On April 22, Nathanaël Benjamin was in an ominous mood regarding the state of the private equity (PE) market. In a speech delivered at a Bloomberg event, the Bank of England (BoE) Executive Director for Financial Stability Strategy and Risk was blunt when bringing attention to the industry that has grown in size, complexity and interconnectedness. From the speech titled ‘Not-so-private questions,’ it was crystal clear that regulators are reaching convergence: the PE industry has ballooned to levels that could pose threats to the global financial systems, yet it continues to operate in opacity.

“Shining a light on the current dynamics in the private equity market is crucial at this juncture, given the important role the sector plays for the real economy,” said Benjamin. He added that making sure the financial system evolves in a way that is conducive to safe and sustainable financing practices is essential for durable economic stability.

For Benjamin, a member of BoE Financial Policy Committee, current realities facing the PE market have converged to present the ideal moment to focus the spotlight on the industry. Notably, recent developments have the potential to disrupt the supply of funding to real economy companies. Besides, they have the potential to cause systemic institutions, including banks, to experience significant and correlated losses due to exposures linked to private equity.

“These dynamics, as well as exogenous shocks, could all be amplified by vulnerabilities in this sector, such as opacity and interconnectedness across institutions and markets. So this is typical financial stability ground. That’s why we care,” he stated.

Clearly, these are not the days when regulators turn a blind eye on the PE market. Having achieved exponential growth over the past two decades, the industry is floundering. Up until two years ago, the PE market had managed to thrive riding on a model built on cheap financing and leverage. However, the confluence of higher borrowing costs, market volatility and economic uncertainty has brought about considerable challenges for the PE ecosystem. These challenges have regulators ringing alarm bells.

“Clearly debt markets have impacted returns,” says Mike Donaldson, CEO at South Africa-based RMB Corvest, a pioneer in private equity that is 100 percent focused on equity investing, with PE being its primary asset class. He adds that while PE has encountered headwinds in recent times, what is indisputable is that PE has matured into a multi-trillion-dollar industry that is absolutely critical in driving growth of businesses and job creation.

The PE growth trajectory
That PE has achieved phenomenal growth is evident. Data indicates that globally, assets under management in the private equity sector have increased significantly over the past decade from $2trn in 2013 to $8trn in 2023. The industry, however, remains relatively small compared to the public equity market, whose size stands at $100trn and banking sector balance sheets at $98trn.

The vibrancy of capital markets is facing real threats from Private Equity firms

In the US, PE firms generate vast economic output. They create 12 million jobs and contribute 6.5 percent of the gross domestic product, amounting to $1.4trn. In the UK, the sector plays a crucial role in funding businesses, with around $313bn actively invested in companies. British Private Equity and Venture Capital Association data show that last year, UK businesses backed by PE and venture capital (VC) employed 2.2 million workers (1.9 million are PE-backed only), collectively earning $94bn. More notably, suppliers to these businesses employ an additional 1.3 million workers. Overall, this is comparable to the entire education sector’s workforce.

The situation is similar across other regions including Asia-Pacific, Latin America and Africa. In Asia-Pacific, for instance, PE investments have been on a growth trajectory, hitting a five-year high of $244bn in 2021 according to KPMG. In recent months, however, investments have plunged to $84.7bn. In Africa, the PE industry has emerged as a lifeline providing alternative routes to growth for companies that may otherwise have struggled to achieve the requisite scale. PE and VC investments in Africa soared 66 percent in 2022 to $7.7bn according to S&P Global Market Intelligence data, the highest aggregate value for the region.
“The flow of PE investments has been healthy in Africa and continues to facilitate growth for many businesses for which bank credit was not easily accessible,” notes Paras Shah, Managing Partner at Bowmans Kenyan office. He adds that the majority of the deals in the continent are relatively small, ranging between $15m and $25m. This, however, reflects the small nature of the market.

