Private Equity and Market Volatility

Keeping calm in the face of disruption

After weeks of historic levels of value erosion in global capital markets, many an asset manager is considering the changing investment landscape and trying to mitigate emerging risks whilst finding new opportunities. Economic experts anticipate more volatile capital market shocks for the rest of the year. Private equity, as one of the main alternative investment classes, finds itself in an interesting position in the face of such market volatility.

As an alternative asset class, private equity funds commit to a higher return profile than the open markets in the medium to long term. Private equity funds are also characterised by a 10-year tenure, which contemplates that fund managers shall sit tight in the face of market volatility and not rush to make short-term decisions. These are redeeming qualities that are likely to give asset managers a better level of comfort in times of uncertainty.

Value creation and risk management

However, the extent to which private equity can attract additional capital may be restricted by regulatory prescripts governing the asset classes that asset managers are permitted to invest in. Further, the private equity market is not immune to the impact of economic uncertainty. The portfolio companies that generate the underlying value that fund managers are expected to deliver to investors, also face the inflationary impact of increased importation costs. Depending on the price elasticity of the goods or services that a portfolio company provides, this may have a significant impact on the sales of that underlying business. Where supply chains have been disrupted in their entirety, the portfolio company will need to seek alternative supply sources. In a world of ever-growing exclusion lists due to an investment ethos based on sustainability, sourcing alternative supply chains is not always a straightforward exercise. The skills that reside within the post-implementation support team of a private equity fund will be essential in assisting portfolio companies with these market changes. Fund managers who have not seriously invested in developing internal geopolitical analysis capabilities or retaining external advisors for this purpose should review their approach to this facet of their business.

There are many features of fund management documents that are aimed at putting private equity funds in a better position to weather the storm. Fund documents usually provide for geographic and sector diversification. An investment mandate will also guard against concentration risk that arises when a fund invests a significant portion of its funds under management in a single company. However, some of these protections may not be available to specialist funds that like data centre funds, which depend on sector concentration to build and leverage scale. These specialist funds will rely on their skills base and an ability to leverage existing and alternative supply chains to weather the storm. One would also expect to see private equity funds explore opportunities that enable the creation or control of vertically integrated supply chains that will give them better visibility and control of cost inputs (other than the tariffs).

Economists predict that increased tariffs will have a general inflationary impact on the market. Apart from the rising costs of goods that portfolio companies may need, inflation may also lead to increased borrowing costs. When debt is more expensive, private equity funds that ordinarily use leveraged buyout strategies may be limited to smaller cheque sizes. This may lead to private equity funds seeking more co-investments, acquiring smaller businesses and then expanding them through bolt-in acquisitions and relying on deferred consideration structures (such as earn-outs) more regularly.

Exits and opportunities

From an exit perspective, market volatility can affect the ability of private equity funds to exit investments by way of a public offering. One expects to see some funds deferring the timing of public offerings until market conditions are more favourable. Fund managers may also choose to run private auction processes that involve other funds or trade buyers instead of waiting for market conditions to improve.

On the flip side, depressed capital markets do provide opportunistic investors with the ability to implement take-private transactions. However, this option will only be available to funds that have significant cash resources or co-investors that will enable them to make attractive offers to listed targets. For this reason, some private equity funds may wish to pace the deployment of their funds under management as they assess emerging opportunities. This will ensure that they have sufficient resources to take advantage of a change in market conditions. Foreign investors in emerging markets may seek to exit emerging markets in times of uncertainty. This may create new opportunities for private equity funds to acquire local divisions of well-established international brands that have decent growth profiles.

Conclusion

Notwithstanding the current economic headwinds, fund managers will continue to find great opportunities in sectors that have great scaling prospects, such as digital infrastructure, consumer goods, manufacturing and financial services, to name a few. Fund managers need to continue focusing on value creation and the risk management levers at their disposal to respond to market changes. However, the medium to long-term focus of private equity makes it the perfect asset class in a world faced with increasing volatility.