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Private Equity

Preqin Special Report: The Future of Alternatives in 2027

In this article

Written by Cameron Joyce, CFA, and Angela Lai, CFA


October 5, 2022

Macro conditions to weigh on performance and industry growth


The tailwinds that have helped private equity outperform public equity markets are being eroded

Deteriorating global macroeconomic picture

The global macroeconomic picture has deteriorated significantly since our previous forecasts were compiled. Powerful post-COVID-19 monetary and fiscal stimuli have fueled inflationary pressures at a time when global supply chains have been disrupted. What’s more, the war in Ukraine has added to investor uncertainty while further stoking food and fuel prices.
As a result, slower economic growth is expected at a time when the market is anticipating tighter policy from central banks, and so pricing in higher short-term interest rates. The IMF currently expects global growth to slow to 3.6% in 2023. It also foresees inflation reaching 5.7% in advanced economies, and 8.7% in emerging economies in 2022.[1] The US, Europe, and China are all expected to see major slowdowns, with recession a material risk. The US Treasury curve remains inverted, with the 10-year yield 25bps lower than the 2-year yield as of September 9, 2022 – a further indication that bond markets are pricing in recessionary concerns.

Low long-term interest rates will continue to support risk assets, given that discount rates have not increased significantly compared with the historic average. However, investors are becoming more risk averse as confirmed by our latest institutional investor survey. We observed a shift in preference away from comparatively higher-risk asset classes such as private equity toward the perceived relative safety of real assets and private debt.

Stronger inflation in the US and a comparatively stronger monetary policy response have caused the interest rate differential between the US and other leading economies to widen. This has fueled strength in the dollar, with the DXY index reaching highs of almost 112. This places a significant strain on emerging economies as it effectively exports inflation to these markets through higher import prices in local currency terms. The higher contribution made by food and fuel to the CPI baskets of emerging economies has also put pressure on discretionary consumer income. This is at a time when the cost of servicing dollar-denominated debt is significantly higher in local currency terms. All these factors contribute to our comparatively muted outlook for the APAC region and Latin America, particularly.

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Global private equity performance expected to soften

We expect macroeconomic headwinds to weigh on private equity performance over the next five years. Our latest forecasts expect global private equity net IRR returns to slow to 13.5% from 2021 to 2027, compared with 15.4% per year in the 2015 to 2021 period (Fig. 1.6). While we do not forecast performance for global public equity markets, the MSCI ACWI has returned 9.4%[2] per year over the last 10 years, in comparison. The forecast decline in performance is most pronounced for global buyout strategies, perhaps the private equity strategy most impacted by recessionary risks.
As a result of slowing performance and downside risks emerging within private equity, we expect the pace of fundraising to slow considerably. Following a 33% jump in global private equity fundraising to $561bn in 2021, our model expects a 21.5% decline in 2022 before an additional 2.7% decline in 2023. We then forecast modest annual growth in fundraising for the remainder of the forecast period (Fig. 1.8).
The denominator effect is among the factors expected to drive softer fundraising. As public equity and fixed income markets have declined in 2022, private equity allocations are proportionately higher as a percentage of investors’ overall portfolios, given the delay in private equity valuations reflecting those of public markets. As a result, some investors have found themselves relatively closer to long-term target allocations, which could curb their need for fresh allocations.

In this environment we expect holding periods of private equity-backed companies to be extended. This will weigh on exit activity and hence the return of capital to LPs via distributions. In turn, it will curb the amount of capital assigned to redeployment into new funds. However, this will boost unrealized value, given that private equity positions will remain invested for longer, thus boosting this portion of assets under management (AUM).

We also expect more activity in the private equity secondaries market. As of the end of 2021, secondaries AUM accounted for 5.7% of total private equity AUM[3]. However, as some investors grapple with the denominator effect we expect to see more fund interests on the market, which may improve secondaries deal flow. More GPs are likely to utilize continuation fund vehicles to prolong fund lives and facilitate exits into more favorable market conditions in future. As a result, we expect secondaries’ share of the total market to increase.

