Industry Trends
Shaping the future of private markets: Key considerations
Economic sentiment in 2024 is more favorable than in 2023, but challenges like geopolitical instability, elections, and market volatility persist, affecting private markets' recovery. Key considerations continue to shape the next era of private markets:
- Dealmaking Recovery: 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.
- Holding Periods and Fundraising: Longer holding periods and lack of exits challenge new fundraising efforts. PE fundraising increased by 10% in the first half of 2024 but remains 20% below 2021 levels.
- Asset Class Fundraising: Infrastructure funds raised $51 billion, more than doubling from 2023. Private debt and real estate fundraising decreased.
- Concentration Trend: Large and well-known companies dominate fundraising, with the top ten PE funds accounting for over 35% of capital raised.
- Value Creation Focus: GPs focus on value creation due to increased interest rates and inflation, requiring more cash flow growth for investments.
- Private Credit Expansion: Private Credit is expanding into new areas like asset-based lending and specialized finance pools, despite rising global defaults and regulatory scrutiny.
- Talent Challenges: GPs face challenges in attracting and retaining talent, while portfolio companies struggle with talent shortages in financial roles.
- Interest Rates and Deal Flows: Lower interest rates and spreads may positively affect private-market valuations and deal flow.
- Infrastructure Fundraising: Infrastructure fundraising improved in 2024, driven by digital and energy infrastructure needs.
- US Commercial Real Estate: The sector faces challenges with high financing costs and an impending debt wall, mainly affecting older office buildings.
- Secondaries Market Growth: The secondaries market continues to grow, with robust GP-led transactions and increased LP stake sales.
Source: McKinsey
The next big leap in private equity
GenAI has rapidly become a board priority, offering significant opportunities to enhance dealmaking, integration processes, and overall asset performance. However, the adoption of genAI also presents challenges, including technical capabilities, operational risks, and strategic uncertainties. It emphasizes that while genAI can make knowledge workers more productive and unlock new value, its successful implementation requires overcoming behavioral barriers and ensuring widespread adoption. Only 24% of PE firms currently use AI effectively, indicating untapped potential for productivity enhancements. To navigate these challenges, a bottom-up approach is recommended to unleash the power of people, pilot high-value use cases, and shape workforce transformation. Emphasizing the importance of data modernization and adopting 'Trusted AI' governance frameworks is crucial to ensure compliance and mitigate risks. PE firms must strategically prioritize AI investments to succeed in the AI-driven era. They should begin taking practical steps now to secure a competitive advantage in the changing landscape.
Source: KPMG
Market Opportunity
Infrastructure debt goes mainstream
High inflation, high interest rates, and bank pullbacks drive the rise in private credit loans among infrastructure borrowers. At the same time, investors are keen to invest in counter-cyclical assets that protect against inflation and market fluctuations. Eric Wittleder, Managing Director of Brookfield's Credit Group, highlights the importance of "demand side" decarbonization driven by consumer demand and cost, which has led to investments in energy-efficient residential infrastructure and smart metering in Europe and North America. It also addresses infrastructure debt opportunities arising from global supply chain disruptions and geopolitical events, emphasizing the need for resilient supply chains, particularly in baseload power, critical manufacturing, and logistics. LNG and onshore semiconductor manufacturing are key areas requiring significant infrastructure investment. In the utilities sector, there is a trend towards privatization and alternative funding to meet growing demands on electricity transmission and distribution systems. Both municipal and privately owned utilities seek private capital to enhance grid flexibility and deploy smart metering and energy storage solutions. District energy systems are also highlighted as cost-effective and reliable solutions for local municipalities to achieve decarbonization goals. It further explores opportunities in transport infrastructure, with regional mid-market transportation assets in the U.S. being aggregated by institutional investors to enhance synergies. The midstream sector, particularly natural gas, is identified as essential for supporting renewable energy growth and energy security, requiring private capital investment.
