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Hi everyone, thanks for listening and welcome to this edition of the PE Pulse podcast, where we’ll break down all the important trends and themes in the PE space and fill you in on what you need to know about today’s market. My name’s Pete Witte, and I’m part of EY private equity group. And over the next seven to eight minutes we’re going to unpack some of the major dynamics in the space.

And we have got a lot to talk about. The environment has changed pretty dramatically since the last time we did this back in March – inflation in the US and Europe has spiked to about 8-8.5%; we expected that interest rates would move higher, and now they have – the Fed bumping rates 75 basis points in June, the highest increase since the mid-90s; and global markets heading into widespread corrections, and in some cases – the US notably, actually moving into bear market territory.

So let’s start with a view of where we are, and then we’ll move into some thoughts around where we’re headed.

Where we are

And if you look at where we are now – in a nutshell, it’s this – we’ve seen some measure of deceleration from last year’s pace, but for now, activity is still above pre-pandemic averages. In the first half of this year, PE firms announced deals valued at US$486b, and that’s down about 18% from the first half of last year. But remember – last year was a record year for PE deals, and it wasn’t even close. About US$1.2t in deals announced over the course of the year. So we’re coming off a very high base when we make these comparisons.

So that’s based on value. When we look at volume of activity - the number of significant deals – that is, deals valued at $100m or more – pre-pandemic, we were looking at about 40 of those deals a month. Last year, we’d see about 70 significant deals in a typical month. And right now, we’re about 50. So again, the theme here is deceleration from last year’s highs, but above where we were pre-pandemic. That’s the best way to describe the market right now.

I just got back from SuperReturn a couple of weeks ago – SuperReturn is the largest PE-focused event in the world, every year it’s held in Berlin and this year it pulled together around 4,000 PE professionals from around the world. And obviously, the volatility in the macro situation was on everyone’s mind. What does it mean to deploy capital in this world of rising interest rates, slowing growth, geopolitical instability and market volatility?

And I think we’re seeing investors strike a more cautious tone – folks are underwiring a recession later this year or early next into their base case underwriting scenarios, where that wasn’t really the case back in March. Which makes sense – that’s essentially the consensus or significant minority view at this point.

What was more interesting though, was the optimism that we heard. Historically, volatility has created opportunity for PE firms; and I think across asset classes, investors are looking for those opportunities to acquire high quality assets at better pricing than they could get six months ago. And in particular, they’re looking for assets with characteristics that – will let them perform well through the downturn – long-term contracts and high barriers to entry, for example – and avoiding anything that looks or acts like a fixed rate bond.  

From a fundraising perspective, we’ve seen declines of a similar magnitude – down about 15% in the first half of this year versus last. And a lot of that has really been driven by large scale buyout funds – much more so than the growth equity, for example, and other private equity types that we saw over the course of last year.

Where we’re headed

So that’s sort of the overview of where we are – now let’s talk about the piece that really matters, which is where we’re headed.

I think we should expect to see dealmaking challenged over the short term just because of the widening expectations gap between sellers who want the price from three months ago or six months ago, and buyers who want todays price. It’s a temporary imbalance that typically occurs in periods of excess volatility – like we’re seeing now - that will resolve in time.

I think it’s possible that we’ll see rising interest rates initiate a shift from investment strategies predicated on a “growth-at-all-costs” orientation toward a value orientation. Valuations have risen monotonically in recent years, they topped out at about 11.5x last year, and a lot of deals – especially in the tech space and with growth equity deals - trading much higher. If valuations fall, that’ll allow firms to stay active despite higher costs of capital; and in some cases, we could see value players that have been sidelined by some of these high valuations re-engage with the market.

What it’s also likely to do is elevate the role of operational value add – you think about the levers that PE firms have to pull – leverage is getting more expensive, we’re entering a contractionary environment for multiples, and so it’s value creation – all the roll-up-your-sleeves type work of supply chain management, pricing optimization, digital transformation, working capital, and so on – that’s going to be the primary driver of returns. As one of the panelists at SuperReturn put it - “Everyone has been levering as much beta as they could find; we are now going back to the roots of value creation.” But I think the good news is that the ecosystem is better prepared for this than at any other time in its history – firms have made the investments, they’ve built out these operating capabilities, and they have the right resources to respond.

I think it’s also worth noting that we could see a short-term pullback in fundraising – I mentioned a 15% so far this year – I would be surprised if that decline grew larger over the balance of the year. You think about the velocity of fundraising – it’s really increased dramatically – 10 years ago, maybe you raised a flagship funds every 5-6 years; 5 years ago it was every 2-3; now, it’s every 1.5-2 years. There’s LPs out there that are feeling tapped out, and the denominator effect (which is where your public market holdings fall faster and steeper than your private market holdings, making you suddenly oversubscribed to PE ) are only going to compound this.

That said, the practical impact of this is pretty de minimus though – PE firms still have US$1.2t in dry powder, so they’re not going to be capital constrained. LPs are committed to the asset class and are not market timers – they’re going to continue to do their best to invest at a steady pace.

And then on the exits side, we’ve seen a pretty steep fall in exit activity this year, at least through traditional routes. Overall, exits are down 35% year over year – and that’s really because 2 of the routes that were on fire last year – sales to SPACs and IPOs – are basically closed off – down 94% and 93% respectively. What’s interesting though, is the development of the PE secondary market (trading of LP interests, distinct from secondary exits). That market has grown tremendously in recent years – going from maybe 5-10b in deals every year, to more than $100b over the last couple of years. There have been massive secondary funds that have been raised, and other new entrants into that market. And in recent weeks we’ve seen some pretty significant secondary deals announced. So that’s going to be a really interesting dynamic given the market conditions we’re seeing.

The other interesting dynamic is private debt – remember, most private debt is floating rate, and there’s a sense that – even with all of the growth that we’ve seen over the last decade – that this is really the asset class’s time to shine. Over the last several years, we’ve seen more and more of the syndicated markets shift over to the private side, and with the volatility in the leveraged loan and high yield markets, this shift has been particularly pronounced. So it’s going to be a very interesting 6-12 months in this market.

So to wrap it up - market volatility, inflationary pressures, and rising interest rates certainly make the landscape a lot different than it was six months ago. That said, we think that firms will stay active despite the increased uncertainty. That’s exactly what we saw during the pandemic, when PE firms were among the first to return to dealmaking – initially with pandemic-friendly themes like credit and PIPEs (Private Investment in Public Equities), and later on, placing bets on post-pandemic winners, particularly in the tech space. And LPs are well aware that so many of the best deals are made in the most challenging of markets. So certainly a challenging period, but also one with a lot of opportunity.

That’s it for today – thanks for listening. I’ll see you next quarter!

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