We expect global private equity dry powder will continue to climb to record highs, but also to decline as a percentage of overall AUM. Total dry powder is expected to climb by 61.3% from the end of 2021 to 2027, rising from $1.2tn to $1.9tn. However dry powder will actually continue to decline as a percentage of total AUM – from 28.3% in 2021 to 25.3% in 2027 as AUM increases from $4.2tn to $7.6tn.

North America expected to remain in a favorable position

The US remains in a strong position relative to the global economy, which may help to insulate earnings to an extent. Despite the sharpest forecast drop in expected performance compared with the prior period, North American private equity buyout performance is expected to remain the strongest of any major region over the forecast period. North American buyout funds generated annualized returns of 16.7% from 2015 to 2021, but are expected to generate a relatively softer 14.5% per year until 2027. This compares with an expected 14.3% return for European buyouts and 11.2% for APAC buyouts, and is largely due to the comparative economic challenges faced by Europe and the APAC region.

Nonetheless, we expect the performance of private equity growth funds that are more sensitive to deteriorating economic conditions to fall more sharply. Growth equity backed companies typically have less secure cash flows, which is a concern for investors that are becoming more risk adverse – and as a result less prepared to pay higher multiples for these assets. North American growth funds generated annualized returns of 17.4% for the 2015 to 2021 period but we expect that to drop to 12.8% for the forecast period. This is primarily because private equity growth returns are more sensitive to lower expectations for economic growth.

While the North American private equity market remains the most advanced in the world, private equity AUM still accounts for a mere 7.4% of total public and private equity in the region. Assuming that public equity markets maintain their historic growth rate of 9.4% per year, our forecasts suggest that this share will increase to 7.7% by 2027 – still a comparatively modest figure, which highlights the headroom still available for the market.

In spite of the current macroeconomic challenges, we forecast overall North American private equity AUM to grow at a CAGR of 13.5% from the end of 2021 to the end of 2027 (Fig. 1.6). This represents a modest slowdown from 16.2%, compared with the 2015–2021 period.

Geopolitics pose continued risk to the outlook for Europe

The war in Ukraine has had a significant impact on risk assets across the continent. It has left investors grappling with considerable uncertainty and prompted them to demand higher risk premiums across financial markets. On top of this, the restriction of Russian natural gas flows into Europe poses significant risks for European industry and households. These factors are expected to weigh on performance, as our forecast shows annualized private equity returns in Europe declining to 14.4% for the forecast period, from 17.3% between 2018 and 2021 (Fig. 1.6).
Risks have also emerged in the sovereign debt market. Italian 10-year bond yields have risen by 380bps to 4% since the start of 2022, reminding us of the fragilities of the euro currency project. Any major escalation of pressures could have implications for credit markets across the region and strain financing conditions for buyout transactions. While the ECB appears poised to act if Italian yields increase too much in relation to German bund yields, its ability to implement easier monetary policy conditions will be constricted by the increasing FED funds rate, which is helping the dollar index move considerably higher. In 2022 the euro has depreciated to reach parity with the dollar, which contrasts with 1.18 a year ago.

The strengthening dollar is also likely to prompt an increase in acquisitions of European companies by US-backed private equity sponsors. This is an existing trend that we expect current market conditions to accelerate. European public market equities currently trade at 11.4x forward earnings compared with 17.3x for the US market, which may also prompt more public-to-private transactions.

Macro factors to weigh heaviest on APAC private equity performance

We estimate that APAC private equity funds will return a net IRR of 11.6% over the six-year period from 2021 to 2027, which implies underperformance against global private equity. In addition to the macroeconomic factors discussed above, idiosyncratic factors in the Chinese market are expected to contribute to the diminished outlook for returns. China’s record trade surplus highlights weak domestic consumption under still relatively strict COVID-19 policies, and recent news such as the surprise rate-cut and a rumored, unprecedented bailout of the property sector by the government points to the urgency of an economic slowdown that may be more widespread than expected.

