The Challenges Ahead for Private Equity Investing

As PE Investments Grow More Attractive, Investors and Managers Must Deal with Adverse Consequences

The mindset in private equity (PE) investing doesn’t seem to have changed since I first wrote about PE investing for Financial Poise fourteen years ago.

According to Preqin, assets under management of private market funds have reached $13.7 trillion as of December 2023. Assets managed by PE (venture capital, growth capital, LBO, and turnaround capital) funds alone have reached $8.4 trillion. The total capital available to PE investments, which includes direct co-investments and segregated accounts (which are largely under the radar), is estimated to have reached $10 to $11 trillion at the end of 2023.

Over the last 15 years, investors enjoyed attractive returns on PE investments. Record net distributions were reinvested, and allocations to PE were increased to compensate for the extended low-yield environment. New capital available for investments (‘dry powder’) reached roughly $2 trillion as of September 2024, slightly below the all-time high of $2.1 trillion of December 2023.

That said, the ratio between dry powder and the amount actually invested fell from an average of 89% over 2000-2004 to 36% over 2019-2023. Some of this dry powder has been used to transfer assets from funds to funds, through secondary leveraged buyouts (LBOs), for example, which now represent roughly 30% of the exits for LBO funds. Under this light, there is limited cause for alarm.

However, this attractiveness creates increasing challenges for PE:

• The speed of accumulation and the concentration of capital in some strategies can have adverse effects.
• A prolonged period of benign investment conditions can lead some investors to forget basic rules.
• Fund managers have yet to assume their mantle as a major source of corporate financing with all the associated consequences.

Too Much, Too Fast, and Too Concentrated

Apollo collected $24.7 billion in 2018 and CVC $29.8 billion in 2023 for, respectively, the largest ever US and European LBO funds. Large investors collectively decided to concentrate their investments in a smaller number of funds. The aim is to gain better fund terms and reduce costs, notably by free-riding fund managers through co-investments.

This herding behavior has multiple detrimental effects.

First, by investing larger amounts in larger funds, investors force fund managers to focus on larger deals. Private markets are not scalable: fund and deal sizes are directly correlated. Because the number of new investment opportunities does not depend on the amount of capital available, an inflation of valuations in large and mega LBOs has occurred.

Though fund managers have historically shown a certain discipline in deploying capital, 13 years (2009-2021) of abnormal market conditions have put pressure on them to collect more capital (or be ignored) and deploy it in a short amount of time. Their freedom, a condition to generate higher returns, has in turn been significantly reduced. The consequences will be disappointing returns and possibly an increased number of bad deals.

To avoid this fate, fund managers have adapted.

Many LBO funds have engaged in so-called ‘buy and build’: acquiring platform deals and then making add-on acquisitions. Smaller assets are less expensive in both absolute and relative terms and benefit in aggregate from a multiple expansion effect. The synergies are then converted into profits at exit.

Forgetting the Basic Rules of Private Equity Investing

Benign investment conditions have also lured investors into eliminating the middleman in transactions. In PE that’s the fund manager. The clearest example of this can be found in startup investing. A long-standing myth is that there is not enough capital to fund them. As a result, financing channels such as equity crowdfunding and initial coin offerings (ICOs) have popped up.

Startups have a 50% chance of survival during their first five years. The amount of capital invested does not change these odds. In fact, the contrary applies: the more capital is invested, the more competitive the environment is for startups. This increases the chances of failure, because it takes longer to establish a viable business and recoup investments. Excessive venture investments in such markets lead to an immediate price war between startups, from which they might never recover.

Expertise provided by active investors, such as venture capitalists, is in short supply. It enhances the chances of success but is not scalable. Removing those key individuals deprives startups of such input, while degrading their market conditions.

Proactively Addressing Concerns and Challenges of PE

At the end of 2023, there were roughly 5,700 companies listed on the NYSE and the Nasdaq, while there were roughly 12,500 in the portfolio of LBO funds. These numbers reflect an extended decline that started in the late 1990s. In parallel, the significant increase of companies under PE ownership drew public attention to the power vested to fund managers, with mixed results. The SEC investigated broker-dealer rules infringement and hidden fees charged to investors. The EU is also crafting a revamp of its ill-conceived AIFM Directive.

This regulatory pressure can only worsen if fund managers do not engage constructively and pragmatically with political and regulatory bodies at national and international levels. Managers command power on large swaths of developed economies, as illustrated by Softbank’s Vision fund, which raised a record-breaking size of $98.5 billion in 2018. They will suffer the backlash of preeminent failed operations, as in Toys ‘R Us. This company was delisted through a leveraged buyout. As it reduced progressively its debt, fund managers re-leveraged it to distribute an anticipated profit to investors (through a ‘dividend recap’). The company struggled to repay and went into bankruptcy, where it was liquidated.

They need to prove they are a force for good in finance, act responsibly, and pre-empt contentious debates by offering innovative, concrete, and attractive solutions to political, regulatory, and social representatives. ESG (environmental, social, governance) should not be an afterthought, at least in Europe, as the EU Taxonomy and SFDR regulations are now in place.

Managers have demonstrated an ability to adapt to new conditions. They need to rise beyond simple lobbying and whitewashing. This is the price to pay for a thriving private equity sector.

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[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Understanding Risk Management Basics for Business Owners
2. Defending Against Bankruptcy Avoidance Actions
3. Common Issues and Strategies in Business Breakups

This is an updated version of an article originally published on May 12, 2021.]

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