By Chase Nerison
Private Equity is a highly sought-after sector of finance. The 2020 market environment challenged even the most successful private equity (PE) businesses. Despite the market volatility and business uncertainty throughout the year, the PE industry was able to adapt practices and prosper, with many firms hitting records highs in 2021’s Q3. Evolving as an industry, private equity is placing more importance on digitization, AI, ESG, traditional exits, and sector expertise.
Before diving into current trends, the previous years must be examined with such volatility in every industry and aspect of life. Obviously, 2020 brought unprecedented challenges with the Covid-19 pandemic. Though deals were down, surprisingly, total investment value was supported by ever-larger deals. Private Equity firms were forced to embrace the new reality by adjusting their operating models, strengthening their operational improvement capabilities, and by leveraging skilled advisors to adapt business models to become more agile and resilient. This resulted in massive bounce-back growth as shown in the graph below.
Throughout the crisis, PE firms have navigated difficult market conditions and positioned themselves for accelerated growth. General Partners remained bullish on the outlook for 2021 even in the midst of the pandemic with the amount of capital continuing to rise. This market opportunity is demonstrated by the increasing amount of deal activity and the increasing average deal size. Another trend that built momentum during the year and should accelerate further is successful GPs diversifying into other alternative asset classes. This includes private credit, real assets, distressed and special situations, ESG and social impact, and other thematic specialty funds. Due to this product diversification, many funds have grown their assets under management (AUM).
Looking at current trends, interest rates always play an important role. Specifically, deal activity has benefitted significantly from the low-interest rate environment. Making money cheap for firms creating debt notably helps this industry. Additionally, IPOs have been surging since markets quickly bounced back and trade sales declined. Exit value and numbers are on the rise and already ahead of pre-pandemic numbers. Transitioning to the emergence of special purpose acquisition companies (SPACs), this has posed an interesting challenge for PE firms to match or beat SPAC valuations. This is something to watch as we could anticipate longer holding periods and possibly more traditional exits, increasing IPO numbers even more in the long term.
The third quarter was a lucrative three months for private equity firms. Business-to-business deals continued to account for the majority of transactions with IT carving out a larger share as well. As previously stated, PE exits have been on a tear. Year-to-date exit value is already 50% larger than the next-highest annual figure, currently estimated to be $638 billion through Q3. PE public listing activity is also on pace to more than double 2020's totals. Lastly, the four largest publicly traded private equity firms broke individual records, bringing in unprecedented amounts of money.
Private Equity firms’ historical role of acquiring assets at a bargain and selling off in pieces is rapidly changing. Many firms are viewing their role as a change agent, so we are seeing fewer deals based only on the traditional playbook. They are becoming comfortable with their ability to execute strategic initiatives, which is driving valuations. The historical approach of valuing a business based on free cash flow has evolved. PE is also valuing businesses based on their potential post value creation. This strong value creation plan is a must to justify aggressive valuations. Along with its traditional uses, many portfolio companies are increasingly viewing private equity firms as strategic partners to assist in growth aspirations. To succeed in value creation programs, companies should include strategic sourcing plans, integrated tax planning, and a model for working capital success. Firms are also looking at the potential of workflow automation, cloud transformation, digitization, and more as technology continues to grow.
Some trends have stayed consistent. The sectors that have been the most resilient to the pandemic have been technology, industrial goods, financial services, and healthcare. These four broad sectors accounted for over 65% of all transactions last year and they are not going anywhere. Since many deals are in these areas, sector and subsector expertise have never been more important. Sectors like technology are making deals at or near record high multiples. These experts are key as today’s valuations leave little room for error.
While some trends remain, others need attention. Private Equity is typically a highly labor-intensive, paper-driven industry. The pandemic showed how inefficient this is as firms need to accelerate their transition from analog to digital. As seen in almost every industry, zoom can be very effective. In this case, interactions can be faster and more frequent instead of flying to meet investors or portfolio company management.
The trend of artificial intelligence should continue. Before Covid-19 hit, the most effective firms were already using AI, big data, and other technology to make smarter, faster decisions. These tools have shown they can contribute important insights into how industry patterns are shifting, where disruption is coming from, and whether their portfolios are prepared for the future. These assets along with digitally aided due diligence will rapidly transform the industry.
