosted liquidity that flowed through to deal-makers.

But this year the stimulus is gone and interest rates are rising, thus pumping up the cost of capital for buyouts. Another headwind: Special purpose acquisition companies—PE entities known as blank-check operations—were robust acquirers in the beginning of 2021, but now SPACs have withered amid a spate of bad deals and tougher government scrutiny.

“As we shift into the year’s second half, activity is slowing down,” a report from Bain & Co. says. “Deal pipelines in many sectors are softening, in technology especially.” For this year’s first half, the total PE deal value of $415 billion was a 28% fall from 2021’s first six months.

Nonetheless, expectations are for a strong year-end finish that should result in the second-highest annual deal value since the record-topping 2021, per law firm White & Case, which specializes in mergers.

According to research firm Preqin, the average public pension’s allocation to private equity grew to 8.9% in 2021. That marks a steady expansion; in 2012, the figure was 6.5%. The trend shows no sign of abating. For instance, the board of the Employees Retirement System of Texas voted in August to up the fund’s PE allocation to 16% from 13%. PE, says Texas ERS’ CIO, David Veal, has been a “critical element” of the fund’s success; private equity posted a 28.4% increase in its fiscal year ending in June.

Not all allocators have been PE fans, often to their regret. At the California Public Employees’ Retirement System, new CIO Nicole Musicco told the CalPERS investment committee this week that the pension plan’s decision a decade ago to limit PE was a mistake. This strategy cost it an estimated $18 billion in returns it could have otherwise reaped, she said.

The lure has been the outsize increases that PE can generate. Data obtained from Preqin show the average annual PE return net of fees for North American pension funds was 17.6% from 2009 to 2018. Meanwhile, the S&P 500 index logged an annual 13.6% for the period. One big PE winner has been the Pennsylvania State Employees’ Retirement System, whose 17.2% gain in 2021 was powered by the asset class, which logged a 52.8% gain for the fund.

With the stock market in a poor state these days, exits are harder for PE operators. “People say, ‘Why take a 10% haircut’” by selling a holding in the public market, notes Joshua Maxey, co-founder of research firm Third Bridge. He suggests that waiting out the bad time may be a more prudent strategy, and says the returns “will take longer” to achieve.

This year, awash in uncertainty due to high inflation, rising interest rates and a war in Europe, some PE operators are spooked. First-half fundraising was down 27%, to $337 billion, according to Private Equity International data. The number of new funds closed—i.e., they finalized investor gathering and started operating—was down 40%, to 622. The fledgling funds were dominated by the largest players: Advent International, Insight Partners and KKR, who together accounted for nearly 40% of the fresh PE capital invested.

That said, PE is not wanting for capital. Right now, it has $1 trillion in cash, known as dry powder. That means, the Bain report says, the asset class is “well positioned to ride out a downturn and prepare for the recovery.”

All the nervousness may have gone too far, in the opinion of several Wall Street savants. To some, “it seems prudent to pass on the 2022 vintage year,” observes Stuart Katz, CIO of Robertson Stephens. “But historically, that doesn’t make much sense,” as PE is a long-term investment. “The heart can interfere with the head,” he says.

Of course, PE has fared so well in recent times that talk arises that it may have peaked. “When a Kardashian starts a private equity fund, that signals a market top,” jokes Bill Kelly, CEO of the Chartered Alternative Investment Analyst Association. Indeed, reality TV star Kim Kardashian, along with a former Carlyle Group partner, launched a PE fund earlier this month.