Visibly, PEs have unleashed their pooled financial war chest to snap up valuable companies in pursuit of handsome returns within the shortest period possible. Companies in industries like software, communications, IT and media, semiconductors, health and pharmaceuticals, renewable energy and agriculture have attracted massive investments across the globe. It has been a similar case for sectors like financial services, transport, fast moving consumer goods and tourism and hospitality.

The growth of the PE industry and its expanding tentacles of influence is also bringing about another phenomenon – migration of highly qualified professionals from industries like banks and insurance to PE ventures. Banks, in particular, are feeling the weight of the exodus with erstwhile employees now becoming direct competitors or clients. More alarming, however, is that banks are witnessing an increase in default rates of leveraged loans. Though unclear how deep the malady runs, for banks that are overly exposed the risks have the potential to blink red.

Into the unknown
After years of sustained growth, the PE market has over the past two years been sailing in uncharted waters. The rosy growth that had been witnessed in prior years started to crash in 2022, and continued last year. The root cause of the crumble: the Fed’s rapid increases of interest rates, the sharpest since the 1980s. The Fed’s aggressive approach to arrest stubborn inflationary pressures has had contagion effects, instigating hikes across the globe.

“The strong growth and attractive returns of the private equity asset class over the last 10 years has occurred during a period of low interest rates. However, since the start of 2022 interest rates have increased substantially,” observed Benjamin. He added that markets are not expecting for the foreseeable future a return to the low levels seen in the recent past.

High borrowing costs have inevitably exposed the PE industry’s soft underbelly. Apart from sapping the confidence of investors, it has brought about excruciating challenges. Evidently, it has been a season of slump across all matrices for PE cutting across fundraising, dealmaking and exits. The ripple effects are being felt across the whole ecosystem. Desperate companies – a majority being small and medium-sized companies (SMEs) – in need of growth capital cannot attract financing.

General partners (GP) who manage funds are feeling the squeeze in terms of management fees and carried interest dry up. Limited partners (LPs), the investors into the private equity funds who include sovereign wealth funds, insurers, pension funds, foundations, and wealthy individuals, among others, are in a state of despair, with funds returning the lowest amount of cash since the financial crisis 15 years ago. The “majority of PE houses have not realised their core investments during these cycles and have chosen to hold for longer,” explains Donaldson.

Global consultancy firm Bain & Company’s 15th Annual Global Private Equity Report clearly captures the reality of the PE industry in recent times. The report contends that echoes of the 2008 global financial crisis have reverberated loudly. However, the industry has never seen anything quite like what has happened over the last 24 months. “The sheer scale and speed of rate rises last year, and the uncertainty around that, was a shock for the industry in 2023,” said Hugh MacArthur, global private equity practice chairman at Bain & Company.

Confidence was the first casualty of the Fed’s jacked rates, something that left the PE industry gasping for air in terms of investments, according to the report. In 2023, buyout investment value dropped to $438bn, a 37 percent nosedive from 2022 and the worst total since 2016. When compared to 2021’s peak, it was 60 percent down. Overall deal count dropped by 20 percent to around 2,500 transactions. Against 2021 highs, deal count was down 35 percent. The malaise infected regions across the world, with North America, Europe and Asia-Pacific experiencing significant declines. While dealmaking was badly off, exit activity fared even worse as rising interest rates and macro uncertainty left buyers and sellers at odds over valuations. In fact, exits have propelled to the pinnacle and have become the PE industry’s most pressing conundrum. Apart from seizing up and stanching return flows of capital to LPs, they have left GPs sitting on an aging $3.2trn of unsold assets. This accounted for a staggering 28,000 companies in which PEs cannot exit.

The sheer scale and speed of rate rises last year, and the uncertainty around that, was a shock for the industry

Notably, the median holding period for a buyout has also increased and now stands at 5.6 years, way above the industry norm of about four years. In 2023, the businesses that held for a lengthy four years or longer comprised 46 percent of the total, the highest since 2012. The plunge in exit activity saw buyout-based exits drop by 44 percent to $345bn by value globally. The number of exit transactions fell by 24 percent to 1,067 during the year. A drop in exits was recorded across all geographies.

