As inflation climbs to 40-year highs, the private equity industry is preparing itself for an economic environment the likes of which few in its ranks have ever experienced. Indeed, it seems clear that the specter of soaring costs and eye-watering wage increases has the asset class on edge.
When asked which economic and political factors will have the biggest impact on private equity over the course of this year, 63 percent of respondents to our Private Funds Leaders Survey 2022, conducted in partnership with MUFG Investor Services, cited inflation, compared with a mere 27 percent a year before. Associated interest rate rises, meanwhile, were the next most widely held concern.
“Inflation, interest rate rises and quantitative tightening will be the biggest influence on the private equity market in the coming few years,” says Silverfleet Capital managing partner Gareth Whiley. “QE specifically set out to achieve asset price inflation – QT will have the opposite effect and so valuations should start to decline cyclically sometime soon.
“This may take longer than the next 12 months; first as, absent a shock, the aim will be to let the air out of the balloon slowly, and second because governments may seek to delay taking their medicine because of cost-of-living crises.”
“I think inflation covering wages, raw materials and supply chains and logistics are likely to have a greater impact on the asset class than rising interest rates,” adds Joshua Davis, founding partner at Stellus Capital Management.
“When I look across our portfolio of 80-plus companies, there are very few that are not being affected in some way. Interestingly, that impact has been somewhat muted by the ability to pass on these costs to the end customer, but we have seen some market contraction as a result.”
Indeed, while the survey itself was completed prior to Russia’s invasion of Ukraine, it is clear the industry believes further pressure on supply chains and heightened geopolitical uncertainty will exacerbate market unrest.
Percentage of fund leaders citing inflation as having a big impact on private equity
“There may be little direct impact on private equity, but the accelerant effect of Russian sanctions on energy and commodity prices, and logistics costs and therefore inflation, will potentially be dramatic,” says Whiley. “If the economic war with Russia ignites such that energy supplies to Europe are disrupted, then I think this will be the shock that precipitates a correction.”
Steve Darrington, partner and CFO at Phoenix Equity Partners, says: “War in Ukraine has turbocharged underlying economic factors that should otherwise have been no surprise to anyone. At the point at which 13 years of QE was due to wind down, the pandemic hit, and we ended up with QE by another name – covid support packages. The bucket was bound to overflow. And now it is.”
Indeed, pervasive economic uncertainty does seem to have chipped away slightly at private equity’s confidence. Just over 60 percent of respondents say that they are either positive or very positive about the operating environment in their region, compared to almost 80 percent a year ago. Those that describe themselves as negative or very negative has climbed to 10 percent from just 3 percent. Meanwhile, less than half (44 percent) expect their funds to perform better over the next 12 months than over the past year, compared with 61 percent in 2021.
Faith in the superiority of private markets for weathering a storm remains unwavering, however, with more than three-quarters of respondents describing themselves as positive or very positive about private equity’s performance versus the public markets in the course of the next year.
And the industry shows no signs of moderating its ambitions. More than three quarters of survey respondents are raising funds larger than their predecessors. “I do not see any material reduction in investor appetite for private equity assets and access to the better performing fund managers. In fact, there may even be an increase in appetite that is only prohibited by previous capital committed – where fund managers are coming back to market earlier than anticipated,” says James Yates, chief financial officer at IK Partners.
Christiian Marriott, partner and head of investor relations at Equistone Partners Europe, agrees but cautions that the denominator effect could become an issue. “Investor appetite for the asset class remains strong but there is clearly pressure on fundraising as so many investors have found themselves above their target allocations due to private equity valuations outstripping public markets,” he says.
“Add to that the tendency of some big GPs to come back 18 months after their last fund with a bigger target, and there is clearly a huge constituency of LPs that are going to struggle to pick which GPs they want to invest with.”
Meanwhile, the asset class is increasingly enthusiastic about the prospect of opening up the high-net-worth and even retail markets, with 60 percent expecting the proportion of private wealth in their funds to grow, and 52 percent predicting the same of retail investors.
“There are a growing number of asset managers that are providing solutions for what historically would be deemed the affluent retail investor,” says Yates. “This is following on from the increased appetite from private wealth to have access to alternatives and private equity, in particular.”
“There are some interesting groups aggregating high-net-worth and even retail money,” adds Marriott. “The classic private bank feeder has been around for a while, but there are lots of groups trying to pivot in different ways within this space, and that’s going to be an interesting area for most of us.
“Most mid-market GPs are now well used to having their ex-management teams as significant LPs: in a way, there’s no better validation of our model than when people who we’ve done deals with in the past want to invest in our funds to access deals that we are going to do with the next generation of successful entrepreneurs in Europe.”
Whiley, however, is more circumspect about capital continuing to pour into the asset class, particularly in the context of a reverse in recent central bank monetary policy. “Personally, I think the super-cycle of interest in alternatives is nearly over,” he says.
“As interest rates start to rise and QT kicks in, I suspect the attractions of liquidity will mean that there isn’t a further pronounced shift into alternatives and that there may possibly even be a withdrawal of capital.”