The private equity market is in turn impacted by the current economic climate. Numerous factors are shaking up the market, creating uncertainty for investors.
What impact are inflation, the health crisis, ecological pressures and rising interestrates having on the market? Despite these disruptions, how does private equity investment continue to generate opportunities?
Private equity turbulent in an uncertain economic climate
We currently find ourselves in an inflationary context, which is eroding company margins. This is forcing them toraise prices, but also toinnovate in order to differentiate themselves in a tight market.
The old adage that "necessity is the mother of invention" has never been truer. We've seen it, for example, with the unprecedented increase in investment in innovative solutions for managing the transit of goods and services, since the start of COVID-19. We are also witnessing an increase in the interest shown by financial institutions in digitalization in the broadest sense, and the diversification of long-term financial hedging products.
As a result, interest rates are on the rise, pushing up the cost of credit and impacting the terms of leveraged buy-outs (LBOs). An LBO involves borrowing money to buy shares in a company. However, the rising cost of money is disqualifying a significant number of investors who would be interested in such opportunities, generating a considerable slowdown in M&A deals. The world of "Buy Low, Sell High" arbitrage opportunities is gradually dissipating against this backdrop offinancial market insecurity.
The world of finance is also impacted by the energy transition. A transition that represents a very significant and urgent cost for small and medium-sized businesses, particularly in the current geopolitical context. Increasingly, these costs have to be factored into the business models of companies seeking financing.
Inflation, rising interest rates and the growing importance of the energy transition are the three main influences currently tugging at the heartstrings of both lenders and investors.
2023 financial market trends
A desire to democratize private equity
Private equity funds are increasingly turning to retail. Europeans have accumulated 600 billion euros in savings, in addition to the 1,400 billion euros in pre-COVID-19 savings. This stock is attracting financial institutions and funds of all kinds, and of course private equity funds. There's a certain desire to democratize private equity by bringing entry-level investment ticket prices down to the lowest possible level. Today, you can invest as little as €5,000 in a private equity fund, which was not possible just 5 years ago.
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The growing trend towards specialization and concentration
We also note that performance dispersion in private equity is becoming increasingly important. It is very close to that seen in listed assets, which implies a need for extreme selection and an ever-increasing effort to specialize.
Today, there are fewer and fewer diversified investment funds dedicated to all sectors, and we are witnessing a real sector focus per investment mandate. The aim of this specialization is to reduce investment risk by bringing in specialist consultancies to bring out the best in investment opportunities.
Growth in real estate private equity
Another notable trend is thegrowth of real estate private equity. Real estate is a tangible investment, offering greater security and reduced risk as part of a long-therm approach.
Real estate private equity involves the conversion or restructuring of existing real estate assets. This is particularly true of transactions involving the conversion of offices into apartments, followed by block resales or apartment divisions in the post-COVID 19 context.
Unlike the traditional SCPI (Sociétés Civiles de Placement Immobilier) model, private equity is concentric. Investment funds work on small projects of €30 to €50 million with 1 or 2 large buildings, and offer entry-level investment tickets at increasingly lower prices. As mentioned above, you can participate in this type of project from €10 or €20,000, and some asset managers are even beginning to open up to €5,000 tickets.
Growth in continuation funds
We have seen strong growth in continuation funds. Today, at the end of a traditional private equity investment cycle with an average 10-year horizon, investors have several choices:
- A classic liquidation of the portfolio position by reselling shares on the secondary market.
- Rolling over shares through continuation funds: a very interesting alternative that allows investors to keep control of the highest-yielding assets in their portfolio, and companies to stay with investors they already know.
The impact of ESG regulations
Regulations relating to environmental, social and governance (ESG) aspects are also impacting private equity, and ESG indicators are coming under increasing scrutiny. Of note is the new EU directive on sustainable finance disclosure published in 2021, which requires private equity management companies to publish their ESG indicators with a view to ongoing transparency.
Climate change is a universal issue that is increasingly on the minds of both investors and management company employees. As a result, asset management companies today are more sensitive in their investment choices, and many are choosing to be more respectful of the environment and the impact their activities have on society.
Private equity investment: opportunities to seize
Due diligence minimizes risk
Private equity investment is what's known as a "slow-pace " investment. To invest in a private company via a private equity fund, it can take between two and four years from investor commitment to actual deployment as a fund call. This is quite a long time, as it involves a great deal of workanalyzing investment opportunities before the investment decision is made. During this "due diligence" phase, management companies assess the strengths and weaknesses of companies seeking investment, calling on external service providers and sector specialists. It's a costly process for investors, but one that is extremely useful in the long term for minimizing risk.
Strict monitoring of the investment cycle
Unlike banks, private equity firms offer genuine support to the companies they invest in. Project managers provide monthly, quarterly, half-yearly and annual follow-up to monitor progress in the investment cycle. Investment An investor can benefit from monitoring of invested companies through a number ofpre-established indicators prior to financial release, ensuring that the investment is secure and aligned with the initial objective of the investment mandate.
Co-investing with a specialized management company for added security
Despite the current climate, investment security can also be enhanced by involving the management company in the investment effort(co-investment transactions). By investing as an institutional, individual or solo investor with specialized management companies, you benefit from risk "sharing".
The management company receives carried interests based on the returns generated, and brings an additional capacity for analyzing investment opportunities, thus reinforcing investment security.
Conclusion
Rising debt servicing costs in recent months, as well as inflation and market volatility, have put negative pressure on private equity financing. This manifests itself mainly in increased reticence and longer pre-investment due diligence cycles.
Nevertheless, to date, there is no shortage of capital in this market. Rather, capital is being redirected. Capital will increasingly be channeled into strengthening the most resilient private companies in a context of uncertainty and price volatility.
By Wafed Souissi
Managing Consultant at AssetValue Consulting