Recovering fund valuations – can it be done?

Recent interest rate hikes are impacting fund valuations and damaging investor confidence as concerns grow that funds may not be able to deliver the returns expected.

For several decades, the industry has benefited from a sustained period of low interest rates, with cheaper debt being leveraged to achieve exceptional levels of growth. But recent increases in interest rates have brought a sea change in private equity markets, limiting deal activity and depressing fund valuations. Many funds have high levels of debt, which have become more costly to service, and even those with significant dry powder are finding it more difficult to finance deals due to a lack of lender and/or investor support.

Another key factor that is limiting fund valuations in the current market is the performance of existing assets. With high inflation, high interest rates, rising prices and significant demand uncertainty, many businesses across industry sectors are finding it difficult to manage working capital and stay afloat, let alone meet their growth targets. Assets structured on standard earn-out models, linked to the performance of the business over a period of two or three years, are no longer able to deliver the returns forecast at the time of the investment.

In the current climate, it makes sense for private fund professionals to take a more selective approach to investment activity. Focusing on business-to-business targets could be preferable to business-to-consumer, as there is likely to be more scope to pass on price increases or otherwise spread the cost impact across the value chain. Investing in businesses with long-term contracts, or those operating a subscription model, could also be perceived as less risky. However, care is needed as some contracts may not include wording that allows them to pass on energy price increases, for example.

Instead of pursuing value through investment activity, private fund professionals should be allocating more of their time to getting the best from their existing assets and identifying opportunities for value creation. From a consultancy perspective, more funds are seeking advice about how to de-risk their current portfolios on an asset-by-asset basis by analyzing costs and operational efficiency, and taking steps to ensure things are running as efficiently as possible.

For most private fund professionals, switching from full-throttle deal-making mode to close and proactive management of existing assets will require a change of mindset, and striking the right balance is important. Instead of pursuing organic growth, they should aim to work with portfolio companies to identify levers with value-driving potential, such as operational efficiency, pricing, technology and data-based systems. In the case of digital tech assets, such as platform companies, it may be possible to scale quickly to achieve growth, without necessarily increasing the size of the workforce or expanding its operational footprint. Data and analytics can play an important role in unlocking these growth opportunities.

Private fund professionals should aim to get closer to their portfolio companies and explore ways to deliver positive outcomes at speed. This will require an in-depth, analytical understanding of the challenges these companies are facing and the opportunities that might exist to reduce costs and increase revenues. Instead of holding portfolio companies to account, they will need to take a more collaborative approach, working with them to support working capital management and unlock opportunities for growth. In some cases it may be necessary to change incentives for management teams – for example, they could be linked to net growth or EBITDA, rather than net profit. They could also introduce new incentives for efficiency improvements and effective working capital management.

To optimize value creation, some portfolio companies may need to find capital to fund investment strategies – for example, capital investment or digital systems. This is likely to require a focus on both cost reduction and operational efficiency and the ability to measure and report back achievements is key.

Even with much greater collaboration and amended incentives, it is likely that private fund professionals will at some stage have to consider extending the term of their investments to stand a chance of achieving the returns they are looking for. In these situations, open dialogue with all stakeholders is critical to ensure all parties understand which levers need to be pulled to achieve the best outcome and how success will be measured.

Tom Acfield is strategy director and Julie Neal is a director and private equity market expert at management consultancy, Vendigital.