“Breaking the logjam will need GPs to take charge of their destiny in terms of how they can manage portfolios in order to generate increased distributions for LPs,” noted Rebecca Burack, head of the global private equity practice at Bain & Company.

This is critical, and somewhat urgent coming on the backdrop of PE funds returning the lowest amount of cash to investors last year. Data by US-based investment bank Raymond James Financial shows that distributions to LPs totaled 11.2 percent of funds’ net asset value. This was the lowest since 2009 and stood well below the 25 percent median figure across the last 25 years.

No way out
Inabilities by PE funds to exit and return capital to LPs had a battering effect on fundraising. The silver lining is that new fundraising contributed an impressive $1.2trn to the stunning $7.2trn in fresh capital the industry has accumulated since 2019. That, however, was the only positive. This is because the amount raised last year was actually the least the industry has pulled in annually since 2018. More tellingly, it was down 20 percent from 2022 totals and almost 30 percent off the all-time high in 2021.

The biggest contributing factor in fundraising plunge is that low returns have prompted LPs to become overly selective on any new redistributions. In essence, LPs are opting to carry out thorough due diligence seeking to zero in on GPs that have over the years demonstrated resilience in returning capital. “Assuming patient capital, the returns should materialise once markets re-rate,” explains Donaldson. Investments, exits and fundraising challenges have put the PE industry at a crossroads. The situation has been exacerbated by a whole basket of dry powder that cannot be deployed due to slowdown in dealmaking. According to S&P, global private equity dry powder soared to an unprecedented high of $2.5trn in 2023 from $2.3trn in 2022, an eight percent increase. Notably, 25 PE firms held 21.8 percent of the dry powder, 19 of which were headquartered in the US. Apollo Global Management led all other firms, with $55bn in uncommitted capital available to its private equity strategies. Other firms sitting on record levels of dry powder include Blackstone, KKR, Carlyle Group, CVC Capital, Warburg Pincus, Brookfield, Bain Capital and Advent International, among others.

“The accumulation of dry powder is an indication that firms have been facing challenges in looking for deals. There haven’t been that many targets,” notes Shah. He adds the economic uncertainties have created a scenario in which investors are more restrained and selective. The dynamics have also been complicated by the valuation gap, which has been one of the primary impediments to dealmaking in recent months. Due to high interest rates, vintage PE assets have faced the risk of valuation mismatches at exit. To a large extent, this explains the increase in the median holding period for a buyout.

The valuation quagmire has forced GPs and LPs to seek solace in the secondary market in pursuit of liquidity. Yet even here, increased supply has put downward pressure on the prices and valuations. Research by US-based financial services firm Jefferies shows that secondary volumes stood at $112bn in 2023 compared to $108bn in 2022, representing a four percent increase. Robust buyer demand, significant supply of both LP portfolios and GP-led opportunities and stabilising market conditions drove secondary volume higher. Of importance to note is that although pricing overall had improved due to rising public valuations, only one percent of LP interests were priced above the net asset value (NAV) of the company portfolio.

“Sustained high interest rates in 2023 altered investors’ required return on capital and limited their use of leverage, resulting in a mere one percent of funds pricing above NAV, and many older, tail-end interests trading below 75 percent of NAV,” states a report by Jefferies.

Undoubtedly, it has been a turbulent period for the PE industry on all fronts. This, however, did not stop the execution of some earthshaking deals last year. A majority of the top deals closed were valued at below $1bn. Only about a quarter were valued at more than $1bn, according to Pitchbook.

The $13.5bn acquisition of Japanese conglomerate Toshiba by PE firm Japan Industrial Partners stood out among the topmost deals. The transaction was nothing short of groundbreaking. It marked the end of a 74-year era for Toshiba as a listed company. It also gave the struggling conglomerate a new lease of life. Toshiba was just one of a growing number of take-private deals.

