Topic Tags: Private Equity

3Q 2024 Market Insights

This video is a recording of a live webinar held October 23 by Marquette’s research team analyzing the third quarter of 2024 across the economy and various asset classes and themes we’ll be monitoring over the remainder of the year.

Our quarterly Market Insights series examines the primary asset classes we cover for clients including the U.S. economy, fixed income, U.S. and non-U.S. equities, hedge funds, real assets, and private markets, with commentary by our research analysts and directors.

Sign up for research alerts to be invited to future webinars and notified when we publish new videos.

If you have any questions, please send our team an email.

Can Interest Rate Cuts Revive Private Equity?

It has been well documented that private equity has been experiencing pressures over the past two years, marked by declines in both deal activity and recent performance relative to the strong returns generated in prior years. Since the asset class is heavily reliant on leverage to fund deals, the private equity landscape has been impacted by the historic rise in interest rates that has made debt more expensive over the last several quarters. That said, the Federal Reserve has now shifted its policy stance with inflation seemingly contained, and several rate cuts are expected to occur in the near term. But will lower rates drive a rebound in private equity activity?

While a recovery in activity likely won’t occur overnight, private equity firms seem to be preparing for a significant increase in deal making on the horizon. Due to the high financing costs associated with higher interest rates, recent years have seen a shift away from debt-laden leveraged buyouts (LBOs) and towards growth and expansion deals, as those transactions typically require minimal leverage. Over most of the last 15 years, LBOs consistently accounted for a larger share of U.S. private equity deals relative to growth and expansion transactions, but this dynamic reversed in 2023. We do not expect recent trends to continue in perpetuity since lower borrowing costs should usher in a new wave of LBO activity. More broadly, M&A activity appears to be showing signs of turning a corner. To that point, in the first half of this year, North American M&A activity advanced by roughly 13% on a year-over-year basis in terms of both deal count and value (including estimates for unreported deals).

In short, recent shifts in monetary policy may provide tailwinds for the private equity sector. In addition to lower borrowing costs that will likely underpin future deal activity, rate cuts also benefit existing portfolio companies by easing the debt service burdens on their balance sheets. This offers companies the flexibility to pursue new acquisitions, initiate organic growth initiatives, and, ultimately, drive potential returns higher for investors. As always, we continue to closely monitor the emerging trends and their implications for the performance of the private equity asset class.

The Magnificent Five of Private Equity

In investment management, asset allocators and their advisors frequently revisit the concept of portfolio diversification — whether by geography, market capitalization, security, or industry. While Marquette advocates for a diversified portfolio within private markets, it is important to recognize that not all diversification strategies are equally effective. Certain industry characteristics make specific sectors more attractive for private investments, particularly those that exhibit sustainable growth driven by favorable demographic or secular trends, fragmentation, capital constraints, and market inefficiencies. These features are often advantageous in private markets as they create opportunities for value enhancement and potential alpha generation.

Within the private equity asset class, five core sectors — what we refer to as the “magnificent five” — have consistently dominated merger and acquisition activity over the past six years. These sectors are healthcare, technology, industrials, business services, and financial services. According to Dealogic, over 60% of deals across 13 tracked industries have been concentrated within these five sectors, as measured by transaction count. Moreover, these industries have outperformed relative to top-quartile multiple on invested capital (MOIC). It is therefore logical that private equity managers would focus their capital in areas with higher probabilities of outsized returns, which in turn shapes the composition of investor portfolios. It is also important to note that this concentration also intensifies competition for deals within these sectors.

A critical point to consider is the dispersion of returns between top and bottom quartiles across industries — the wider the dispersion, the greater the risk. It is no surprise that the highest-performing industries, healthcare and technology, are often heavily represented in private equity portfolios. In this competitive and risk-laden environment, particularly within the private equity asset class, manager selection becomes increasingly crucial for investors seeking to achieve superior outcomes.

2024 Halftime Market Insights

This video is a recording of a live webinar held July 23 by Marquette’s research team analyzing the first half of 2024 across the economy and various asset classes and themes we’ll be monitoring over the remainder of the year.

Our quarterly Market Insights series examines the primary asset classes we cover for clients including the U.S. economy, fixed income, U.S. and non-U.S. equities, hedge funds, real assets, and private markets, with commentary by our research analysts and directors.

Sign up for research alerts to be invited to future webinars and notified when we publish new videos.

If you have any questions, please send our team an email.

Credit Check

Interest in private credit has grown considerably in recent years and the asset class has moved from a relatively small or non-existent allocation in institutional portfolios to a multi-trillion dollar market accessed by a wide variety of investors. Demand for private credit remains high, but the rapid growth of this space has sparked debates about potential bubbles and whether underwriting standards have diminished given intense competition among lenders. However, recent survey results indicate that underwriting standards may actually be more conservative today than in prior years, highlighting increased caution with regard to both borrower leverage and required levels of equity within borrower capital structures.

