Industry Trends
The role of ESG in private equity investments
Private equity and responsible investing (RI) share long-term investment horizons, making them naturally compatible. PE can drive responsible transformation in portfolio companies through effective governance. Although the PE industry has lagged in sustainability, it is rapidly catching up, particularly in Europe. Over the past decade, RI has been integrated into various stages of the PE investment process, with governance often prioritized over climate and social elements.
Data availability and reporting standardization challenges persist, necessitating high-level institutional decisions to align investment horizons. The PE industry's growing size and strategic influence significantly impact global efforts to address climate change and responsible management. Academic research and surveys indicate PE investors are increasingly incorporating RI, driven by investor pressure, stakeholder expectations, and evolving regulations like the SFDR and CSRD in Europe.
RI is seen as beneficial for portfolios' risk-return profiles, with ESG-integrated PE funds perceived as less risky and more diversifying. Thematic investing, particularly in innovative climate solutions, is well-suited to PE. RI criteria are integrated throughout the PE investment process, from due diligence to exit, with engagement being a core aspect. Governance criteria, including business ethics, compliance, and cybersecurity, are systematically considered, while climate priorities focus on emission measurement and reduction.
Data and reporting challenges remain despite progress, prompting collaborative efforts like the ESG Data Convergence Initiative. Successful RI implementation requires accountability at the highest institutional level and the integration of sustainability knowledge across the organization.
Source: Amundi Investment Solutions
Market Opportunity
Asset-Based finance: A new frontier for private credit
Private credit expansion into the asset-based finance (ABF) market is vast and largely untapped, with potential funding opportunities exceeding $5 trillion in consumer credit and up to $40 trillion in esoteric asset-backed securitizations. This expansion offers differentiated capital sources for borrowers and the potential for higher returns for investors due to the complex nature of the assets involved. Securitization, a key financial innovation, facilitates capital flow to illiquid and complex assets, allowing investors access to higher-return investments with clear risk visibility. The rise of private credit funds holding leveraged loans has significantly grown over the past 30 years, shifting the balance of power from bank funding to institutional investor funding. Private credit funds are increasingly adopting credit trenching, making their structures comparable to collateralized loan obligations (CLOs). The growth of alternative asset managers has led to more vertically integrated platforms, enhancing their capacity to fund more significant transactions. The potential for private funding in ABF is enormous, with estimates suggesting a market size of $20 trillion to $40 trillion. This growth presents opportunities that may surpass traditional credit markets, which are highly competitive. However, the expansion is not without risks, as private markets lack the transparency of public markets, and increased private credit presence could amplify credit risk during economic downturns. There is a need for careful structuring, management, and investment in ABS to mitigate these risks.
Source: S&P Global
Market Sentiments
The rising momentum of PE exits
The private equity market has shown signs of improvement in 2024, particularly in the US, where favorable financing conditions and a more receptive IPO market have driven a 51% increase in exit value. Lower debt costs, driven by central banks' rate cuts, have stimulated deal markets, including exits. The Federal Reserve and European Central Bank have reduced rates, easing leveraged finance costs and boosting debt issuance for refinancing and new buyouts.
Despite these positive trends, challenges remain. Macroeconomic uncertainty, valuations, inflation, and geopolitical risks could impact exit markets. However, the outlook for exits is promising, with lower interest rates and improving IPO markets creating favorable conditions for portfolio sales. Private equity firms are also exploring secondary liquidity solutions, with secondary fundraising reaching $76.6 billion in the first nine months of 2024.
Investors are focused on Distributed to Paid-In Capital (DPI) as a key return metric, and GPs are under pressure to return cash to LPs due to aging portfolios. The median holding period for PE assets sold in H1 2024 was 5.8 years, an improvement from 2023. With $3.2 trillion in unrealized PE portfolios, secondary liquidity solutions are expected to remain popular. Overall, the stage is set for a significant upswing in exit activity, offering private equity firms a chance to turn potential into concrete performance.
Source: Moonfare
Effect of rate hiking cycle on private credit
Private credit, which involves bilateral corporate loans made by specialist investment funds rather than banks, is facing its first significant interest rate hiking cycle. Despite interest rates starting to decline, the previous period of intense monetary tightening has left many smaller companies and investment funds struggling. Higher rates have increased interest income but also made debt servicing challenging for many companies, leading to a rise in defaults and the use of payment-in-kind (PIK) loans, where interest payments are deferred and added to the principal. This trend indicates growing stress within the private credit sector.