APAC private equity AUM, excluding RMB-denominated funds, stood at $554bn at the end of 2021 (Fig. 1.5). Our most prominent concern is a deterioration in the exit environment for the region. Against the backdrop of a global risk-off market sentiment, public equity markets in the region have underperformed global peers. As a result, we expect the translation of private markets asset pricing to be more marked in the region as well. This particularly as deal valuations here had often priced in higher growth premiums that are now increasingly being challenged. Information technology, which made up the largest proportion of deals in APAC over the last five years, with many of these deals in China, fell out of favor with investors in public markets. The MSCI China Tech 100[4] one-year return was -33.1%, compared with the MSCI World Information Technology[5] which declined by -20.2% in the same period.

A less favorable exit environment, as seen in the dampened exit activity, would mean that investors may either have to accept lower exits or extend their investment horizon, both of which reduces time-weighted performance returns. Within APAC private equity, we expect slightly better performance in growth funds, which are estimated to return 12.6% over 2021-2027, compared with buyout funds which are estimated to return 11.2% in the same period (Fig. 1.7). We expect this because the near-term exit environment is less favourable to buyouts, which are typically larger in size, and that the use of leverage under higher interest rates increases the cost of this strategy.

APAC-focused fundraising to see a gradual pick-up after the 2022 decline

While we expect fundraising in APAC private equity to end 2022 with a year-over-year decline of 27%, we believe that underlying demand will support a gradual pick-up, with fundraising recovering 2021 levels by the end of 2027, or at a CAGR of -0.3%. Over the long term we expect the fundamental growth potential of several large, under-served markets to maintain strong appeal to long-term investors. Despite some aversion toward the China market in the interim, investors’ increasing interest in India and Southeast Asia, according to our latest investor survey, should continue to attract funds into APAC-focused private equity. India, for example, has not shown signs of a slowdown in private equity deals or IPO activities.[6] Deals are also diversified across sectors, indicating wide-ranging opportunities in this third largest economy in APAC by GDP.

In an exceptional year, $62bn in net capital distribution was returned to APAC private equity investors in 2021 after five years of being in a net investment phase. In future we expect this trend to diverge between buyout and growth strategies. Our base-case assumption is that growth funds will revert to calling more capital than they distribute, as better investment opportunities present themselves in the region and support an appetite for calls. Growth funds currently have relatively less dry powder as a proportion of AUM, compared with buyout funds, which have a larger percentage of undeployed capital. We expect fundraising for buyout funds to pick up more slowly, with the prevailing risk-off sentiment in the near term generating less demand for large, leveraged investments, as is characteristic of buyouts. At the current fundraising forecast level, we expect the growth in dry powder to slow, from 14.7% between 2015 and 2021 to 5.1% CAGR over 2022-2027. Dry powder in APAC private equity as of December 2021 represented 24% of total AUM, and we expect this to deplete slightly as more funds dip into this reserve in the near term.

Increasing wealth in APAC also underpins the demand for alternatives assets in the region. Besides fundraising from institutional investors, we see some potential for retail distribution, primarily through private banks to high-net-worth individuals, to become an increasingly important fundraising channel. As an example, according to HSBC[7], which has recently started distributing hedge funds to private banking clients in China, its private client commitments in alternative investments globally increased by 40% year-over-year in 2021, to $3.2bn, of which $1.9bn came from Asia. While this does not currently seem a significant part of the total (less than 6% of total AUM from the same disclosure), if it indicates the momentum of growth in this segment, retail distribution should be worth considering as an up-and-coming source of funds. One of the drivers is the expectation that the population of high-net-worth and ultra-high-net-worth individuals is projected to grow faster in APAC than in any other region.[8]

Overall, our forecast for APAC private equity is more conservative than in other regions, but this could change as the dynamics in the region evolve. For example, if swift government policies in China facilitate a soft landing for the property sector, together with effective post-COVID-19 stimulus, this might warrant more positive assumptions, as would a strong rebound in public markets. On the other hand, a sudden and severe deterioration in the China economy would pose further downside risk to our forecast.

Overall our forecasts suggest that the sweet spot that private equity markets have enjoyed over the last few years is likely over. Our model suggests a clear slowdown in activity across the board, while mounting macroeconomic concerns suggest potential additional downside risk.