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Tips for adapting PE investment strategies during uncertainty

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GPs these days are facing an uncertain climate, with market conditions shifting as the result of numerous overlapping crises and external influences. An upswing in inflation, interest rates, supply chain shortages, the ongoing war in Ukraine and persisting risks relating to COVID-19 have collectively created an unstable environment and brought on the transition into a bear market.

According to recession model data gathered at the end of April, there is a 20% chance of a recession hitting the US in the next 18 months—and many GPs are reacting accordingly. With this possibility on the horizon, we have devised a series of insights and recommendations to help GPs adapt their private equity investment strategies to cope with instability and prepare for what may come over the next months and years.

1. Optimize benchmarks to inform forecasts

Private equity benchmarks will be a major point of interest for GPs in the coming quarters, as the effects of discount rates across different sectors, or how expected value and the rate at which an investment will reach it affects its present value. We expect that a business or industry’s reaction to these discount rates will be a valuable predictor of their future trajectory and how well they will perform—which GPs should observe and adjust to accordingly.

GPs should also be mindful of public market data relating to the effects of repricing since it can serve as a forecast of similar trends in the private sphere.

Exit value has seen a significant decline compared to 2021, with a lower multiple on invested capital (MOIC)—which is calculated by dividing a fund’s cumulative realized and unrealized value by the total dollar amount of capital invested by the fund—meaning less potential for returns. As such, assets whose value is mainly derived from expected revenue and earnings growth are highly susceptible to these developments. As Residual value to paid-in (RVPI) calculation ratios become less favorable, GPs must turn their attention to profitability rather than growth.

2. Follow private equity trends and reconsider positions in tech and startups

Private equity fundraising and investments—which have historically been resistant to discount rates—lost some of their resiliency with the shift towards tech, an industry characteristically contingent on potential growth. Given this dynamic, the shift into a bear market has negatively impacted the price of tech shares, creating a pitfall for those that may have adopted this equity investment strategy.

Startup valuations are also on a downward trend, similarly affected by the emerging bear market. Between these lower valuations and GP portfolios reconfiguring to take on less risk, tech startups—which have long been a pillar of PE—are now under greater scrutiny. With these changes to the established order, the tenets of how to evaluate fund manager performance are being reexamined.

Specialist fund managers, which may have previously been held in high regard, might now be falling out of favor compared to generalists who invest in multiple industries and therefore may have avoided overcommitting to tech.

3. Watch for the effects of inflation in different industries

Another factor with the potential to shake up the PE landscape is inflation, which is poised to bring both positive and negative effects based on the subset of industries a company may be positioned in. Companies that sell existing goods such as natural resources or energy will benefit from inflation, since retail prices will go up without a proportionate increase in operating costs, allowing them to sell at a wider profit margin.

Conversely, companies that need to produce their goods and therefore don’t have them readily available will be negatively impacted by inflation since the cost to manufacture their goods will rise. This narrows their profit margins and effectively mitigates the profits they would have seen from selling products amidst inflation.

Though targeted industries are a major predictor for how inflation will affect fund performance, it is not the only factor at play. Another part of the equation is how far along the fund is into the investment cycle. Following the J curve graph, we see it is very possible that funds early into an investment will see a dip before ultimately rising significantly above their starting point.

J Curve graph example

Take real estate benchmarks for example—new real estate funds may initially struggle, especially as they make efforts to improve their property. However, during periods of inflation, these funds can actually stand to benefit if they made their improvements prior to the onset of inflation.

GP takeaways for how to stay ahead

As current events continue to affect the investing landscape, GPs will need to look at public market statistics and the impact of repricing to accurately assess how to move their PE investment strategies forward. This precedent will provide an idea of how private market investments will be affected—notably in the case of discount rates, which we expect to be a major influence on private equity, along with inflation.

As noted, inflation is not an inherently negative development in all industries and may actually benefit GPs if their portfolio is well suited to it. GPs should also be mindful of the bear market’s effects on startups, not only because startups occupy a central role in the PE landscape, but also because it may be suggestive of indirect market shifts in adjacent spaces.

 

Curious to learn more?

The turbulent start to 2022 has had a profoundly negative effect on public equities, sending stocks tumbling and leading to billions of dollars in losses. Read our analyst note, Analysts Advise on Key Trends to Watch as Markets Return to Turmoil, to learn even more about the potential long-term impacts of the current macro backdrop on deal activity, valuations, sustainability and more across private equity and venture capital.

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