Average returns across private equity have come off their 2021 peak. Fund managers say portfolios remain resilient and, in a recession, the asset class can still outperform…
Private equity benchmark returns have begun a descent from their post-pandemic high.
Average global returns for Q3 2021 fell to 6.8% from almost 15% in Q1, the strategy’s lowest quarterly IRR since the pandemic rocked public markets in Q1 2020, according to Pitchbook, which shows a further decline to 3.42% in Q4 based on preliminary data.
“A tighter policy environment is putting downward pressure on risk assets and causing returns to normalise after several standout quarters driven by ultra-loose fiscal and monetary policies,” it said.
According to qualitative research by Private Equity Wire during June, the decline has continued into the first half of 2022.
Asked whether they are seeing an increase, decrease or the same performance in returns across their most active buy-out strategies, only 20% of respondents to a survey of more than 50 industry stakeholders reported an increase during H1 – with the majority seeing flat or downward numbers.
Almost half of respondents expect a decrease in returns for their buy-out strategies in the second half of 2022.
“There’s absolutely no doubt that asset classes are being impacted [by a slower dealmaking environment and an adjustment in valuations] and it’s going to continue like this,” says Jean-Baptiste Wautier, partner and chief investment officer at BC Partners. “There will be a bit of a mourning period, risk will reprice and then things will start back up again but this is exactly where we are right now.”
The Private Equity Wire survey found that the majority of respondents (51%) believe data from North America will show the strongest fund performance by year-end 2022, with Europe (26%) only slightly above Asia (23%).
Europe has its own unique set of challenges and has been more exposed to issues relating to the war in Ukraine, says Simon Finn, managing partner at Intriva Capital. “But I’d like to just hold breath on the impact until we get to Q4 2022 because I think by then you will start to see everything wash through. At the moment there’s more downside than upside, but we see opportunities and remain acquisitive.”
Even for managers seeing no impact on their 2022 Q1 or Q2 numbers, there is a growing sense of caution around several pronounced macroeconomic risks: from inflation and interest rate hikes to war in Europe and public market volatility.
“Private equity has been an enduring and growth asset class and continues to outpace over time, by and large, the public markets,” says Hythem El-Nazer, managing director at US-based private equity firm TA Associates. “However, I think there’s likely to be a real reckoning of private equity firms. Not everybody is created equal, and with a more challenging market backdrop, firms will need to generate differentiated value in order to sustain top quartile returns.”
Following a risk assessment earlier this year, France-based fund manager Ardian found inflation to have a net zero effect on its portfolio but considers a potential European energy crisis after the summer to be a “big unknown”, says Oliver Personnaz, head of Ardian Buyout UK and managing director at Ardian.
Others are more sanguine. “We think that the overall benchmark coming down could be a good thing, because we feel really good about the portfolio we have and the potential performance of that portfolio of assets. And so, the sort of eye-popping IRRs generated in 2021 by many of the tech focus funds will come down to a more normalised level, and I think that will be a good thing for us as a firm,” says Davis Noell, senior managing director and co-head of North America, Providence Equity Partners.
Fund managers also agree that private equity investments with a three- to seven-year horizon are typically stress-tested under a recession scenario and although a public market correction does influence private market valuations, it is not a direct correlation.
“There’s really no tactical change we have made because a recession shouldn’t be a surprise to anyone,” says Nils Rode, chief investment officer at Schroders Capital. “Private equity should be more resilient than the public markets [and] I believe we will benefit from the strategy bias and the sector bias that we have in our global diversification. We are sleeping well.”
Multiples flatten
Recent increases in sponsor returns have come from the expansion in valuation multiples, but a rising interest rate environment is likely causing multiples to flatten and returns to reduce.
In the latest benchmark figures, returns have dropped across all fund size buckets and regions, but with greater resilience coming out of Europe and for funds sized under $500 million. Mega-funds ($5.0 billion or larger) continued to drive returns in the year through Q3 2021, buoyed by a healthy exit market for larger assets from cash-rich corporates, according to Pitchbook. But the exit environment in 2022 has shifted drastically (see Chapter 3).
“We expect to see in the benchmarks that small should be doing better than large and early-stage growth should be doing better than late,” says Rode, adding that larger fund managers can be more exposed to corrections than smaller managers, due to the amount of leverage in their portfolios and their entry valuations which can be elevated.
While the dispersal of returns within the asset class has widened over time, the growth of specialist managers may make recent high performers, for example in the technology sector, more vulnerable to concentration risk when valuations shift downward. Venture capital – which is heavily weighted towards growth-orientated tech start-ups – is facing a cyclical reset in 2022, following years of rising and largely unrealised valuation growth.
However, to put things in context, Q3 returns for private equity still outpaced the quarterly returns of the S&P 500 and STOXX Europe 600 and were still above private equity’s five-year quarterly average.
According to research by Private Equity Wire, the asset class is also positioned to perform well in a recessionary environment (see box below).
New paradigm
Speaking in June, the CEO of IK Partners Chris Masek was reported saying: “We believe there will be attractive investment opportunities at more reasonable multiples using more rational baseline metrics (cash EBITDA rather than multiples of ARR) with conservative financing. Investors will be taking their time to consider which strategies are the winning ones in this new environment where we see a move towards quality and tangible performance as the key differentiator. We believe our firm has long been prepared for this and will thrive in this new paradigm”.
Other established managers have been raising special-situations funds, which deploy capital into troubled industries and credit-constrained companies.
In June, JP Morgan’s asset management unit closed its Lynstone Special Situations Fund II, raising $2.4 billion beyond $2 billion target. Oaktree is currently marketing its third special-situations fund, seeking to raise $2.5 billion to $3 billion, and MidOcean Partners, is marketing Tactical Credit Fund III, to invest in stressed and distressed assets.
Indeed, when asked ‘Which private equity strategy do you expect to see the strongest returns going forward?’ in Private Equity Wire’s June survey, special situations/turnaround was the third most popular strategy for respondents, after buy-out and growth equity.
“We believe private equity has the unique ability to deliver flexible capital solutions in the private markets, so we’re spending a lot of time thinking through our areas of expertise, focus, capabilities, and the companies where traditional M&A financing may not be available, but where there’s an opportunity to invest,” says Daniel Penn, managing director at MidOceanPartners. “I think you will see funds with different mechanisms for capital deployment emerge in different macro environments.” 