Regarding portfolio construction, Ian Simes, Managing Partner at Brookfield's Credit Group, emphasizes the importance of diversification and detailed analysis in managing risks. The complexities of infrastructure debt, including the need for thorough diligence and understanding of each asset, make it an attractive investment despite its challenges. It concludes by noting the massive global infrastructure investment required through 2040, estimated at $94 trillion.
Source: Brookfield Asset Management
Creating outsize returns: The M&A approach in private equity
In a challenging growth environment, private equity funds increasingly use add-on acquisitions to enhance their portfolio companies. In 2023, add-ons accounted for 70% of total PE deals, up from 57% in 2017. This strategy has gained traction due to changes in the investment and macroeconomic landscape, making traditional growth strategies less effective. Add-on acquisitions help PE funds achieve revenue, cost, and capital synergies, enhancing EBITDA, expanding multiples, and attracting talent. PE funds pursue add-ons for three main reasons: capturing synergies, achieving higher valuations, and attracting and retaining talent. For instance, a software company boosted its EBITDA and valuation by acquiring six add-on companies, while another increased its exit valuation by integrating hardware companies into its software offerings.
Additionally, add-ons can offer career growth opportunities, making companies more attractive to employees. To execute successful add-ons, PE funds, and portfolio companies should focus on five key levers: acquiring add-ons early in the holding period, concentrating on top value drivers, creating a repeatable integration process, rigorously tracking performance, and building sustaining M&A capabilities. Early acquisitions and efficient integrations are crucial for recognizing synergies. Companies should also focus on key value drivers and develop a rigorous stage-gate process for integration decisions. Performance tracking and building internal M&A capabilities are essential for ongoing success. Despite the benefits, challenges such as protecting base business revenue, ensuring cultural compatibility, and navigating regulatory scrutiny must be addressed. A comprehensive diligence process is vital for mitigating risks and ensuring compliance. Add-on acquisitions can lead to significant EBITDA growth and increased valuations when skillfully implemented.
Source: McKinsey
Direct Lending: Uncovering the strategic edge
The global private credit market is valued at $2.1 trillion, with direct lending being the most prominent asset class, holding $1.4 trillion in assets under management. Direct lending, which provides execution certainty and tailored solutions, is crucial for fueling M&A activity. Despite recent subdued M&A activity, middle-market private equity dry powder has reached over $500 billion in 2023. Middle-market loan issuance hit its highest level since mid-2019 in Q1'24, driven by a surge in leveraged buyout (LBO) issuance. Refinancings contributed $17.5 billion to the overall direct lending transaction volume in Q1'24, with "jumbo" loans making up $10.2 billion. This trend is expected to continue due to market dynamics and the maturity of middle-market direct lending debt. Direct lending offers customized financial solutions, enhancing risk management and providing a "complexity premia" for higher returns. This market segment includes middle-market and lower-middle-market companies with unique financing needs, attracting investors willing to engage in intensive due diligence. The illiquidity premia associated with these investments can offer superior risk-adjusted returns compared to traditional broadly syndicated loans (BSL). Investors benefit from a broad opportunity set, competitive deal flow, and attractive return premia with structural protections. However, effective market navigation requires expertise in understanding appropriate terms and pricing for each segment.
Source: Macquarie
Midyear Review
U.S. private equity market recap - September 2024
The latest insights into the U.S. private equity market reveal a mixed landscape. Despite a 22% drop in deal count in August, deal value hit a twelve-month high, contributing to a 10% year-to-date (YTD) increase. Larger deal sizes are trending, with deals over $500 million comprising 49% of 2024 YTD deals, up from 28% in 2019. Take-private deals have surged, with 27 deals YTD, driven by PE firms deploying high levels of dry powder. Cross-border investments in U.S. companies are also rising, particularly from the UK and Germany. Fundraising remains challenging, with both fund count and capital raised down and the average fundraising period extending to a record 29 months in 2024 YTD. The leveraged loan market saw a significant slowdown in August, with issuance dropping 57% from July amid market volatility and cooling investor demand. The IPO market recovery is expected in 2025 due to recent volatility, election uncertainties, and anticipated Fed rate cuts. The sports sector, particularly women's, youth, and amateur sports presents growing investment opportunities, with the NFL recently allowing PE investment in franchises. PE exit activity remains subdued, with firms exploring liquidity alternatives like continuation funds and NAV loans. PE executives are optimistic about a dealmaking resurgence following expected rate cuts later this month.
