David Schäfer is co-founder and managing director at Munich Private Equity Partners

Private equity in multi-crisis times: Which strategies are in demand now

Corona aftermath, energy crisis, supply chain bottlenecks, inflation, interest rate turnaround: The multiple challenges that have caused volatility in the public capital markets since 2022 have not left the private equity asset class unscathed. David Schäfer of Munich Private Equity Partners explains what is important when selecting funds in the current market situation.

Economic crises are not a new phenomenon. At least since the financial crisis of 2008, they even seem to have become a kind of permanent condition in Europe. Some crises announced themselves insidiously like the debt and currency crisis from 2010, others came suddenly like the Brexit crisis, triggered by the referendum of the British in 2016, or the Corona crisis from 2020. In the midst of all these economic challenges, private equity has established itself as a reliable asset class among institutional investors, which has not only delivered consistently high returns, but thanks to the long-term investment horizon and the periodic valuation of assets has also proven itself as an anchor of stability in portfolios, especially in times of crisis.

The years 2014 to 2019 were the most successful in the history of the private equity industry. According to the Global Private Equity Report by management consultants Bain & Company, almost USD 3.2 trillion flowed into buyout transactions during this period. Even the outbreak of the Covid 19 pandemic in spring 2020 was only able to slow down this positive momentum for a short time. In 2021, the private equity industry once again raised more capital than ever before, at USD 1.2 trillion.

Drastic change in sentiment and declining capital commitments

But the year 2022 brought a rupture for the financial markets that affects all asset classes and also brings some changes for private equity. Since then, investors have been confronted with several simultaneous challenges that add up and reinforce each other. The current “multi-crisis” began in February 2022 with Russia’s invasion of Ukraine. The war turned energy markets upside down, fueling inflation and forcing central banks to raise key interest rates sharply for the first time in more than a decade – to a current 4.59 percent in the U.S. and 2.5 percent in Europe.

On the public capital markets, the mix of energy crisis, inflation, supply shortages and interest rate turnaround triggered a drastic change in sentiment and led to sharp corrections, particularly in equities. Although the valuations of private equity funds again remained largely stable, capital commitments declined significantly for the first time in years. According to data from analyst firm Preqin, investors put an estimated 21.5 percent less capital into private equity funds in 2022 than in the previous year.

According to our observations, this development can be attributed to two main factors:

1. Denominator effect

Many institutional investors – above all insurance companies and pension funds – have allocation guidelines with which they must comply. For example, the private equity share in the overall portfolio must not exceed certain thresholds. If the value of a portfolio falls as a result of heavy losses in individual, more volatile asset classes such as equities, these investors can no longer easily increase their formally “increased” private equity allocation. Last year, this denominator effect led to many private equity holdings rising above these permissible thresholds. As a result, many investors were forced to limit or even rationalize their exposure to private equity.

2. Fewer returns

Comparatively few exits took place last year. As a result, the return flows from private equity funds to their limited partners were also lower than in previous years, and there was a corresponding lack of capital for new investments in the asset class. The multi-crisis environment favored this development in three ways:

First, volatile equity markets led many companies to hold back on IPOs. The number of initial public offerings (IPOs) fell by almost 45 percent last year, according to data from management consultants EY. Especially for private equity funds from the large- and mega-cap segment, where IPOs are a frequent exit channel, holding periods have lengthened as a result. Second, the turnaround in interest rates has made financing conditions more difficult for funds, making acquisitions more difficult. And third, the complex macro environment meant that many deals were not completed because the price expectations of buyers and sellers were too far apart due to the many open variables.

Which segments are attractive now?

According to a survey of 441 institutional investors worldwide by financial services firm Natixis, about 43 percent plan to increase their private equity allocation this year. The asset class is therefore still in demand as a stabilizing building block in portfolios, but the multi-crisis environment has temporarily reduced the scope for private equity investment. As a result, investors have had to examine potential and existing investments far more carefully than before to determine whether they justify the limited space in their portfolios.

In the search for attractive niches, it is worth taking a differentiated look at the various segments of the market. Investors can expect more stable returns in the so-called lower mid-market segment, i.e. in private equity funds that specialize in small and medium-sized companies. They are hardly affected by the shrunken IPO market, as IPOs tend to play a subordinate role as an exit channel. In addition, the entry multiples are generally lower, which allows the participating managers a more solid financing structure with lower debt ratios. They therefore tend to be less affected by the interest rate turnaround than funds in the large and mega cap segment, which generally work more with leverage and in some cases also rely on more debt capital due to higher valuations. Here, (re-)financing problems could arise if the central banks maintain their restrictive course.

As a rule, investments in hidden champions, i.e. medium-sized companies with strong unique selling propositions that are among the leading providers in their niche, prove to be particularly resilient in periods of economic weakness. Many of these companies offer key technologies and services for which there are no or only a few substitutes. As a result, they develop comparatively independently of the overall economic situation.

Access and diversification

SMEs are also more agile than large corporations and find it easier to adapt to new situations. This is especially true when they are supported by experienced private equity managers. Teams with a proven track record of strong performance over several fund generations and business cycles usually know exactly what decisions need to be made in a crisis to keep companies on a sustainable growth path. Their in-depth sector and industry expertise also tends to make it easier for them to develop business models detached from the prevailing macro environment and to leverage potential across all market phases.

A crisis-proof private equity portfolio is characterized on the one hand by the selection of these top tier managers, and on the other hand by a well-thought-out diversification across different investment regions, strategies and vintage years. Especially investors with only a small or medium private equity allocation face challenges: Building a diversified fund portfolio on one’s own is costly and capital-intensive. In order to identify the best funds in the respective segment, these investors often lack resources and expertise. Many fund managers also require minimum commitments of millions of dollars from their limited partners, which requires a sufficiently high private equity allocation for the entire program.

In addition, selecting the right private equity funds is only half the battle; access is also crucial. Management teams with proven expertise in navigating cyclical and structural dislocations are in extremely high demand and continue to complete their fundraising in record time and heavily oversubscribed. Given the increasingly complex macro environment, demand is likely to be even more concentrated on this small group of top performers. For small and mid-sized houses or those with limited internal resources, private equity funds of funds therefore offer an indirect access route. With a single subscription, they already provide access to a broadly diversified fund portfolio.

Twofold stability in crises

From a strategic perspective, it may make sense for investors to invest in the asset class now. The multiple challenges tend to lead to lower valuations, so private equity funds can buy into companies comparatively cheaply. Crises also always open up opportunities to expand into new markets or consolidate existing ones by acting with foresight. In addition to in-depth sector and industry expertise, sufficient liquidity is an important prerequisite for this.

During the financial crisis of 2008/2009, it was easy to see what effect cooperation between financial investors and companies can have. At that time, private equity-financed companies performed significantly better than the control group, as a joint study by Universities of Stanford, Harvard and Northwestern shows. According to the study, private equity funds were able to use their capital resources to offer equity financing to portfolio companies outside the credit markets. Thanks to their excellent banking relationships, they were also able to raise more debt capital. As a result, private equity-financed companies had around six percent more capital available for investment and recovered from the crisis not only faster but also more sustainably. They thus acted as a double stability factor – for economies per se and for investors’ portfolios.

About the author

David Schäfer is co-founder and managing director at Munich Private Equity Partners, or MPEP. The company offers private equity funds of funds with a focus on mid-cap buyouts in Europe and North America. He is responsible for portfolio management and a member of the investment committee. Previously, he worked at various subsidiaries of MPEP’s parent company. Schäfer holds a degree in business administration and sits on various advisory boards of private equity funds.