After several heady years of elevated risk appetite and market-beating returns, private equity (PE) firms are shying away from big wagers and looking at safer bets such as growth equity as market volatility and interest rates rise.
Between 2019 and 2021, the rolling six months PE deal value more than doubled to $450 billioni. The shares of global buyout and growth equity assets of PEs also more than doubled.
Cut to the first half of 2022, however, and both fundraising and deal activity slowed. Risks stemming from rising interest rates and macroeconomic uncertainty heightened the urge among general partners (GPs) and limited partners (LPs) to alter their portfolios and intra-asset allocations to shield margins and reduce volatility of returns.
With rising caution on new fund investments, there was increasing preference for growth equity that could provide a safe bet in a turbulent market. These investment strategies focus mostly on relatively mature and high-potential companies.
That said, the PE market is expected to grow from $6 trillion in 2021 to about $9 trillion in 2025ii, according to Preqin. But while the outlook for growth capital is positive, PE firms need to continue to tweak their strategy amid rising volatility across economic parameters and in secondary markets.
The investable universe of growth companies has expanded substantially, driven by rising need for capital to accelerate transformation, and increasing preference among companies to remain private for longer.
Most growth-stage companies are looking for growth capital to accelerate their topline by disrupting existing market positions. PEs have moved in to fill the space, and the supply of growth equity vehicles has evolved. In the past decade, six of the 10 largest buyout managers have launched a growth vehicle.
As of 1Q22, venture capital and growth equity together accounted for almost 55% of PE dealsiii.
Increasingly, investors are tracking down growth and diversification wherever they can across the broad PE spectrum. They have found a willing borrower in firms looking for technology-enabled growth, an aspect brought more into focus by the pandemic. In fact, all markets have felt the need to digitally innovate their offerings and operational processes.
The surge in activity has also been driven by PE investors seeking exposure to higher growth companies at an earlier stage, rather than go for buyouts. This allows them to invest at more reasonable multiples. The rising number of funds that target growth equity indicates as much. For instance, TA Associates raised $12.5 billioniv of funding towards the end of last year, while Summit Partners raised $8.35 billion. Also, funds have been empowering special arms, as Blackstone did with Blackstone Growth, to further their presence in growth equity.
PE firms have a significant amount of dry powder that they need to invest. But the competition for assets is high. The market upheaval is also now making it harder to justify the valuations and multiples that they were paying. In contrast, in growth equity, they invest in a stable business with a clear agenda for funding. Therefore, it is easier to write bigger cheques than in venture capital, as the companies invested in are generally larger and better established. This current trend leads to the following interpretations:
As per a report by Preqin, buyouts, growth equity, and venture capital account for about 69% of the PE spacev. PE firms, whose funds have long been a core holding for pensions and other institutions, are racing to develop new products that will appeal to wealthy individuals, marketing these to financial advisers who manage their money.
To conclude, the current trend in growth equity shows that uncertainty in the market is significant and is unlikely to return to the successful listings and value creation last seen in 2020-21.
Public listings, which had driven PE exit value in the past six quarters, slowed significantly in 1Q22. This resulted in an increase in the holding period and a focus on asset portfolio, as well as the need for LPs to look for liquidity via sponsorship sales.
To quote a major PE consultant, “It will be essential to help management wring out revenue gains, preserve (and even expand) margins, and manage cash on the balance sheet. At the same time, it will be important to help future-proof the business by focusing on key initiatives such as environmental, social, and corporate governance.”
Tweaks in strategy
PEs have identified two key focus areas in addition to their business as usual:
i. Consult their portfolio companies for more efficient operations, help them create value, and be prepared to exit as soon as the market normalizes.
ii. Fully understand the microeconomics of the sector, the value creation levers available, and the risks they are underwriting. There are now inflation playbooks developing across the GP and LP landscape as investors race to protect margins and future returns.
That said, PEs are known to have a finger on the market pulse. So, when they sense a shift, we will see their strategy change again.
i https://www.ey.com/en_gl/private-equity/pulse
iii The Private Equity Market in 2021: The Allure of Growth | Bain & Company
iv https://www.wsj.com/articles/ta-associates-closes-latest-growth-fund-at-12-5-billion-11622672516
v https://www.preqin.com/insights/research/quarterlya-updates/private-equity-q2-2022
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