Source: Ropes & Gray
Private Markets: Monthly insights and analysis - September 2024
- Real Estate: The past two years have been challenging for real estate investors, but signs of recovery are emerging in selected markets. Transaction volumes are stabilizing, and investment volumes are rising in the UK. Rate cuts by central banks, including the ECB, Fed, Bank of Canada, and Bank of England, are anticipated to improve the market further. Property yields are flattening, signaling the end of the capital value correction phase. However, short to medium-term appreciation gains are unlikely, making rental income more crucial. Favorable segments include residential and logistics.
- Infrastructure: The Fed's rate cuts, following those of other central banks, are expected to improve financing markets for infrastructure, which typically employs high leverage. Despite slowed inflation, it remains above the 2% target, and GDP growth exceeds expectations. The combination of rate cuts, economic growth, and structural changes like decarbonization and digitalization creates favorable conditions for private infrastructure investment.
- Private Equity: The Fed's rate cuts could revitalize private equity exits, which have been sluggish due to higher borrowing costs since 2022. Lower rates are expected to boost deal activity and fundraising, particularly benefiting large and established managers. Co-investment dynamics favor LPs, and secondary deal flow remains active, offering opportunities for selective investors.
- Private Credit: Lower rates benefit corporate borrowers, real estate owners, small businesses, and consumers by allowing refinancing at lower costs. In residential real estate, lower mortgage rates improve affordability and demand, stabilizing home prices. However, increased supply from existing home sales could moderate price growth. Lower rates will also impact prepayment speeds, benefiting legacy bonds but negatively affecting mortgage derivatives.
Source: UBS
Market Sentiments
Private Credit surpasses private equity in Q2 performance
In the second quarter of the year, private Credit outperformed private equity and private real assets, achieving a return of 2.1%, according to MSCI. Private Credit maintained positive returns across senior, mezzanine, and distressed debt funds, while private equity and real assets experienced some negative returns. Venture capital within private equity dropped 0.4%, and real estate funds within real assets fell 0.3%. This marks the ninth consecutive quarter of negative returns for real estate, which decreased by 0.8% in Q1 and dropped 6.4% in 2023 overall. Global private equity funds returned 0.8% in Q2, down from 1.2% in Q1, while private real asset funds returned 1.1%, up from 0.7% in Q1. Executive Director of MSCI research, Keith Crouch, highlighted the uncertainty in the private-capital landscape as asset managers and owners await better exit opportunities. Despite generally positive performance and low capital calls, there are warning signs, particularly in venture capital, where the share of value in older investments is increasing. Holding periods for private market investments have risen, with venture capital reaching a record weighted average of 5.4 years. High-valuation investments are being held longer. Unrealized holdings have seen significant valuation growth since 2020, with private real estate and infrastructure exceeding $400 billion and buyout funds nearing $2.5 trillion. Venture capital valuations, however, have fallen below the $1 trillion mark from nearly $1.3 trillion. Crouch noted the substantial growth of the private capital industry over the past 14 years, with most asset classes quadrupling in size. A significant portion of current valuations is in younger holdings, with older holdings also growing in value, particularly in venture capital, which has over $200 billion in investments into its eighth year.