The IMF has noted that while some firms maintain robust margins, defaults are increasing among weaker companies. The private credit industry, which has grown rapidly and now holds between $2 trillion and $3 trillion, faces potential risks from deteriorating underwriting standards and weakened covenants. Although default rates reported by Proskauer and Fitch Ratings are not alarming, the increasing reliance on PIK loans and the potential for deferred realization of losses pose significant concerns.
Business Development Companies, which provide some transparency into the private credit market, show a rise in non-cash-generating PIK loans, indicating that companies are struggling to make cash payments. This situation could lead to a crisis of confidence, freezing fundraising, and causing a ripple effect across the financial system. While the current economic strength in the US provides some buffer, the lagged impact of high rates and potential future policy changes could exacerbate the challenges faced by the private credit industry.
Source: Financial Times
Artificial Intelligence Scope/ Trends
Role of AI in shaping the future of private credit
The private credit market is experiencing significant growth, driven by more flexible terms and fewer regulations, making it easier to access and underwrite businesses overlooked by traditional banks like J.P. Morgan. Projected to reach $1.7 trillion in loan volume for 2024, the market could double to $3.4 trillion in four years, according to BlackRock. Significant deals include Ares Management's $34 billion fund and Apollo's $25 billion fund with Citigroup. However, mid-market and fast-growing startups often remain underserved due to focusing on more significant deals, which require similar effort but yield higher returns.
The qualification and underwriting of private debt are labor-intensive and costly, making it challenging for more considerable funds to deploy capital at scale in the lower middle market. AI is poised to revolutionize this space by enabling lenders to analyze financial data more efficiently and accurately, reducing the need for increased staffing. AI can help private credit funds originate and underwrite more opportunities without sacrificing precision, lowering loss ratios through more brilliant credit models.
Private credit funds can provide leverage that traditional banks cannot, highlighting the competitive edge of private credit. As AI adoption increases, private credit funds are expected to outperform traditional banks, even in the lower middle market. Examples include ExecThread and IDMission, which secured financing quickly through AI-powered private credit marketplaces like Arc Capital Markets.
Integrating AI in private credit will democratize access to debt capital markets for mid-market businesses, addressing the insatiable demand for private credit and the relative shortfall in supply. This technological advancement will enable investment funds to maximize efficiency and better serve the businesses that drive the US economy.
Source: Forbes
Generative AI: Unlocking new potential in private equity
Many PE firms are urgently exploring GenAI use cases and pilots, recognizing the immediate value-creation opportunities this new technology can provide. Some firms already use large language models (LLMs) to analyze market trends and patterns, manage documents more efficiently, and automate back-office and customer-facing functions.
However, the rapid adoption of GenAI also presents strategic challenges that must be addressed. PE firms are considering how GenAI might affect their investment strategies by transforming target verticals and horizontals. There are also broader risks associated with using GenAI, which extend beyond traditional concerns such as privacy and cybersecurity. These new risks include biased training data or "hallucinations," which can impact value and reputation.
It is essential to achieving the right balance of tactical and strategic decision-making while managing potential risks amid the hype surrounding GenAI. PE firms can implement measures to capitalize on the opportunities presented by GenAI, indicating that this is a multifaceted issue that demands thorough consideration and strategic planning.
Source: EY
Future Perspective
Private equity's path to a brighter future
Regulatory pressures and Limited Partner (LP) demands are driving General Partners (GPs) and their portfolio companies to focus on sustainability, with frameworks like CSRD, SFDR, and TCFD becoming increasingly important. LPs demand greater transparency, with 44% of PE respondents indicating that over half of their LPs require ESG reporting. Evidence shows that strong sustainability performance can enhance value creation and returns, with 83% of M&A leaders willing to pay a premium for assets with firm ESG profiles.
To lead in sustainable investing, GPs should take several practical steps:
- Baseline Understanding: Structure the firm’s strategy, investment process, and enablers to objectively assess the current position and prioritize the next steps. PE deal count remained constant, but total deal value rebounded by 20% since early 2024. However, transaction levels are still below 2021 and 2022 levels.
