A Turning Point
A Turning Point
We see European Private Equity at a potentially critical juncture, with the outcome dependent on answers to five key questions (below), that we group along two key axes of uncertainty: Speed of Deal Activity Recovery vs. Achievable Future Investment Returns.
i) How quickly will deal volumes recover now that interest rates are falling?
ii) Will the unsold backlog be cleared fast enough to alleviate liquidity and fund raising challenges?
iii) Are the valuations of unrealised assets in PE portfolios achievable?
iv) Are we entering a period of sustainably lower Private Equity returns?
v) For how long can PE funds avoid significant fee margin pressure or substitution risk?
Critical Axis (1): Deal activity
Critical Axis (1): Deal activity
Private equity deal activity has begun to improve but is still at only half the historical average rate. Falling interest rates (lower financing costs) and an economic 'soft landing' should support recovery in activity levels. We anticipate a pick up in IPOs as an exit route, with follow-on trading volumes: positive for Exchanges and - potentially - public market asset managers. IPOs have historically accounted for only ca. 20% of private equity fund exits, but the size of the backlog of private equity transaction activity is significant and we see public markets likely to play a role in unlocking deal liquidity. Activity pick up is needed: our detailed analysis of historical cashflow J-curves shows the pressure on asset allocation pacing models. With Private Equity capital call rates currently more than double distribution rates, the industry has a lot of catch up to do before over-extended asset allocators can return to target Private Equity allocations. This could mean fundraising headwinds remain in place for some time even after activity picks up.
Critical Axis (2): Investment returns
Critical Axis (2): Investment returns
Linked to the so far slower than expected recovery in PE deal activity is the question of the achievability of current portfolio valuations, and the sustainability of investment returns. There is risk that some investments will need to be sold at discounts to carrying values to facilitate deal execution. At the same time, in a higher interest rate environment, deal refinancing and new transactions at higher rates could mean future achievable returns will be lower. These factors suggest significant scope for dispersion of return outcomes between fund managers. Returns achieved last time that interest rates were at current levels were high - but with larger fund sizes and more AUM (USD 5.5 trillion end 2023) at, or waiting to be put to, work now than ever before, it is not clear if these rates of return can be delivered again. At the same time, private equity indices are becoming increasingly sophisticated and investible. If this trend continues, higher fee, illiquid Private Equity could face risk of i) substitution by, or ii) fee margin pressure from, liquid Public Market Replication funds.