Based on a survey conducted by Proskauer capturing responses from 178 senior-level private credit executives, lenders have reduced the maximum level of leverage they are willing to underwrite in private credit deals in recent years. In 2021, more than 68% of lenders to U.S. corporate borrowers were willing to underwrite deals with more than 6.0x leverage, as measured by borrower debt-to-EBITDA. That figure increased to over 82% of U.S. lenders in 2022 but has since fallen sharply, with now just 45% of lenders willing to underwrite highly leveraged deals. Today, more than 55% of private credit lenders cap deal-level leverage at 6.0x, indicating a shift towards more cautious standards in the current interest rate environment. At the same time, borrowers are now requiring more subordinated equity exposure in the deals they underwrite. Deal equity, often provided by private equity sponsors, represents the amount of equity subordination in a borrower’s capital structure and offers a degree of downside protection for the lender if stress arises for the borrower. In 2021 and 2022, those lenders requiring less than 35% equity in deals represented 18% and 22% of Proskauer survey respondents, respectively. However, the proportion of lenders willing to lend with less than 35% deal equity fell to 13% in 2023 and currently sits at approximately 12%. Conversely, lenders requiring at least 45% equity in deals increased from 25% to 55% over the last three years, again highlighting the trend towards more conservative deal structures.

In summary, given elevated interest rates, lenders are prudently reducing the amount of leverage they are willing to support for corporate borrowers and are also requiring more deal equity. These efforts are largely aimed at enhanced downside protection and reflect increased caution among lenders in response to broader economic conditions. At the asset class level, private credit remains an attractive opportunity set for investors, offering attractive yields, portfolio diversification, and downside protection.

The Growing Popularity of Continuation Funds

Historically, the private equity secondary market has been used by limited partners (“LPs”) to sell exposures at the end of their lives and as such contained only tail-end exposures. Selling these lingering exposures to private equity funds allowed LPs to clean up their balance sheets and fueled the growth of secondary private equity funds within the broader private equity space. As the market evolved, however, higher-quality assets began transacting as investors started to use secondary markets as a useful portfolio management tool. More recently, general partners (“GPs”) have come to occupy an increasing percentage of the overall market. In 2023, about $110 billion in volume traded in private equity secondaries, with about 50% of the total transaction activity represented by GP-led transactions.

In this newsletter, we provide an overview of continuation funds, including their growth, structure, transaction requirements, and considerations for investors.

1Q 2024 Market Insights Video

This video is a recording of a live webinar held April 25 by Marquette’s research team analyzing the first quarter of 2024 across the economy and various asset classes and themes we’ll be monitoring in the coming months.

Our quarterly Market Insights series examines the primary asset classes we cover for clients including the U.S. economy, fixed income, U.S. and non-U.S. equities, hedge funds, real assets, and private markets, with commentary by our research analysts and directors.

Sign up for research alerts to be invited to future webinars and notified when we publish new videos. If you have any questions, please send us an email.

Another (Down) Round

Venture-backed companies tend to be nascent and typically deploy investment capital in an effort to drive revenue expansion, often to a point at which they are losing money. Given this profile, these businesses must raise new capital every few years to fund future growth. In normal circumstances, each capital raise is conducted at a higher valuation, assuming the company remains financially viable. That said, there are occasionally instances in which the market’s perception of valuation has materially changed or the company is not achieving specific growth targets. Cases like these, which are referred to as down rounds, result in companies being forced to raise capital at lower valuations than the ones exhibited during the most recent fundraising period.

Many venture-backed companies raised capital in 2020 and 2021 at relatively high valuations. Since that time, a significant portion of those companies have seen cash levels depleted and are now returning to the market in order to fund operations for the next few years. However, today’s market environment looks quite different from those of 2020 and 2021, which means these companies are being confronted with much lower valuations as they attempt to raise capital. As displayed in this week’s chart, these dynamics have led to a steady increase in the number of down rounds over the last several quarters. To that point, down rounds (as a percentage of all fundraising rounds) hit a new high of nearly 27% in the third quarter, which is more than double the long-term average.

The trends depicted in the chart above are likely to lead to some disappointing returns for venture capital funds with vintages from 2018 through 2021, as these funds deployed significant amounts of capital during those years and now face a more challenged valuation landscape. On the bright side, these dynamics may present an opportunity for funds with more recent vintages and fresh capital to invest at more attractive valuation levels. Marquette will continue to monitor developments within the venture capital space and provide recommendations to clients related to existing exposures and future commitments.

2024 Market Preview Video

This video is a recording of a live webinar held January 25 by Marquette’s research team analyzing 2023 across the economy and various asset classes as well as what trends and themes we’ll be monitoring in the year ahead.

Our quarterly Market Insights series examines the primary asset classes we cover for clients including the U.S. economy, fixed income, U.S. and non-U.S. equities, hedge funds, real assets, and private markets, with commentary by our research analysts and directors.

Sign up for research alerts to be invited to future webinars and notified when we publish new videos. If you have any questions, please send us an email.

2024 Market Preview: A 40 Degree Day

A former colleague once described his brother-in-law to me as a “40 degree day.” The puzzled look on my face revealed my unfamiliarity with the term, so he went on to ask me: “When does anyone get upset about a 40 degree day?” I laughed and shook my head — it was genius, the perfect way to describe something more forgettable than memorable…not especially good or bad, just average.

Given what markets have been through over the last four years — COVID, outsized returns both good and bad, record inflation, sky-rocketing interest rates, geopolitical conflict, and elevated volatility — I know I’m not alone in hoping that 2024 market returns will resemble a 40 degree day. Indeed, an “average” year of returns across markets will equate to positive portfolio performance for most asset allocations and allow investors to satisfy their risk and return goals.

Of course, there are potential stumbling blocks to a “normal” year. In particular, we will closely watch the Fed pivot and the disparity between expected and actual rate cuts, geopolitical conflicts, and the U.S. presidential election.

With that as background, we offer our annual outlook across asset classes, highlighting trends and themes for the year ahead. Happy reading and here’s to a year of normalcy!