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Low liquidity, elusive debt: why private equity’s current problems are the perfect recipe for co-investment

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Federated Hermes‘ head of North America private equity Brooks Harrington explores how the current macroeconomic conditions, volatile public markets and lack of exit liquidity are set to shape private equity investing in 2024.

After a four decade absence from developed economies, high levels of inflation returned to the market in 2022/2023, forcing central banks to act decisively, raising base rates as governments began removing capital from the global economy. Private equity came to maturity as an asset class during a prolonged period of low interest rates and low inflation, becoming accustomed to profit driven by rising valuations, easily available debt funding for investment in cash intensive business models, and buoyant consumer spending. In 2024, we will see the unlevered or low-levered segments of private equity – including lower mid-market, recurring revenue, and secular growth strategies – perform well, as rates are expected to stay high and financing conditions tight.

After the frantic fundraising environment of the ‘great exit’ years of 2021 and 2022, 2023 saw the industry finally catch its breath as we moved into a markedly tougher fundraising environment. We saw many GPs extending their fundraising timelines and revising target fund sizes to reflect the more muted market appetite. In the year ahead, while some LPs will be ready to restock, the denominator effect is still likely to continue, impacting cross-asset class performance and fundraising.

Given the macro-economic and unstable geopolitical backdrop, track record and consistency of performance across cycles will be central to allocator decision making. Over the last four years, we have witnessed an unprecedented period of a global pandemic, geopolitical conflict and wars in Ukraine and the Middle East, stock market volatility and a steep rise in bond yields globally. In light of these uncertain conditions, funds that can demonstrate consistency of performance during these challenging times are expected to be the best positioned for the next five years. Indeed, GPs with strong existing partnerships with investors have still been able to achieve fundraising goals over the last year, even when faced by market challenges.

It’s not all doom and gloom; we have also seen defiant, and healthy levels of activity for certain investment strategies and sectors which remain driven by longer-term, non-cyclical, structural changes. Technological innovation continues to accelerate rapidly. 2024 is expected to herald an attractive vintage of buyout strategies targeting structurally profitable investments with strong organic growth in attractive market niches. These strategies are not reliant on large, debt-driven deals, and therefore are less exposed to financing conditions and able to sustain transaction activity levels.

Although public markets continue to be volatile and challenging to accurately predict, there is plenty of dry powder in the private markets for sponsors to put to work. However, pressure on valuations will likely keep the lid on the temperature, preventing it from rising too fast. Valuations are very much a central focus on any current transaction – a marked shift from the zero interest rate environment. While the performance of the market in recent weeks suggests that many believe inflation and interest rate rises have peaked, larger or faster rate cuts by the central banks in 2024 could provide some upside, raising multiples and reviving activity the exit market.

Liquidity will continue to be a significant consideration for private equity in 2024. With deal flow and fundraising remaining challenging for many, we expect to see a sustained rise in secondary transactions as investors seek an alternative to traditional exit strategies. In addition, 2023 saw increased demand for co-investment capital to execute deals. The demand for co-investment capital is driven by:

1) investors pulling back, especially those who piled into the market during the last few years

2) debt packages that are both harder to come by and are far more expensive

3) GPs are utilizing co-investments to extend their fund life in order to push out fundraising timelines given the tough fundraising environment.

We expect all of these trends to continue. Given the challenging exit environment for GPs, we expect GP led transactions to continue being a significant part of the secondary market, as they gain widespread acceptance as a feasible exit route alongside more traditional exit strategies. We believe there will be continued growth of NAV financings and preferred equity deals to meet short term liquidity needs, albeit at a higher cost of financing. Thus far, NAV financing has been used only selectively in the market, for a variety of ends, including providing further capital for follow-on investments in the fund, raising further capital to execute on additional new investments to delay the need to commence fundraising and to support DPI ahead of fundraises. Given the cost of borrowing has increased substantially, this has made NAV financing (and preferred shares) somewhat less attractive in recent months, although with sustained pressure on exit markets we may see more of these deals as a means to support short term liquidity needs in 2024. We also expect a pick-up in LP transactions as LPs seek to boost distributions.

In 2024 and beyond, investment returns for private equity will rely more heavily on organic revenue growth and cash flow generation in their portfolio. Successful investments will be driven by business models that are not only exciting and providing real economic value in the short-term but have secular growth tailwinds that will significantly increase franchise value in five or ten years’ time. Cutting edge industries such as blockchain and AI will present further potential future opportunity for investors that are able and willing to participate but must also be able to separate the hype from reality from an investment perspective.

While the global economy may have reoriented significantly in 2023, in the year ahead there will be new opportunities for private equity investors. In the face of new tailwinds and market dynamics, investors with adaptable and global investment frameworks will be best placed to access new opportunities created by the current market conditions.

The value of investments and income from them may go down as well as up, and you may not get back the original amount invested.

The views and opinions contained in this document are those of the author and may not necessarily represent views expressed or reflected in other communications. This does not constitute a solicitation or offer to any person to buy or sell securities or related financial instruments.

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