An inflection point: PE’s bright future

The thought leadership piece below was written as part of HVPE's June 2024 capital markets day

It is no secret that private equity has been hard hit by the change in market environment. It is one of a suite of listed alternatives that has seen its shares struggle in the face of rising interest rates and a weaker economic climate. Discounts to net asset value (“NAV”) have widened considerably, and buyers have retreated, despite valuations remaining resilient. However, the sector could now be at a turning point.

The size of the drawdown is not out of step with history. The scale of the peak to trough fall in the share price of listed private equity trusts has been witnessed before. Nor are the challenges that have driven the sector lower unprecedented - marginal buyers have been moving to fixed income, fund managers have faced redemptions impacting whole indices, interest rates have risen, and investors have worried about valuations. However, the duration of this fall is unique. Previous falls have lasted around 18 months on average. This downturn is now in its 41st month¹.

The macro environment has undoubtedly been challenging. The rapid rise in interest rates and spike in inflation has had a chilling effect on investment activity for private equity globally. The IPO market has been sluggish, with merger and acquisition activity also weak. To put this in context, investment activity and liquidity generation halved between 2021 and 2023.

The market is turning

However, green shoots are emerging, with several factors changing the outlook. The first of these shoots is that net asset values are back on an upwards trajectory, having remained stable throughout this challenging period. The NAV of the HVPE portfolio is up 4% for the latest financial year (ended 31 January 2024). This is below the long-term NAV growth, which is 13.4%, but represents resilient performance in a tough market.
There is increasing confidence on the NAVs of the sector more broadly. Private equity groups have introduced greater transparency around the calculation of NAV figures, which has provided reassurance to analysts and market participants. At the same time, greater IPO and M&A activity is confirming NAV as shown by the average uplift to carrying value. Today, valuations within PE portfolios are typically held at a discount to the latest funding round and look cautious even though public markets are hitting new highs.

Distributions are likely to improve

A weak IPO market and falling M&A activity has meant that distributions from maturing investments have been weak. Yet cash calls from existing investments have continued. This has reduced cash flow.

Yet there are more IPOs coming through globally and realisation activity is returning to normal levels. Reddit, Galderma and EQT were among the successful IPOs in the first quarter, while a potential Shein IPO is mooted for the London market. Merger and acquisition activity has notably picked up, with general partners and advisory boards reporting increasing levels of interest for their assets since March. Other sources of liquidity are emerging, such as continuation vehicles. This points to a significant pick-up in distributions and improving cashflow.

Optimising returns

The persistent discounts for private equity trusts to NAV have been frustrating. However private equity investment trusts have been taking clear action to optimise returns for shareholders throughout the cycle. For HVPE, this includes a new and significant distribution mechanism, designed to support an expanded buyback programme, plus marketing activities to help trusts reach a wider audience, explore new channels of distribution and build new demand for shares.

Buybacks are vital. This shows confidence in the assets and reduces discount volatility. In the longer-term, a recovery in distributions could be magnified by recovery in shares relative to NAV.

The macroeconomic environment

Interest rate cuts may have been deferred, but the Federal Reserve appears to be winning the battle on inflation and interest rates are unlikely to move higher. The global economy has swerved a significant downturn and economic indicators across the US, UK, Eurozone and much of Asia are improving. This is being reflected in the performance of individual businesses. This is creating greater confidence to invest and investment activity is likely to accelerate in the second half of the year.

Longer-term

Private equity is in a prime position to capture the next growth wave. It has consistently delivered better revenue and EBITDA (earnings before interest, taxes, depreciation and amortisation) growth than the public markets. The different sector mix is an important part of this strength, with higher weightings in areas such as technology, business services and healthcare, which tend to be higher margin and faster growing. For example, 20% of the HVPE venture and growth investments at a company level are identifiably dedicated to AI, machine learning and cloud computing.²

The HVPE portfolio is exposed to more than 1000 material private companies¹. They are distributed around the world and in various different sectors, and in different stages of development, from early venture, through growth equity and through to buy-outs. This brings real diversity of companies and opportunities.

There are, of course, still question marks. There is some unused capital waiting to be invested – will the best managers have the discipline to pay the right price? A greater volume of private equity investment is coming from the private wealth, rather than institutional investors and this may have an impact on the market.

However, the slowdown in private equity markets has been vastly exaggerated by the widening of discounts. There are signs of a revival across private equity markets, as the IPO market and M&A activity pick up, distributions increase, valuations edge higher and investment companies optimise returns for shareholders. The future looks brighter.

¹ As at June 2024.

² As at 31 January 2024