In the current context of heightened volatility, we continue to view private markets as an attractive source of much-needed diversification, especially if inflation remains elevated for some time.
However, as in public markets, excesses and demanding valuations may deter investors. This is understandable. According to alternatives researcher Preqin, total private equity (PE) deal value surpassed $800 billion in 2021, 70% higher than pre-pandemic levels. In addition, investors have more than $1.32 trillion of “dry powder” chasing a limited number of targets.
Private equity mega deals in vogue
But beyond the headlines, just like with sectors and stocks in listed-equity markets, not all segments of the private equity market saw outsized growth last year. Mega-deals (above $1 billion) were particularly frequent, with, according to researcher Pitchbook, more than 100 transactions in the US representing 32% of all US PE deal value (see chart).
On the other hand, the share of deals between $100 million and $500 million, characterised as mid-market, was stable at around 60%. Similarly, in Europe, where the PE ecosystem is growing ever stronger, deals sized between $100 million and $500 million contributed most to the record-breaking deal value ($755 billion). Unlike in the US though, their share increased somewhat year-over-year.
Mid-market managers face less competition
Middle-market managers haven’t seen the type of inflows that other segments of the private equity universe have experienced in recent years. According to Pitchbook, US mid-market managers had raised $97 billion as of the third quarter last year, far below the $150 billion raised in the whole of 2019. As a result, their share in overall capital raised in the US had declined to 48%.
This trend has been constant for a few years now and can be explained by the well documented “strategy drift”: as PE managers realise there is significant demand, they may be tempted to raise more money than planned. As a result, some mid-market funds become larger, abandoning their niche and true expertise.
Recent capital raising trends reflect the level to which some middle-market funds have grown. The dry powder amassed by US middle-market funds has risen twofold over the last 10 years, while capital to be invested in the rest of the US PE market expanded fourfold. With a multitude of possible targets, and less capital chasing them, mid-market private equity managers face less competition, when looking to acquire stakes in companies they find attractive.
Similarly, when the time comes to exit an investment, mid-market managers tend to have more options at their disposal, than managers in larger markets. Exiting from a large, or mega, deal often requires PE managers to resort to initial public offerings (IPO), as potential buyers are rare. This leaves them exposed to the inherent volatility of listed markets. On the other hand, smaller-sized deals can be exited by selling the position to larger PE managers that, as we’ve established, are desperately looking for ways to deploy their vast war chests.
How much of a risk is sustained, higher inflation?
Outside of valuations, another key concern for investors is the prospect of higher inflation. Private companies aren’t necessarily better positioned than their listed peers to ride out periods of higher prices. They all face the same supply-chain constraints, input costs and labour shortages.
However, whether it’s operationally (driving down costs while ensuring pricing power) or financially (deal structuring itself), private equity markets often offer more levers with which to fight inflationary pressures for the underlying investors. This is particularly true in the mid-market, where companies tend to be smaller, can pivot more easily, and may innovate faster.
That being said, even if a company is managed privately, battling inflationary pressures isn’t easy, and, just like in the listed market, some sectors and companies may fare better than others. The key to minimising the negative impact of inflation, is to invest primarily in these sectors and business models that naturally allow for higher costs to be passed on to customers.
Spotting private equity targets
Ultimately, for investors to be resilient in the face of changing market While this process requires detailed due diligence on each potential target company, there are common traits investors (and PE managers) can look for:
- Secular growth drivers: investing in companies benefiting from long-term trends that won’t be disrupted by short-term macroeconomic volatility
- Market positioning: being a market leader or operating in high-barriers-to-entry industries decreases competition, typically improving pricing power
- Profitability: in an environment when the cost of money (interest rates) is going up, being profitable and exhibiting sustainable levels of leverage reduce a key risk and allow for better visibility over growth potential
- Sustainability: In addition to the critical environmental, social and governance (ESG) considerations, such as climate-change risk, sustainability also encompasses the company’s ability to continuously deliver value for all stakeholders
While we would apply the above criteria to investments in listed markets, we believe it’s even more powerful when applied to private markets, especially in the mid segment.