By Richard Damming, Head of Private Equity Investments, Europe at Schroders Capital

Although deglobalisation, decarbonisation and demographic change - the “3D Reset” – will keep inflation and interest rates higher for longer, global private equity returns have been robust throughout different macroeconomic and geopolitical periods. As such, investors can keep calm.

While inflation is moving steadily lower, we believe the secular shifts of deglobalisation, decarbonisation, and demographic change – the “3D Reset” - will keep inflation and interest rates higher for longer. With the added challenge of geopolitical conflicts, many investors are reassessing their private equity allocation. But almost every year since 2008 has involved a crisis for investors in private equity. 

And yet, double-digit returns have been earned by global private equity investors in every single year over this period, whatever the global economy and markets have thrown at them, recessions included. 

One reason why performance has been so resilient is that private equity funds benefit from “time-diversification”. Capital is deployed over several years, rather than all in one go. This reduces sensitivity to market events and means that the concept of market timing doesn’t make sense when it comes to allocating to private equity. Likewise, private equity investors are long-term asset holders without pressure to divest if market conditions are not conducive to return maximization. 

Rather than being a time for investors to worry about allocating to private equity, recession years have been a pretty good time to invest. Funds raised in bad times can pick up assets at depressed values as a recession plays out, and then exit later on in the recovery phase when valuations are rising. There are many value-drivers that go well beyond economic or domestic industry-specific growth. For example, mergers and acquisitions/consolidation, technical innovation, professionalisation, and export-oriented business models. These can generate value even against a challenging macroeconomic backdrop. 

But a tailwind from rising leverage and falling borrowing costs is ending. 

One factor that has been supportive through this period is cheap, easily available debt. This has helped more leveraged transactions “juice” returns, especially when accompanied by rising valuation multiples.  

With long-term inflationary pressures created by the 3D Reset, we believe the era of ultra-low interest rates is behind us. Debt will cost a lot more and leverage levels will be lower because higher interest costs will make it less appealing.

 But, offsetting this, falling valuations mean that it costs less to acquire a company today than it would have done 12 months ago. And the price reduction required to offset a lower level of leverage and leave returns unchanged is less than you might think. A 12.5% reduction could be enough to offset a reduction in leverage from 65% to 50% without impacting returns, all else being equal (see worked example). 

One change is that the types of strategies that look set to be more successful could look quite different to those that succeeded in the past decade. With leverage and rising multiples unlikely to propel returns, there could be a sweet spot for strategies focussed on revenue growth and profit margin improvement.

For example, expansion of product lines or geographic footprint, and professionalising management to improve profit margins. This is all easier to do among small- and medium-sized, often family-owned, companies. At larger companies, which have often been through several rounds of private equity or institutional ownership, it is much harder to add the same value. 

Buy and build strategies are also well positioned to do well, with opportunities to buy smaller companies, expand, improve profitability, and then sell at the valuation premium that larger companies go for compared with smaller ones. 

What about inflation higher for longer? 

The combination of ageing populations, slowing globalisation, and the transition to more expensive energy sources are set to keep inflation structurally higher. This is a global problem which is affecting all asset classes, across equities and bonds, public markets, and private ones. Private equity is not immune. As well as impacting leverage, as described above, the profitability of many companies will come under pressure as their cost base increases. 

However, not all will suffer. Those which are able to pass on higher costs into higher prices will prove more resilient. Those with weaker market positioning or whose products and services are more easily substitutable will struggle. This will increasingly differentiate between successful companies and successful private equity investors in the years ahead. 

Conclusion 

Investors in private equity need not fear the implications of structurally higher inflation and rising geopolitical conflict. Although the global economy continually faces challenges, returns have been strong through thick and thin. The tailwind from cheap interest rates may be fading but the ability to buy companies for less will go a long way to offsetting that. Funds focussed on smaller and medium-sized companies look to be particularly well positioned to navigate the times ahead. 

Further reading : click here