Source: MA Financial Media
An alternative perspective: Past, present, and future
The Alternatives market, though significant, represents less than 11% of global GDP and only 2.4% of total global financial assets. Despite its modest size, the industry has seen explosive growth, with assets under management expected to rise from $15 trillion to an estimated $24 trillion by 2028. This growth is driven by the need for private capital to fund infrastructure and other critical asset classes as governments face fiscal constraints and geopolitical challenges. The industry's expansion is also fueled by the demand for retirement security, with a global retirement savings gap projected to reach $400 trillion by 2050. Private investments have become crucial for providing capital across various industries, especially during the COVID-19 pandemic, highlighting the need for infrastructure and supply chain resiliency. The Alternatives market includes diverse strategies such as Private Equity, Infrastructure, Real Estate, and Private Credit, each offering unique performance and diversification benefits. The shift towards private capital is also seen as a response to the end of the low-growth, low-inflation environment, with investors seeking resilient, all-weather portfolios. Strong returns, reduced volatility, and access to thematic opportunities further enhance the industry's attractiveness. However, the journey is complex, with different needs for various market segments and the importance of consistent performance throughout investment cycles. As the industry evolves, it must innovate and adapt, learning from past experiences to meet future challenges and opportunities.
Source: KKR
Expert Opinion
UK's private equity sector remains strong in the face of competition
Ahead of this month's Private Equity Europe Forum, HSF partner John Taylor talks about market trends, London's deal hub status, and the investor outlook on the new government. In recent years, the UK PE market has seen a deepening and broadening trend, with funds shifting from sector-agnostic to more focused strategies and taking a closer operational view of managing assets. This shift is driven by increased competition for deals and capital, necessitating a sharper focus on value-added and sector expertise. Despite political instability and Brexit, London remains a leading private equity hub in Europe, bolstered by its status as a global financial center. The city continues to attract funds, maintaining and even strengthening its preeminent position. The market experienced a surge in activity post-lockdown in 2020 and throughout 2021, followed by a pause in 2022 due to interest rate uncertainties. While the upper market has started to recover, the mid-market is still unwinding. Sellers have struggled to offload assets, and investors are eager to deploy capital, indicating a need for dealmaking to resume. Expected UK policy changes, such as phasing out non-dom status and overhauling the tax on carried interest, could impact the attractiveness of London for private equity managers. However, London's inherent advantages may outweigh these concerns. The recent change in government brings some uncertainty, but the new administration's focus on economic growth and stability is seen as positive for the industry. Private equity funds are adapting to the end of ultra-low interest rates by emphasizing operational expertise and sector focus over leverage. The gradual increase in UK private equity investment is expected to continue, with ample capital available and sellers ready to transact at the right price.
Source: Herbert Smith Freehills
Artificial Intelligence Scope/Trends
GenAI's energy demand surge attracts private equity to fossil fuels
The global oil and gas industry has regained the attention of private equity firms due to the high energy needs of generative AI. From January to mid-August, private equity and venture capital deal value in the oil and natural gas sector surpassed $6.61 billion, with 47 investments announced. The US and Canada accounted for over half of these deals, while Europe had 11 transactions. Acquiring fossil fuel assets is strategic for private equity as AI data center infrastructure requires consistent energy that renewable sources alone cannot provide. AI data centers are projected to use 8% of US power by 2030, up from 3% in 2022. The largest private equity-backed oil and gas deal was Apollo Global Management's $1.92 billion acquisition of U.S. Silica Holdings. The second largest was Bernhard Capital Partners' $1.75 billion planned acquisition of New Mexico Gas Co. Despite this, private equity investments in renewables were significantly higher, totalling almost $21 billion with 69 deals. The largest renewable deal was Energy Capital Partners' $7.87 billion purchase of Atlantica Sustainable Infrastructure, followed by Brookfield Asset Management and Temasek Holdings' $7.86 billion acquisition of Neoen. Several large private equity energy funds are also being raised, particularly in China. The largest is Dongguan Financial Holdings' $1.4 billion fund, followed by GEF Capital Partners' $380.2 million South Asia Growth Fund III. There is an expectation of rising demand for both gas and renewable energy as AI spreads, with higher natural gas demand in the short term and increased sales of new renewable and natural gas power generation equipment in the medium to long term.
Source: S&P Global