Arguably the biggest trend in private equity is the focus and expanding case for ESG. Customers, employees, and investors are demanding more sustainable, socially conscious corporate behavior. The difficulty in this area is establishing a positive correlation between environmental, social, and corporate governance (ESG) investing and financial returns. It is very challenging to quantify and link ESG investing. Until there is representative data, private equity investors will show skepticism. However, if a PE firm can deliver environmentally and socially friendly good companies, I predict they will be wildly successful.
European institutional investors show they are more committed to climate-related financial disclosures than North American institutions. While 80% of the top 20 EU-based institutional investors have committed to either the PRI, the UN’s Net-Zero Asset Owner Alliance or the Task Force on Climate-related Financial Disclosures, the Americas lag behind Europe and Asia with less than half of the top 20 institutions to do so.
European LPs have embraced ESG more than those in North America, but there is still significant room for growth as shown below. Despite no scientific proof, the European PE market is as busy as it’s ever been. They have focused on digitizing and compressing deal lifecycles, along with the importance placed on ESG. This combination has shown to be very successful. Despite these numbers, many firms still are hesitant to bet for or against ESG as it could be an investment fad that eventually fades. The PE industry can attribute its past success to its ability to anticipate future currents of value creation and to think more broadly about how they will reveal themselves; this very well could be one of those moments. For now, it is less about ESG in isolation and more about using it to create value. To create this value, its needs are:
· Clear definition, alignment and ambition.
· Focused execution
· Full integration
· Capability investment
· Measurement of results and continuous improvement
I believe ESG skepticism will persist as long as we lack empirical evidence that it contributes to higher returns. Devising the right measures will take time and creativity.
As for my own predictions on the future of private equity, I see continued growth, which is great to see in a desired career field of mine. I expect to see this growth increase at a decreasing rate as this level of growth will be difficult to continue, and interest rates are expected to increase in the coming years. With heavy research, IPOs and implementation of technology and AI should only increase in my eyes. We are becoming more technologically advanced, so I foresee less paper but a similar number of in-person meetings as I still believe this is an important aspect of business. I anticipate firms to focus on ESG as a part of the diligence process. Surveys show that consumers love companies that they believe act responsibly. Though “doing the right thing” is a difficult concept to identify, consumers know when they see it and it is a critical element of customer loyalty. To add to this, 88% of limited partners globally use ESG performance indicators in making investment decisions, and 87% said they invest in companies that have reduced their near-term return on capital so they can reallocate that money to ESG initiatives. According to the 2020 Edelman Trust Barometer Special Report, ESG is the future.
Looking at this growing industry, its development and evolution of these trends will be interesting to follow. 2020 posed interesting market conditions, but PE came out bigger and stronger. Digitization, AI, ESG, traditional exits, and sector expertise should all increase industry efficiency. What trend is next?
Works Cited
European Private Equity Market Trends 2021: Where are we now? Alvarez & Marsal | Management Consulting | Professional Services. (2021, October 11). Retrieved November 10, 2021, from https://www.alvarezandmarsal.com/insights/european-private-equity-market-trends-2021-where-are-we-now.
Global private equity report 2021. Bain. (n.d.). Retrieved November 10, 2021, from https://www.bain.com/insights/topics/global-private-equity-report/.
KPMG. (2021). Looking ahead: Private equity trends for 2021. Retrieved November 11, 2021, from https://assets.kpmg/content/dam/kpmg/cn/pdf/en/2021/01/looking-ahead-private-equity-trends-for-2021.pdf.
Prete, R. (2021, November 2). 'big four' PE firms Notch Records in Q3. PitchBook. Retrieved November 11, 2021, from https://pitchbook.com/news/articles/big-four-pe-firms-earnings-records-q3.
Prete, R. (2021, November 8). Understanding PE's Q3 performance through six charts. PitchBook. Retrieved November 10, 2021, from https://pitchbook.com/news/articles/private-equity-q3-2021.
PricewaterhouseCoopers. (n.d.). Private equity deals insights: 2021 midyear outlook. PwC. Retrieved November 10, 2021, from https://www.pwc.com/us/en/industries/private-equity/library/deals-insights.html.
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