How will high-entry valuations affect the funds making deals and what impact will 2022’s backslide have on fund portfolios?
How will high-entry valuations affect the funds making deals and what impact will 2022’s backslide have on fund portfolios?
The current inflationary and interest rate environments have made for a much different buyout market in 2022, as the global economy wrestles with rising interest rates and market volatility. The effects are already apparent in the broader buyout market, in which the number and volume of deals have fallen sharply from the enthusiastic activity seen in 2021. During that period, the combination of cheap money and high demand drove nearly every market metric to new highs.
This included the price of entry. As ticket prices rise the eventual exit prices will need to rise the same for returns to keep pace. Recent history shows that low-entry multiples can present a long runway for asset performance (Fig. 1) with a pronounced negative correlation between entry values and value returned to investors. While more recent deals may be less mature, the market they close in will influence how they perform down the line.
Vintages of the best-performing buyout deals also coincided with the low-rate environment (Fig.2). Aggressive interest rate policies have led to very sharp increases in base rates. While the hikes that began in December 2015 took 37 months to reach a peak of 2.5%, so far this year it’s taken just 7 months, from March 2022 to September 2022, to climb from 0.25% to 3.25% (Fig. 3). And further increases are not out of the question. US inflation, the key driver of this year’s rate increase has shown few signs of slowing, with the most recent year-over-year change reported at 8.2% for September 2022.
The broader implication for the buyout market is that there is the potential for more risk for deals made in a rising rate market, compared with those made during a stable rate environment. This is a critical point to consider for deals made this year and into 2023, however, this will be less important for those made once rates find their plateau. The underperformance of deals made between 2016 and 2018 compared with those made between 2017 and 2019 (Fig. 4) can in part be attributed to markets in the former period dealing with a rising rate environment, among other market factors. During such periods, prices are forced to cope with greater uncertainty than if rates are stable and known. It’s likely that the 2016 – 2018 deal set would have continued to lag were it not for COVID-19 stimulus and the market uptick following the pandemic – a rising tide lifts all boats.
In the Preqin Special Report: The Future of Alternatives in 2027, we note that North American buyouts will underperform compared to years past in the period to 2027, which looks likely considering the confluence of market conditions. They are predicted, however, to outperform the global market going forward. Even with the predicted slowed rate, growth is still predicted to be positive and in the double digits. There is a possibility that the denominator effect could mean assets are drawn to public equities from private in the short term, however, don’t expect longer-term, strategic allocations to change, as allocators are unlikely to alter their strategic planning and will maintain long-term commitments to private equity.
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