While on the surface many areas of private equity remain robust, we are a long way from the sector’s pre-crash glory days, especially as the full impact of the U.S. administration’s recent actions in deregulation, tariffs and taxes play out. Glory days aside, we continue to see transactions—one-off and otherwise—that produce striking returns for investors and sponsors. Similarly, while there was a large pullback in megadeals following the crash, there have been several multi-billion-dollar transactions of late, including club deals.
What drives this resurgent activity is the substantial money in the market supporting both transactional work and development. Successful private equity firms are awash in un-invested capital. But capital has also come into the sector via private credit funds, which replaced the bank lending that dried up following the financial crisis and tighter regulation. Credit funds’ explosive growth in the market is evidenced by the staggering amount of money raised in the sector. They’ve transformed from being small players to real transaction drivers doing billion-dollar financings—transaction sizes that were not on the horizon even a year ago for most players. Since recent U.S. regulatory proposals have eased the post-crisis regulatory restrictions on bank lending and investing, we believe the market will now have more financing liquidity available to it in at least the short term.
All of this capital in many ways has made both the “middle” and “high end” markets to a certain extent a very commoditized space. It is progressively harder to find and finance companies capable of yielding the rich returns that attracted investors initially. However, firms are finding opportunities with small and medium enterprises (SMEs) that potentially offer more transformational growth and returns. This SME focus is not limited to smaller funds (themselves often spin-offs of larger funds) but also a number of funds that went upmarket in the past that are now going down-market to SMEs (including with specific SME-focused funds) due in large part to the fact that this sector has the traction to get profitable deals done.
Despite these changes and challenges, consolidation of private equity players has not yet been a large part of the landscape, although transactions between private equity firms as part of portfolio restructuring remain robust, as has investment in management companies to contain overhead. That said, as existing leadership steps down, these attitudes may change. In the meantime, there will be increasingly sophisticated sales and transactions between and among funds to consolidate portfolio positions. We also have been seeing a newer phenomenon of “merger of equals,” an equity-type deal where separate firms put smaller portfolio companies together to make a synergistic play—not exiting holdings per se, but rather owning a smaller piece of a bigger pie they can jointly take to market. These future strategies will be shaped by technical aspects such as holding periods, but will challenge investors/limited partners (LPs) to ensure they are not holding positions in the same companies across multiple portfolios.
Competition for transactions has also been increased by the rapid growth of direct investors—Ontario Teachers is a perfect example of this—as well as family offices. These new players are large and sophisticated enough to undertake their own private equity-style transactions, and they position themselves to sellers as a better play because these independents can be longer-term investors with lower management fee charges.
Looking ahead, we think the interest rate environment will renew focus on distressed and special situation funds. From the interest rate perspective, each rate increase builds up until the floodgates open and over-exposed borrowers buckle. Of course we’ve been saying that for 10 years; however now we actually believe it is happening. The amount of distressed deals, with interest rates increasing and banks not willing to “amend and pretend” anymore, will lead to an upturn in bankruptcies and restructurings. This will be a springboard for private equity funds adding debt funds and distressed funds to their suite of offerings – something already happening at all levels of the PE market at an expedited pace.
Changing times don’t change investment priorities where individuals prioritize different levels of security and returns. Investors will stay with PE, but with a sharper eye, looking at who they are investing with, their track record and strategy, and whether they can get deals done. That will mean a time of smarter money, tougher money, and tighter returns.