- Articulate Direction: Develop a clear vision and ambitious targets that align with the firm’s goals and resonate with stakeholders.
- Integrate Sustainability: Use ESG metrics in acquisitions and divestitures, apply negative and positive screening criteria, incorporate sustainability performance into valuations, and conduct integrated due diligence.
- Active Ownership: Set expectations with portfolio companies pre-acquisition and support them in improving sustainability performance without hindering growth.
- Develop Internal Capabilities: Build internal capacity through targeted recruitment and training, ensure transparency and compliance with reporting regulations, and leverage data and AI for better decision-making.
- Training and Development: Embed ESG knowledge throughout the firm to enhance education and commitment.
These steps are essential for GPs to meet regulatory requirements, satisfy LP demands, and leverage sustainability to create value and higher returns.
Source: Deloitte
2025 vision: Five pivotal venture capital trends
Elena Volotovskaya, Head of Softline Venture Partners, highlights significant transformations in the venture capital landscape as we approach 2025. Despite promising technologies, the overall investment climate 2024 saw a 15% decline. Key trends include the rise of mega-deals with unicorn companies, substantial investment in AI startups, the struggles of zombie venture capital firms, the maturation of GenAI, and the democratization of venture assets. To lead in sustainable investing, GPs should take several practical steps:
- Increase in Mega-Deals with Unicorn Companies: The number of unicorns has surged from 142 in 2015 to over 1,200 by May 2024, with mega-deals involving these companies on the rise. Hectocorns, like ByteDance, are also emerging.
- Robust Investment in AI Startups: Despite a slight decline in overall startup funding, AI startups attracted $18.9 billion in Q3 2024, accounting for 28% of global investment. Major venture firms continue to back promising AI projects, highlighting the sector's potential.
- Challenges for Zombie Venture Capital Firms: The number of active venture capital investors in the U.S. dropped from 15,300 in 2023 to 11,400 in 2024. This decline reflects a consolidation trend and the struggles of many firms to stay relevant.
- Advancements in GenAI: Generative AI is evolving from quick responses to deeper reasoning capabilities, enabling complex problem-solving across various sectors. This shift towards service-based approaches signals significant investment opportunities.
- Expansion of Equity Crowdfunding : Build internal capacity through targeted recruitment and training, ensure transparency and compliance with reporting regulations, and leverage data and AI for better decision-making.
- Training and Development: Equity crowdfunding is growing, democratizing investment opportunities and fostering innovation. This trend represents a fundamental shift in how startups access capital.
The venture capital landscape 2025 will be dynamic, requiring investors and entrepreneurs to remain informed and adaptable.
Source: Forbes
Soft landings and dry powder: Private equity predictions for 2025
In 2023, the market experienced wide bid-ask spreads, tighter liquidity, and downward pressure on cashflow multiples due to higher rates and inflation. This created a mismatch between buyer and seller prices. However, conditions began to improve, with venture capital valuations rebounding and an unprecedented volume of continuation fund transactions in the first half of 2024. As we look to 2025, falling rates and easing cost pressures are expected to promote higher multiples and improve exit multiples due to high demand and low supply.
Fundraising among large-cap funds grew significantly from 2010 to 2022, but small and mid-sized funds saw better deal flow growth relative to fundraising. This imbalance pushes up entry multiples for large transactions, reducing performance potential, while lower entry multiples for small and mid-sized funds offer better returns. Private equity, especially small and mid-buyouts, has shown resilience during market volatility, outperforming listed equities during crises like the Dotcom crash, the Global Financial Crisis, the Eurozone Crisis, and the COVID-19 pandemic.
The structural nature of committed capital in private equity allows firms to retain assets during crises and sell them when conditions are favorable, avoiding fire sales. This and performance-based compensation and control over portfolio companies promote superior long-term returns. GP-led secondaries have become popular, allowing sponsors to enhance portfolio value with additional time and capital, mitigate execution risk, and provide liquidity to primary fund LPs.
As we enter 2025, private equity shows signs of resilience and growth, with falling interest rates and easing inflation setting the stage for improved multiples and continued investment in GP-led secondaries.
Source: Schroders