Others included Silver Lake with the participation of CPP Investments paying $12.5bn to acquire Qualtrics, an experience management company, and Stonepeak paying $7.4bn to acquire Textainer, one of the world’s largest lessors of intermodal containers. Other notable deals in 2023 included Roark Capital paying $9.5bn to acquire Subway, one of the world’s largest quick service restaurant brands, and Apollo agreeing to buy out the shareholders of Univar Solutions, a commodity and speciality chemical distributor, at a cost of $8.1bn.

The fact that PE firms are increasingly becoming vultures devouring publicly listed companies is among the reasons why regulators are shining the spotlight on the industry. Globally, the vibrancy of capital markets is facing real threats from PE firms. A survey conducted by US-based multinational law firm Dechert last year paints a clear picture. In the survey of 100 senior PE executives in the US, Europe and Asia, 94 percent said they have plans to pursue take-private deals. In 2022, only 13 percent had take-private ambitions.

The enormity of PE devouring publicly listed companies is unprecedented. Over the past three decades or so, the number of listed companies in the US has plunged by more than half from about 8,000 to less than 4,000 currently. A large number have been taken private by PE firms. In the first quarter of this year alone, there were 21 take-private deals according to audit firm AY. “This underscores the degree to which PE firms continue to perceive opportunities and mispricings despite tremendous recent gains in public equities indices,” stated Pete Witte, EY Global Private Equity Lead Analyst.

The end of the tunnel
Unplugging companies and taking them away from the hawk-eyes of regulators and public scrutiny is fuelling the culture of opacity in the PE industry. The effect is that concerns are now mounting that this has the potential to cause tremors, even quakes, on the global financial systems. PE cross cutting links with the banking sector, insurance, pension, sovereign wealth funds, private credit markets and leveraged lending is adding to these fears. “This intricate web of connections adds to the notable lack of transparency, making it difficult to assess financial stability risks,” noted Benjamin.

Over the past three decades or so, the number of listed companies in the US has plunged by more than half

PE portfolio company bankruptcies is another area of grave concern. The devastation of high interest rates has extended to portfolio companies. In the US, for instance, S&P data show that bankruptcy filings by PE and VC-backed companies surged to 104 last year. This was the highest annual total on record, representing 174 percent growth over the 38 filings in 2022 and accounted for more than 16 percent of all US bankruptcy filings. Bankruptcies in the healthcare sector were among the highest, totalling 17.

That the past two years have been distressing for the PE market is not in dispute. The industry, however, is starting to see some light at the end of the tunnel. Easing borrowing costs and a renewed interest from lenders has resulted in a rebound in activity. The trend is projected to gain pace in the coming months. “With rates set to moderate in coming months there is a greater sense of stability,” noted MacArthur. He added that despite the positive signs, cautious optimism overrides prospects in the immediate and medium term.

The first quarter of 2024 offers a glimpse. S&P data show that PE and VC deal value stood at $130.6bn during the period compared to $124.3bn for the same period in 2023, representing a 5.1 percent increase. With 60 percent of GPs expressing optimism on 2024 prospects compared to 34 percent last year, the industry believes the worst is behind it, and probably over.

It has been a turbulent period for the private equity industry on all fronts

The PE industry is looking into the future with renewed potency. Generative artificial intelligence (GenAI) is already shaping up as one of the game-changing tools that are bound to define how the industry operates. The rate of GenAI adoption is proving to be phenomenal. Some 74 percent of PE-backed firms are currently either using AI solutions in their transaction processes or are piloting potential solutions. These cut across making investment decisions, carrying out due diligence, analysing market trends and patterns, streamlining back-office functions to enhancing privacy and safeguarding against cybersecurity.

For the PE market, adoption of smart technologies is not the only necessity. The lessons of the past two years have shown that discarding the principles of measured risk in pursuit of short-term profits can be counterproductive. This reality, coupled by regulators’ resolute view that the PE market must grow in a safe and sustainable manner, is bound to force the industry to change its modus operandi. What will not change, however, is the foundation under which the industry stands – private.